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Crashing Stock Markets Can Provide Opportunity For Longer Term Gains. But Do You Have The Stomach For It?

Sir John Templeton was a twentieth century American-born British investor, banker and fund manager. He entered the mutual fund market and created the Templeton Growth Fund, which averaged growth over 15 percent per year for 38 years. He once said, “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude.” Warren Buffett also once said that it is wise for investors to be “Fearful when others are greedy, and greedy when others are fearful.”

Easier said than done, I hear you say. How do you keep your head around you when everyone is losing theirs? Thinking contrarian has always been a great strategy and one which I have employed extensively over the years. Naturally, to be honest. Thinking differently to the crowd requires patience, discipline, and very little emotion. These are traits that sometimes have to be wired (or indeed forced) into your brain. Especially when you are losing money. Considering every asset class is down, it will pay to be less emotional, have endless patience and more discipline than ever. Testing times with investing. For all of us. Including myself. But I’ve been here before.

Way back in early 2009, and the last really terrible market in my 35 years of financial memory, the world was imploding. Through 2007-2009, what was known as the “financial crisis” actually began years earlier with cheap credit that fueled a housing bubble, which consequently collapsed – costing people jobs, savings, and their homes. Big institutions like Bear Stearns and Lehman Brothers, known for their risk-taking, also collapsed as they held onto large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages which people just couldn’t pay anymore and started to default he. Stock markets were getting hit.

The two-month period from January 1-February 27, 2009 represented the worst start to a year in the history of the S&P 500, with a drop of nearly 19 percent. By March 2, the Dow had dropped more than 50 percent from its October 2007 high. The decline has been compared to that of the 1929 Great Depression, which was 53 percent between September 1929 and March 1931. It was a mess.

Be Contrarian

I’ve always had a contrarian head about me. I’ve never been the mainstream and consequently I never get involved in fads or trends (sometimes to my detriment), but in March 2009, I had been watching the markets collapsing and felt that this had to end at some point. I needed a trigger and it was something out of nowhere which proved to be one. Stocks were getting cheap and I had the benefit of some smart analysts around me to help with valuations. It appeared that some of the great companies were selling for a lot lower than they were actually worth. The economy was in full-blown recession. Bankers and banks were blamed for taking big bonuses and sucking the consumer dry. The world was in turmoil. The markets have not seen anything like this since the September 11 attacks. Unemployment reached 10 percent. About 4 million Americans lost their homes to foreclosures, which were up 81 percent in 2008 and 225 percent compared to 2006. News couldn’t have been worse. The question for me was, where does this end?

I was reading Barron’s newspaper one Saturday morning in March 2009 and I opened the front page. I cannot remember specifically the title of the article, but it was a piece speaking about the turmoil in the markets. The whole paper was full of bad news, in fact. I remember one distinct line that said, “… the small investor is selling.”A lightbulb went on. I knew from experience (and particularly the experience of the dot com bubble in 2000) that the small investor is always the last to get in and the last to get out. This was the opportunity I had been waiting for. I identified what I wanted to buy on my watchlist and ranked them 1-10, 1 being my highest conviction. On a separate note which we wont dig on the details, I went to the wife and asked about remortgaging the house to invest in stocks as this was an opportunity of a lifetime. I received a quick “no,” so that was the end of that. Anyway, on the following Monday, I was filling my boots with stocks that I believed were worth at least 100 percent more than what I was paying. Many of them were trading at their cash levels. The thing was it just didn’t feel comfortable at all, in fact it was quite scary. The market was handing me companies that I thought were free money, but ignoring emotion for you now as it was for me then, this could be the greatest part of your investing armory. The passing of the government bailout packages soon after the collapse stabilized the stock markets, which hit bottom in March 2009 and then embarked on the longest bull market in its history.

So what lessons can you take away from history and apply to todays markets? It’s a cliché, but history really does repeat itself and in particular with overall market cycles. I’ve been around long enough to recognize a big one and a larger one is definitely playing out right now. Consider the following broad framework for investing in the current climate.

The World is Cyclical

The world is made up of cycles. Lots of small, medium and large ones. They exist all around us. Planetary, organic, physics, as well as business and economic. Even the mathematics of the waves of those cycles. The Stock Market is also made up of cycles. One of the differences with Stock Market cycles compared to others that I’ve noticed through the years is that a hell of a lot of emotion is tied up in them. Look at the examples I have given before. How did you feel in 1992 in the depths of recession? How did you feel when the property market crashed in 2007 and how did you feel sitting on dot com losses in 2002? Consequently, how did you feel at the tops of those cycles before it cratered? Great, right? One thing to remember is that it always feels worse on the way down. As humans, we have a pessimistic bias which refers to the tendency to overestimate the likelihood of negative events while underestimating the likelihood of positive events. This can lead to a very depressive outlook on the world. The tendency to overemphasize the negative can have an impact on the choices that we make and the risks that they are willing to take. It’s the same principal as to why “bad news sells.” Furthermore, if you are constantly surrounding yourself with the doomsayers, you can get very despondent about the future and it’s shown to cause deep depression. The problem is that most investors and traders either fail to recognize that markets are cyclical or forget to expect the end of the current market phase.

Below is a great reminder of Stock Market cycles along with the emotion that goes with them. Personally, I believe we are some way between denial and panic, but that’s a subjective opinion. I have made some of my best investments on other people’s panic. This includes stocks, not just markets, so this can be applied to anything financially related. A cycle can last anywhere from a few weeks to a number of years, depending on the underlying cause in question.

Patience is Your Friend

Use the cyclical patterns of markets and stocks to aid timing on entry. Being patient and waiting for that right moment can save you a lot of stress and of course a lot of money. Financial crises in history often culminate in a big failure. LTCM (1998) Worldcom (2002) and Lehman (2008). Watch out for these sorts of events as they could signal a bottoming out. So recognize where we are right now, and as much as I don’t like to see failure, some institutions will spectacularly fall, and it’s here that it may signal some sort of bottom forthcoming. Stock market cycles have typically anticipated economic cycles by 6–12 months on average. The cycles are familiar — the economy expands and contracts and the markets rise and fall. Our emotions often get swept up in the recurring ebb and flow.

Being Ready

So you’ve identified where we are in the cycle. The next step is to choose your stocks. Keep a watch list. You can do this via Google, Yahoo or paid services that will alert you. Ensure you figure out what you want to buy, at what level and valuation, and how much your risk determines you should be filling your boots with. Being prepared is half the battle. We are the greatest investors in the world in hindsight. Sadly, this is where emotion will beat you up. Historically great purchases of mine have been made when the world is theoretically about to cave in. It never has of course, but your emotion will make you believe it and so you will miss that opportunity. As the great investor Peter Lynch once said, “The single most important lesson I’ve learned about being a successful investor is the need to maintain emotional detachment ”.

Lastly, a lot of these points maybe straightforward and you may even say you are already doing them. The question above all is what makes a stock move from price to value? Everything is cheap and getting cheaper by the moment. Some of the tech names I’m looking at right now I expect to go to zero. So where do you look if everything is on sale?

Look for under-covered names that have been discarded by the market. These can include IPOs made at the top of the market, new secondary listings, split offs, carveouts, Spinoffs, and orphan securities. Stocks that are ignored by research analysts and as a result may be trading at low price earnings ratios. Also look for companies that have announced strategic change. You are essentially buying more of a margin of safety and the market, in its malaise, will sell indiscriminately. You can also look for darling stocks that the small investor and media loved at the top. All these names are the first to be sold off when there is panic and blood on the streets as the majority look to exit the last thing they bought and also companies that have a limited trading history. We at The Edge monitor these types of potential investments and they have proven to outperform over any economic cycles.

  1. The World is Cyclical. Recognize the part of the cycle you’re in. The bottom is usually signified by an event, eg bankruptcy, etc.
  2. Ensure You Have a Watch List. Great opportune moments rarely stay for very long in markets. You should be ready.
  3. Make Sure There is a Catalyst to Move Price to Value. Try to buy something not just because it’s cheap, but because there is an added catalyst to move price to value. Eg up and coming corporate transactions like a Spinoff. You will get much more bang for your buck.
  4. Be Contrarian. Go against the crowd. You’ll win more often than not.
  5. Protect Your Capital. Finally, if you can’t make a head nor tail of what is going on, stay out of the market and remember, no one has ever been fired for making a profit.

To discuss the forward calendar of interesting names with a catalyst and how you can capitalize on our research, contact The Edge here. Follow me on Twitter or LinkedIn. Check out my website.

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