Only investing during major crashes/bear markets

Discussion in 'Economics' started by Cutten, May 25, 2005.

  1. Cutten


    It seems that every 3-4 years, somewhere in the world has a massive economic crash and/or bear market. I was thinking, what would be the potential rewards of investing *only* in places where a complete rout has occured.

    To give some examples from recent years:

    i) Asian stocks, Russian stocks, oil, and other commodities in 1998
    ii) Argentina and Brazil in 2002
    iii) World stocks in 2002-2003
    iv) G7 real estate in 1993-95
    v) Gold in 1999-2001
    vi) internet stocks after the bubble

    Although you can say there's an element of hindsight bias, in each of these cases the market in question was i) very cheap fundamentally ii) suffering extreme negative sentiment and media coverage iii) had fallen by very large % amounts relative to typical historical declines and iv) in many cases, there were significant reactions to the large price declines (e.g. street riots in Argentina in 2002 and Indonesia in 1998; Bank of England selling its gold, then the central banks limiting gold sales; OPEC restricting oil production in 98/99.) Furthermore, in each of these cases, the markets subsequently had very large rallies indeed in the following years. The rally frequently lasted at least 12 months after the bottom was in, and often went on longer.

    So I was wondering to what extent it would be feasible to invest major amounts only in markets which have had a huge crash, are dirt cheap, and would be trading at much higher levels once just "normal" valuations return. If we try to characterise these moves by looking at previous occurences, we find that:

    i) they have really massive declines before the lows are put in (e.g. 75%+ for stock indices, 50%+ for commodities, 80-90%+ for sectors, 95%+ for individual stocks)
    ii) they are incredibly cheap at the lows by all fundamental measures
    iii) sentiment is incredibly bearish, very few people stick their necks out and call for any rally at all, let alone a massive multi-year rally
    iv) the lows usually coincide with some major "bad news" event
    v) the subsequent rally usually lasts at least 12 months, and often goes on for many years. Generally it rallies far more than expected.
    vi) there are often a couple of sharp corrections during the subsequent rally (e.g. 15-25%), but the market bottom is never violated once the rally gets underway, and each correction low tends to hold once the market has rallied back.
    vii) once the rally begins in earnest, few people are in on it, and it takes a long time before sentiment becomes genuinely bullish again
    viii) the rally usually tails off once "bullish" signs appear, both in terms of fundamentals and sentiment

    It seems to me that identifying the cheapness is not that difficult - rather, the main risks are i) getting in too soon ii) getting panicked out during the height of the crash/crisis iii) selling too soon during the subsequent rally. This kind of approach would seem ideal for dollar-cost averaging, since the exact timining is difficult, and possibly for playing with long-dated call options once the lows appear to have been put in, since the subsequent rallies are very large and long-lasting.

    What are you thoughts on how feasible this approach is, how to play it, what techniques to use, and what the potential returns are?
  2. In theory this seems to be easy, but in practice it's difficult. A friend of mine tried this strategy and bought DaimlerChrysler at 57 EUR... which market would you invest in now?
  3. mokwit


    Was in Thailand pre and post crisis - You have described the stages pretty well, but calling the bottom is not easy Nobody thought Thailand would go to 207. WRT to valuations, what's cheap? Is a market that was at 3x book cheap at 1x? If it goes to half, which Thailand did then you have lost half your money.
    If it was a cyclical crash then there will be a false rally when interest rates come down See Thailand 1999.

    As for returns, pretty good and nobody would have believed Thaland could have gone from around 207 to 550 in the firts stage and then from around 300 to 800 in the second.

    Best way to avoid the risks you mentioned is to wait for he second stage which is on a more solid footing. there are ealy signs such as MNC' tendering for local subsidiaries, first new business's to open are short cycle cash generative e.g bars and restaurants. Resumption of dividends is probably the best fundamental indicator of a solid recovery and is not too lagging due to unwavering pessimism and disbelief. Thailand followed a pretty textbook cyclical progression with small caps in building materials, property and brokerages rallying first. Watch the local business people - e.g. in Thailand brokerage licenses from defunt brokers which could not be given away became something that was bid up.

    If it was a cyclical crash fundamental approach would be buying e.g cement companies at half replacement cost and selling at maybe 2x e.g Siam Cement SCC. What you are looking for is operating leverage i.e demand returning against a fixed cost base from already in place capacity. This is why early rally can be very steep as earnings growth goes through the roof from a low base. . The exponential money was made (by some) in companies that used the stock market to recapitalise and reduce debt. At the height of the negative sentiment a wise old bird told me this was so and it was.

    Look for companies which have had an active market through previous cycle as the ones that are likely to perform in the next as promoter managemnent start the game all over again, but be aware that due to overcapacity last cycle sector leaders may not recover until the next cycle after eg US Tech ? Go for cyclicals, staples not the dot coms. Somebody wrote in the 1930's how ridiculous the prospectus for a concept stock looks 2 years later.


    P.s A book with some good pointers on cyclical investing is Investment for Appreciation by Angas - if ROSO is the best book on trading this is the best on investing - written in the 1930's but reprinted .
  4. ''Every 3-4 years'' would require certain personality;
    and to use one of you examples Cutten, I dont understand Russian. But did notice they can be difficult on capitalists.

    For sure would want to scale in;
    and not try to predict a one time event.:cool:

    Some sectors, even this year are still in long term polar bear markets;
    like bull markets also.
  5. First you would have to recognize capitulation in the form of price and volume. Then $ cost avg in. Thats the only way to go...and have a looooong time frame. I have considered this in the U.S markets before. You know that old statistic that most % returns are made in so many days a year? Well what if you only bought in your IRA on days that the mkt was down greater than 1 or 2%(rare I know). I am sure that you would clobber the avg`s....just a thought.
  6. Cutten, I love your thinking. If only I could study enough charts to know how difficult it might be. I will say though that there are somewhat repeatable patterns in crashes. Just check out Sornette's anti-bubble theory and how many times that basic downdraft to reinflate to downdraft pattern shows itself. Its uncanny.

    As for the buy when there is blood in the streets argument, Niederhoffer has an interesting study on his site today regarding buying the Dow when it has been beat up for a couple years. Interesting.
  7. Cutten


    I appreciate it's tricky to time the exact lows, and I wouldn't try to do that, hence averaging in. I've traded whilst watching quite a few of these crashes/bear markets develop day by day, and after watching them for 10 years I think I've developed a bit of a feel for when the lows are in sight. You can't time the exact bottom, but I think you can time it so that your risk is maybe another 20% down rather than 50%. I'm well aware that "cheap" can become "dirt cheap" - but your defence against that is averaging in, timing, and patience on entry.

    In a way this is more investing like Buffett, Templeton etc, as you are using extreme valuation discounts to reduce your risk, rather than using stops. You may well suffer short-term quotational loss, but are unlikely to suffer permanent capital loss if you wait for severely discounted prices and capitulation/panic selling. In terms of timing, I've found that if you wait for things like street riots, IMF rescue deals, major corporate bankruptcies, country mutual funds falling 90%+ in assets, investment funds going to 30-40% discounts etc, that this means you don't normally have a huge amount of time left before the bottom. Maybe you can see another 20-25% drop, but if you only invest say 1/3-1/2 of your capital at this stage, then you have firepower in reserve if the market gets even cheaper.

    A further idea for these events is to choose closed-end investment funds - firstly, they tend to do better in a rally than the main stock index, and secondly they are often at massive discounts to asset value. If you buy them near the bottom of a crash, and sell a year or two later once sentiment becomes positive, then you not only get the asset value appreciation, but you make a 50% plus gain as the discount goes from 30-40% to 0% or even a slight premium.

    Regarding a cheap market getting cheaper, one "trap" you can fall into is using outdated or inflexible measures of valuation. During a crash, book value and earnings are often extremely difficult to ascertain or rely upon. There's no point buying a bank on a PE of 4 if it's "E" is going to be massively negative, and bankruptcy is likely. A book value of 1 is not cheap if the value of assets nationwide has collapsed. My preferred valuation method for crashes is market cap to sales. During normal economic times, businesses in each industry sector tend to have an approximate price to sales range, which is driven by the sustainable margins they can make. A business with normal sales of $100 million, which can earn a typical 5% margin, can be expected to make around $5 million during normal times. During a good market it may be on a PE of 20, giving it a P/S ratio of 1 and thus a market cap of $100 mill. Now in a crash, earnings will often go negative, and sales may be down significantly. So let's say this company during the bear market has sales of $70 million and losses of $20 million. Often in a crash you will find such a company selling for 20 or 10 million, sometimes even less. Any time you can buy a company for 10 million, that has 70 million of sales even in an economic crisis, and has 5% margins during healthy times, then as long as the company does not go bust, you have a bargain on your hands.

    So I would be looking for companies that have great financial stability e.g. dominant blue chips that are financially sound, have a stable business, and are not very leveraged. Things like tobacco or drinks companies, newspapers or radio stations, as opposed to banks, property developers or automobile manufacturers. You can reasonably accurately determine what these stocks are worth during normal times, based on their sales and typical P/S ratio. This then gives you an idea of the potential discount involved. If the typical P/S is 1, and you can get a P/S of 0.2 on depressed sales, then that is what I'd call cheap.

    You can either pick up a diversified portfolio of these defensive stocks, or simply wait until they are dirt cheap and then buy the market as a whole. I haven't analysed which sectors tend to perform best coming out of a crash, but that is worth doing too. If the general market is going to triple, then outperformers should quintuple or more.

    P.S. someone mentioned Daimler/Chrysler - I don't think that's an example for two reasons. Firstly, it is a single stock - you should never invest in a single stock in a crash/bear market, but rather a diversified group of stocks. Secondly, the US was not in an economic meltdown at the time that your friend bought this stock. It had a once in a generation bear market though, and if he had bought the S&P on this basis, he would have done quite well. Third, automobile manufacturers have a very real risk of bankruptcy even in normal times - they are bad businesses with poor financial stability.
  8. Cutten


    Good points. I would just point out that if you have studied many previous crashes, especially in emerging markets, there was nothing really surprising about how far Thailand's stockmarket fell or subsequently rallied. This is partly what I mean by learning patience. Value investors who have not studied prior crashes or watched them develop day by day, will tend to be early and suffer big initial losses. More experienced crash observers can usually avoid the worst of this by having patience and waiting until they see blood on the streets.

    Regarding the issue of a "cyclical" rally - I don't think this was why the Thailand rally only lasted a year and a half. Rather, I think its subsequent decline was because western stockmarkets in general had a once in a generation bear market of massive proportions from 2000-2002, and its main export markets also had a moderate recession and a bust in the tech & telecoms sector. If you look at other Asian markets, they also suffered from 2000 onwards - I think the reason was because their main export markets were slowing down. Whereas Russia, for example, did not have the same problem as it was more driven by oil & gas, and the domestic market (e.g. Russian banks), than by hi-tech exporters.

    I like your "signals" of the corner having been turned. MMCs bidding for local companies was definitely something you saw in 1998 in Asia. Signs of normal business activity picking up are also useful. Rather than use them to time entry though, I think I would rather use them to time exit - i.e. do not sell out until dividends, P/S ratios, cost of brokerage licenses & other typical business assets, takeover activity etc are back to normal levels.

    I will check out the book you recommended, it sounds interesting.
  9. Cutten,

    I read some research that showed the Australian equity market had only had two consecutive down years in a row twice since the great depression.

    During the asian crisis the Aussie market pulled back about 500 points from a high of about 2850 and has basically gone straight up since.

    So if you get a 20% pullback and a down year, buy high yeild stocks with as much leverage as you can get your hands on.

    You can usually pick up stocks with a PE of 8 or 9 and the divident basically covers the loan, so carrying the position is basically free.

    Martin Zweig also used the 5th or 6th interest rate rise as a potential exit point. As well as an inverted yeild curve.

    Although I prefer the taxi driver exit. When my taxi driver recommends a stock, I know it's time to get out.

    And hold for 4 to 8 years.

    4 years being a half cycle and 8 being a full boom bust cycle.

    We are coming right into the half cycle now and I think we will see a scare in the next 12 months. These events usually give the market the chance to sell off so a firm base can be established befor the next big leg up.

  10. Runningbear,

    Any idea what makes the Aussie market so resilient over time? Is there something with their economy or resources? I noticed it was up big last year in a strong trend.
    #10     May 26, 2005