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The despondency index

Created:
22 January 2008
Written by:
Mr Bearbull

Now, I don't want to be rude but, every time I mention John Templeton, I have to check whether the old boy is dead. That's how it is when someone gets into their 90s, though, in Sir John's case, I should have had more faith. He passed his 95th birthday a couple of months ago and, in so doing, strengthened the body of evidence which says that one way to ensure a long and successful working life is to immerse oneself in the art of equity investment. He has almost caught up his near contemporary, Philip Fisher, who died in 2004 aged 96, having given us a fine investment text, Common Stocks and Uncommon Profits , as well as an outstanding investment record. Meanwhile, Walter Schloss, an unsung hero of value investment, is still going strong at 85. Even the great Warren Buffett is well into his 78th year, as is George Soros.

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But back to John Templeton. Nowadays he is concerned with giving away his fortune, but when he was still building it, via the Templeton unit trusts, one of his most cited investment aphorisms was in praise of contrarian investing. "It takes patience, discipline and courage to follow the contrarian route to investment success," he wrote. "To buy when others are despondently selling; to sell when others are avidly buying."

If the despondency index truly is a gauge of when to buy, we must be on the verge of a powerful bull market. After all, what can produce more despondency than the sight of bond insurers - the firms that guarantee that so-called Triple AAA bonds are what they say they are - getting into trouble? In any market, if the insurers don't - or can't - pay out, then the assumptions on which it is built become illusory.

Simultaneously, other indicators - both qualitative and quantitative - point to opportunities in UK equities. Scores of investment advisers are peeping above the parapet to say shares are cheap. Some - not investment advisers, but company directors - are putting their money where their mouths are and buying their companies' shares. For example, directors in damaged consumer stocks Marks and Spencer , Topps Tiles and Marston's have all bought shares this month.

Meanwhile, there is no shortage of valuation metrics saying "going up". Take the Rule of 20. This is a quirky rule of thumb that goes as follows: add together the PE ratio of a country's stock market and the country's rate of inflation. If the sum is less than 20, then shares are cheap. If the answer is over 20, shares are dear. Ostensibly, the rule sounds like mumbo jumbo - why should the key number be 20? - but, crudely at least, it has some logic based on the link between inflation, interest rates, bond prices and equity prices. If inflation rises, it will drive down the price of bonds, then equities. But when inflation is low, that offers scope for lower interest rates and that stimulates demand for bonds, then equities. In the UK, the sum of the market PE ratio and the inflation rate is below 16 (11 for the market PE ratio and 4.3 per cent for inflation). True, this rule worked better in the 1970s and '80s when inflation often got into double figures. Even so, intuitively you can grasp the idea, and 16 is the lowest it has been since 1988.

Currently, however, no amount of bullish investment aphorisms or rules of thumb impress me. Nor does directors' buying, which, ostensibly, is the strongest assertion of the cheapness of specific stocks. When a director buys in circumstances like today's, it is more an affirmation of faith in the company than an objective assessment of the value of its shares.

There is nothing wrong with that, but it's out of tune with the times. Faith in financial systems - let alone companies, their profits and dividends - continues to ebb away, taking stock market valuations with it. Investors have no appetite for risk. They only ask themselves: how deep will the recession go? How far will company profits fall? So, it does not really matter, for example, that London's All-Share index trades on just 11 times earnings. No one really believes the earnings forecasts on which the PE ratio is based anyway - and rightly so.

No surprises, therefore, that I am still inclined to go short of shares. True, thanks to its short positions, the Bearbull Hedge Fund is the only Bearbull portfolio that has performed decently lately. But, I want to profit further from the pessimism while it lasts. Five stocks in particular - Cadbury Schweppes, Carphone Warehouse, Enterprise Inns, Unilever and Victrex - look like good ones to short. That's not because of specific deficiencies in their underlying companies, but more because their share prices have held up better than peer companies.

By the time you read this, I should have short sold two or three of these stocks. But I will set tight stop losses because, in the medium term, John Templeton's aphorism is likely to prove right. Certainly, stock market history tells us it will. Meanwhile, as the mayhem continues, it may be best to remember another market maxim - this one from the 19th century writer, Charles Mackay, in his Extraordinary Popular Delusions and the Madness of Crowds: "Men, it has been well said, think in herds; it has been seen that they go mad in herds while they only recover their senses slowly and one by one."

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