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Why It Pays to Fight Fear, Embrace Bad News, and Buy 'Maximum Pessimism'


The stocks that everyone is afraid of are the stocks you consider first.

For many years, Western leaders have leaned on a trope about the Chinese language: the idea that the Chinese sino-characters for "danger" can also mean "opportunity," and thus, that the Chinese see opportunity in a crisis.

In fact, this concept has been thoroughly debunked by academics, but it's still put to use often, perhaps because people like the idea of turning danger into opportunity.

In the markets, it's a bit different. What prevails is that notion that perceived danger equals opportunity. The irony about markets is that, when a stock or market drops and becomes very cheap, people, in turn, become scared to buy it. The average investor reasons that because the stock has dropped, it will drop further. However, usually after something drops a great deal (70-90%), it has reached a greatly undervalued level and often will turn around and rally.

To illustrate this point, I will use a chart by Mabane Faber Research. It shows returns on sectors in a 3-year period, after they have fallen 60-90% in value.

Average 3-year nominal returns when buying a sector down since 1920s:

60% = 57%
70% = 87%
80% = 172%
90% = 240%

As you can see, after a sector falls 80%, the return in the next three years is 172%. When stocks fall 90%, the 3-year return is 240%. Clearly, the greatest returns tend to occur after stocks fall a great deal. For example, Greek stocks fell 95% until their lows in July 2012 and have climbed nearly 100% since this low! This has occurred in spite of horrible economic news during this time frame.

Part of the reasons for these returns is basic math. If company ABC falls 80% from $10 to $2 per share, it only takes a rebound to $4 for it to go up 100% in price. Another reason is sentiment. When a stock goes down this much, people become very negative and dump it; selling brings on more selling. Because you can make money on the short side, the stock going down usually attracts short-selling. (For example, there was huge shorting in bank stocks after they fell 80 to 90% during the financial crisis.) So when the turn comes, these shorts all have to cover en masse, and this short covering only makes the move to the upside very violent. In addition, as most investors have already dumped their shares, the selling pressure is basically gone on the way up as well.

You may ask: Why do most investors not buy when something has collapsed and is so cheap? The easy answer is psychology. When something has fallen a great deal, there is usually terrible news, huge losses at the company, a terrible outlook, etc. However, if you want to be a contrarian, you must embrace this bad news and look beyond. Sir John Templeton himself even said that he had no interest where the outlook was good; he was interested, only, where the news was terrible!

About this new column:

I am the editor of, which I have operated since 1998. I have survived the tech bust, real estate mania, and the beginning of the bursting of the bond bubble. In my first book Stock Market Panic! (Productive Publications), published in late 1998, I predicted the bursting of the tech bubble and foresaw that gold and other commodities would start a multi-year rise. My second book, The Great Super Cycle (Wiley), published in 2010, focused on the debt crisis that the West (especially the United States) still faces. The book also analyzes the shift of economic power to Asia and the East.

I learned about Todd Harrison and Minyanville through a friend who informed me that Todd also happened to be a long-suffering Raiders fan. I thought he must be a good guy. In addition, his site was one of the best and most informative financial websites on the market.

This article marks the launch of my weekly column, which will look a little different from those of most financial authors. I will not solely focus on the Dow Jones Industrial Average (INDEXDJX:.DJI) and the S&P 500 (INDEXSP:.INX), which as it happens, I see as very overvalued at the moment. (They had a huge run from their 2009 lows and do not represent much value or opportunity to the long side.)

Instead, we are going to look at the beaten-up, unwanted, and unloved sectors worldwide. My mentor was the late Sir John Templeton, whose steps I followed in many ways. For one, we both relocated from North America to the sun and beaches of the Bahamas. Secondly, I have learned to adhere to his philosophy of "buying at the point of maximum pessimism."

It is my mission, in the coming months, to provide you with informative articles that you will find both entertaining and educational. It's my hope to deliver to you a whole new perspective.
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