April 4, 2023

Has the Market Hit Bottom?

In 2001, the world was still reeling from the 9/11 attacks on the World Trade Center in New York City. Tensions were mounting in Iraq. Terrorists bombed a nightclub in Bali and took hostages at a Moscow theater. Accounting scandals had shaken investors’ belief in the ethics of senior management. CNBC began to present television programs on shorting stocks.

That was one of the darkest days in financial history. After touching 969 in October 2002, the S&P 500 turned around when military operations began in Iraq. When Iraqi forces crumbled, relief swept the financial markets. From March until December 2003, the S&P returned 40.7%.

Boardroom steals and deals

Investors willing to take the plunge in early 2003 were richly rewarded. But group thinking creates consensus, and there is ample justification for taking a cautious stance. As a Japanese proverb goes, “The nail that sticks its head up is the one that gets hit.” You can’t get fired for making an acquisition when everyone thinks it is safe. But you can get the chop for making a move that appears rash or unwarranted. Although you might benefit eventually, it can be hazardous to your career in the short term.

Corporate governance does not encourage contrarian executives to go out on a limb. Boards vet every transaction, and any deal that appears maverick will not be approved.

Decision-makers are not necessarily rational. Senior executives are subject to the same emotional biases as other mortals and share the same emotions that reinforce their vulnerability toward statistical illusions. The lesson of statistical illusions is to avoid excessive pessimism or the belief that next year will be an incredible one since this year has been so bad. We can only observe a small sampling of peaks and troughs when we study the charts, but we treat them as if we had much more data than we do.

We are all guilty of overconfidence. That means we use confidence bands that are much narrower than warranted to reflect the degree of uncertainty we are specifying. The key is to be very clear about how much information is available for building conviction.

When the crowd is beating down the doors for the latest hot product, executives are comfortable joining the stampede. However, when the herd retreats, investors require solid confirmation of recovery. Typical executive behavior is a “wait and see” approach that does not always work. Prices adjust to current perceptions, so if you procrastinate too long you will miss opportunities.

Firms are concerned with whether they are purchasing assets at a price that generates positive returns and added economic value. That can be achieved at any time and need not take place at the bottom of a market. But if you can acquire an asset for 60% of its intrinsic value, surely that facilitates the task of finding returns that exceed costs.

Hunting for value

Bottom spotters take their pick among a slew of favorite fundamental and technical indicators. Start with the basic premise that most markets eventually revert to the mean. The challenge is to avoid the tendency to overshoot in either direction. Capital flows to what has been done well; it propagates and forms bubbles.

Investors take into account price/earnings ratios, book value, price to growth, price to sales, dividend yield or whichever metrics they fancy. Most value managers set a threshold at which they will buy, even if it means holding their breath while the market goes lower into bargain territory.

How can investors and executives identify today’s best bottoms ahead of the crowd? Inflation and rising interest rates rattle confidence and distort perceptions. It is never easy to make judgments from the eye of an ongoing storm. As we wait for the post-pandemic market to regain equilibrium, some good values may still be lurking in the bargain basement. Every shopper knows that it takes effort to locate the best deals, but remember 2003 and be patient.

Your financial adviser can suggest some areas where you may be able to find undervalued investments.

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