Long Term Investors Would Do Well to Be Contrarians Right Now

The U.S. stock market rebounded last week and it was a breath of fresh air to see things headed up for a change. Interestingly, last Tuesday saw one of the largest single-day gains in U.S. stock market history coincident with a consumer confidence report which registered its 3rd worst month-over-month drop in history. As many readers are aware, such a contrary reaction to bearish news is a bullish indicator that can signal that a market bottom has either been reached or is near.  We have seen quite a few volatile swings in this bear market, but this one was different because the gains were sustained through the remainder of the week.

As you will see in the valuation chart, the price-to-peak earnings multiple jumped to 10.9x this week. We have said for the last few weeks that the market was oversold in the near term and valuations have not looked this cheap for a good many years, but over the past few weeks, the market has been dominated by fear and uncertainty rather than valuation. Perhaps last week’s gains do presage that bearish capitulation has occurred, but we are not market timers and will not try to be. However, for long-term investors, these are justifiable price levels to consider as an entry point into an undervalued stock market.

The percentage of NYSE stocks selling above their 30-week moving average rose to 7% this week in the positive market movement. While this is an improvement in the sentiment indicator, it is still at an extreme oversold level that is seldom seen.  Since we began publishing the Enterprising Investor’s Guide nearly 20 years ago, we had never had this indicator drop below 12% until now. In fact, over the last four weeks, this indicator has been below the 10% sentiment level the entire time. In the past, long-term investors have done well to be contrarians when a clear trend is established, such as the bearish one in the equity market right now. The simple reason for this is that conventional wisdom is often wrong. As we have said before, this is not a short-term market timing instrument but a way to view the market in a broader context. We believe that a deep recession has already been baked into the market at this point. What it really needs now is a bit of stability in order to find its footing and last week was definitely a step in the right direction.

Our asset allocation model is advocating our highest amount of exposure to the stock market right now for investors with a long-term time horizon, of course. We are living through a very unique time in market history right now, as every investor is keenly aware. However, in every instance in the past when historically low valuations have coincided with overwhelmingly bearish sentiment indicators, value investors have been able to find once in a lifetime entry points into quality stocks. A survey by Barron’s of “Big Money” managers found that most are quite bullish right now. The article stated that: “17% remain bearish on stocks, but only 3 out of 70 see the Dow closing out 2008 lower than Monday’s (10/27/08) close of 8175, and only one thinks it will be trading below 8000 next June.”

There are some investors who have been waiting to see the market start to rebound before getting back in, and that is not a bad idea given the uncertainty and emotion driving the market right now. One of these uncertainties is the election for the President of the United States. In our opinion, the market will respond favorably to a victory by either candidate, but look out for a “hanging-chad” event where there is a lingering uncertainty…financial markets hate uncertainty.

Comments

[bbowen7:]

Encouraging, but the problem with statistical analysis of history is that we may be at an inflection point - the game may have changed. We have been increasingly living on a credit card for twenty years, and that game is over. Going forward we will have to pay our bills, if not repay some of that debt. And it is unclear that the new president and Congress will have anything of a "balanced budget" mentality - meaning that inflation will be rampant. Better for equities than debt, but not good for either.

2008 Nov 04 11:39 AM

[john1940:]

rightinsanfrancisco adds important points to consider. Also, shouldn't we be seeing something positive somewhere in the world before we call a turn? These historical graphs are fine for a historical perspective, but I'd feel better with some positive data on inflation, jobs, consumer spending, etc.

2008 Nov 04 12:25 PM

[Schweizer:]

There is no way in hell that this bottom came and went in a month. Get real.

2008 Nov 04 07:19 PM