When Things Can't Get Any Worse

Renowned investor John Templeton once advised investors to buy at the point of maximum pessimism. The problem with this advice is that there's no one to tap you on the shoulder and say, "OK, we're here, back up the truck!" But there are clues that could signal when that point is near.

Irrational selling
For the most part, the stock market does a good job of telling us what a company's worth, and stock prices are generally rational. However, there are times when Mr. Market gets downright depressed.

The best example of this is the Black Monday in October 1987, when the Dow dropped nearly 23% in a single day. If that's not a flashing light that irrational selling was at hand -- I don't know what is. Anyone who bought shares of almost any stock during or after Black Monday would've made money within a couple of months.  

One-time tragic events
Lightning rarely strikes twice in the same place, and once is enough to scare most people away. After the horrible events of 9/11, tourism basically ground to a halt. But anyone who bought shares of travel-related stocks like casino operator MGM (NYSE: MGM  ) or airplane manufacturer and Stock Advisor recommendation Embraer (NYSE: ERJ  ) after that tragedy would've doubled their money within a year.

As a young man, John Templeton famously put his money where his mouth was after World War II broke out. He bought shares of every company trading below $1 on the New York and American Stock Exchange and eventually quadrupled his money.

The B word
Few things are more terrifying to stock investors than bankruptcy. The mere hint of bankruptcy sends even the hardiest investors running for their brokers to unload. After all, no one wants to live in constant fear of waking up and finding out that a bankruptcy filing just put a gigantic hole in their portfolio.

For professional analysts and portfolio managers, recommending or owning a bankrupt stock could put them out of a job. The trick here is to buy stocks on bankruptcy fears only when there's absolutely NO chance of the company going bankrupt.

Warren Buffett bought shares of Wells Fargo (NYSE: WFC  ) when unfounded bankruptcy fears drove the stock to its point of maximum pessimism. You can find more detail of the situation here.

Recently, bankruptcy fears sent E*Trade Financial (Nasdaq: ETFC  ) shares down 60% in a single day. I haven't looked closely enough at the company to have an opinion, but the only way I'd advise investors to jump in is if they have a strong conviction that the chance of bankruptcy is extremely remote.

Can things get worse?
For homebuilders, the answer is clearly yes. Although even the most solid homebuilders, such as Toll Brothers (NYSE: TOL  ) and Motley Fool Hidden Gems pick M.D.C. Holdings  (NYSE: MDC  ) , trade at below book value, there are several scenarios where housing stocks fall further. For example, to date, no major homebuilder has gone bankrupt. All it takes is one to send the entire sector into a temporary freefall.

Of course, this doesn't have to happen in order for the sector to bottom. But it could happen, so it might be a better bet to wait and see.

Foolish thoughts
Trying to pinpoint the bottom can be a terrifying exercise. It's often said there's very little difference between being early and being wrong. That said, investors will probably have a better accuracy rate when they:

  • Look for irrational selling.
  • Wait for one-time tragic events.
  • Buy on completely unfounded bankruptcy rumors.
  • Buy when they can't figure out how things can possibly get worse.

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