Investing Using the Principle of Maximum Pessimism/Optimism

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
~ Sir John Templeton

This famous quote from John Templeton outlines an investment strategy in broad terms that is counter intuitive to the way most people invest, but if applied properly can reward the patient investor with handsome returns over the years. The difficulty in applying the strategy is controlling investor emotions to not get caught up in the euphoria of a rising stock market and having the discipline to wait for those moments of maximum pessimism or optimism. But one important thing to keep in mind in looking for these opportunities in maximum pessimism is that we are not talking about individual companies, but entire industries or countries where a broad basket of stocks can be purchased to control individual security risk and we are looking for a catalyst to drive these stocks higher.

Let's examine some of the moves that Templeton made during his lifetime applying this principle:

1. WWII. In 1939 as the Great Depression was ending, WWII beginning, and much of the US was fearful the Depression would deepen, Templeton foresaw the wartime economy would drive up the demand for commodities and industrial materials.  As a result he invested $10,000 in104 stocks on the US exchanges trading under $1, 37 of which were already in bankruptcy.  As these positions were gradually sold off over the years, Templeton earned a 4 fold return.
2. The Rising Sun. In the late 1950's Japan was viewed as a low-wage manufacturer of cheap, shoddy goods.  Templeton believed that Japan was committed to growth and quality improvements, and as a result of their improved position in the world economy would have to open up their capital markets to foreigners.  In the early 1960's, when Templeton bought in, the Japanese markets traded at a PE of 4 compared to 19.5 for the US with twice the growth rate, 10% verses 4%.  From 1960 to 1990 the Japanese index increased 36 times its original value.  Templeton sold most of his positions before the market peak when he thought they were fully priced and found better values elsewhere.
3. The Regan Revolution and the Return of Optimism. In the early 1980's following the malaise and stagflation of the Carter years, the US was in recession with interest rates raised artificially high to break the back of inflation.  At this time many stocks in the US had fallen to single digit PEs, many people thought the US was in decline, and magazines were running headlines like The Death of Equities (a great contrarian indicator).  In 1979, the PE on the Dow stood at 6.8, book values around one or less, and almost everyone had given up on the market.  With inflation running at double digits, he reasoned the replacement value of assets was much higher than what was carried on the books, and that if corporate profits returned to their historic growth rate of 7% and inflation was reduced to around 5 - 7% that compounded corporate profits could double in 5 years.  
4. The Internet Bubble.  In the go-go 1990's anything associated with the .com revolution commanded astonishing PEs, whether the companies had any sale as assets to back up those stock prices. This was a bubble of historic proportions, similar to the tulip bulb bubble in Holland or the South Sea bubble in England.  Maximum optimism is an understatement in describing the valuations of many of these companies.  The PE of the NASDAQ had climbed to 151 by 1999.  The IPO market for Internet companies was going crazy.  Templeton sold these technology companies short, concentrating on the stocks that had risen at least 3x above their offer price and timing his short position days prior to the lockups expiring, giving insiders the right to sell their shares.  His reasoning was simple: with little behind these companies other than hype, when the last buyer has bought and no more buyers are left there is only one way prices can go-- down.
5. 9/11. Following the horrific attacks on the World Trade Center and the Pentagon, the stock markets were closed for close to a week.  Looking to capitalize on the initial panic and subsequent recovery, Templeton did something few would have expected.  Believing the government would not let the airlines fail, he placed limit orders on the 8 major airlines at 50% below their pre 9/11 closing price, not as long term trades but short term speculations.  Three of these orders triggered and when he sold these stocks in February of 2002, he pocketed gains of 61%, 72% and 24%.
6. The Asian Currency Crisis. Triggered by the devaluation of the Thai currency, a chain reaction of selling ran through countries like Thailand, Malaysia, Indonesia, the Philippines, Singapore, and finally South Korea.  South Korea caught Templeton's attention, having one of the world fasted GDP growth rates, a high domestic savings rate, and a trade surplus.  At the end of 1997, when the country could no longer afford to defend the won, the currency collapsed along with asset values and its stock market.  South Korea was forced to go to the lender of last resort, the IMF, who imposed reforms on the country to open up its markets and change many of its traditional labor practices.  South Korea also raised interest rates to protect its currency.  Templeton began to buy into the Mathews Korea Fund in late 1997, whose 64% decline made it one of the worst perform mutual funds of 1997, viewing that stock market as seriously depressed.  The PE of the South Korean market had fallen from 20 to less than 10 because of its poor outlook.  In two years, as the country and its markets recovered, and the Mathews fund became one of the best performing mutual funds of 1999, Templeton earned a 267% return on his original investment.

Recent opportunities to participate in moments of maximum pessimism occurred in the March of 2009.  At that time almost every market in the world was a bargain and it would have been hard to go wrong buying anything.  But three opportunities especially stood out at this time: financials, REITs, and homebuilders.  Opportunities abounded in the common, preferred and debt securities of each sector.  The common could have been purchased using ETFs to obtain diversity and would have paid off more handsomely than the market as a whole during the recent recovery, while the debt and preferred, with their handsome yields in the teens and twenties, would have to be purchased individually.

But the question each investor should continuously ask themselves is: do any opportunities exist in the market where maximum pessimism or optimism exist.  Today's opportunity may be in shorting bonds.  With the Fed discount rate near zero, the weak dollar and steep federal deficits interest rates will at some point in time have to be raising to protect the dollar, combat inflation and keep foreign investors interested in purchasing government debt.