The Scariest Market in Six Years

"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

Don't you wish you could go back to 2002 and invest when the S&P 500 reached the bottom of the last bear market? It would be nice. But it would have taken some courage to pull the trigger at the time.

See, according to the CBOE Volatility Index (VIX), 2002 was a very scary year for investors. Often referred to as the "investor fear gauge," the VIX measures expected market volatility over the next month; a value above 30 indicates market pessimism, and anything below 20 shows market optimism.

As we know, the S&P 500 doubled from October 2002 to October 2007, and investor confidence once again reigned supreme. Recently, things have taken a turn for the worse, following the fire sale of Bear Stearns (NYSE: BSC  ) , questionable actions by the Federal Reserve, and a continued housing slump.

These developments, taken with mounting concerns about a recession, may end up making 2008 the scariest market of the past six years. So far at least, the VIX seems to confirm an increasing level of investor fear:

Year

VIX Daily Average

Total Return of S&P 500

2008 (ytd)

26.13

(9%)

2007

17.54

5%

2006

12.81

16%

2005

12.81

5%

2004

15.48

11%

2003

21.98

29%

2002

27.28

(22%)

Source: Yahoo! Finance, as of March 28.

Time to test your resolve
In scary markets like this, it's never easy to muster up the courage to invest. CNBC is dropping the "r" word (recession) at least 20 times per hour and the Bear Stearns collapse is on the lips of common shoe-shiners across the country. Unfortunately, succumbing to this fear results in suboptimal returns.

Great investors like Sir John Templeton, on the other hand, have the foresight to add money in pessimistic markets.

In 1939, on the cusp of World War II, Templeton invested in the most beaten-down stocks in the most beaten-down market of his era. He famously borrowed money to buy 104 U.S. stocks trading for less than $1 a share. What's even more amazing is that more than 30 of those stocks were already in bankruptcy. Talk about investing at the point of maximum pessimism!

Templeton undoubtedly caught some flack from his friends. But he ultimately got the last laugh. Templeton had quadrupled his money four years later, and only four of the stocks ended up being worthless.

Finding today's values
Granted, the current market outlook is nowhere near as bleak as it was after 10 years of deep economic depression and with a war looming, but the major lesson still rings true: Buy when market sentiment is most negative.

One place to begin your search for today's values is the list of stocks that have recently hit new 52-week lows. For instance:

Company

Current Share Price

52-Week Range

SunTrust Banks (NYSE:STI)

$54.94

$52.94-$94.18

Delta Airlines (NYSE:DAL)

$8.61

$7.94-$21.95

Micron Technology (NYSE:MU)

$5.46

$5.42-$14.20

USANA Health Sciences (NASDAQ:USNA)

$21.34

$18.25-$51.50

Hansen Natural (NASDAQ:HANS)

$34.67

$34.47-$68.40

Pfizer (NYSE:PFE)

$20.50

$20.19-$27.73

Source: Yahoo! Finance, as of March 28.

While some of these stocks may have deserved their haircut, negative market sentiment may have exacerbated their declines into value territory, thus creating potential buying opportunities.

It's time for a pep talk
In scary markets like this, it's best to tune out the fear-mongering talking heads on TV and focus on finding beaten-down stocks with strong business fundamentals like free-cash-flow generation, market share expansion, and quality management.

This was the tack taken by Fool co-founder Tom Gardner in the December 2007 edition of Motley Fool Stock Advisor, when he rerecommended debt-rating agency Moody's to subscribers. 2007 had been a rough year for Moody's, and the stock's value was nearly cut in half. Despite widespread market pessimism, Tom confidently explained his investment thesis:

You may be thinking that I'm losing it around here; I'm recommending a company tied to the U.S. mortgage industry! But here's the gist: Of the 35 stocks on my side of the scorecard, I believe Moody's gives us the best shot at smashing the market over the next five years. Over the next five months? Perhaps not. ... I'm focused on your portfolio in 2012 and beyond, and I know Moody's is a stock you'll want to own.

While this pick has yet to prove itself, Tom has a good track record with Moody's. In fact, it was his first Stock Advisor recommendation during the scary market of April 2002. Even factoring in Moody's nosedive over the past year, the pick is still up 74% for subscribers.

Taken together, Stock Advisor recommendations are up 50% since the newsletter's inception in 2002, versus 14% for like amounts invested in the S&P 500. If you'd like to learn more about the Stock Advisor service, a 30-day free trial is on us. To take advantage of the offer, click here.

Fool contributor Todd Wenning watches Band of Brothers when he needs some inspiration. He does not own shares of any company mentioned. Pfizer is a Motley Fool Inside Value and Income Investor pick. Moody's is a Stock Advisor and Inside Value recommendation. The Fool's disclosure policy serves in a company of Fools.


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