Follow the Herd, End Up In The Slaughterhouse & Other Cliches

Cejay Kim August 5, 2015 Category: Research

This cartoon, drawn by Keven Kallaugher (KAL) in 1989, was featured on cover of the Economist and it's surprising how relevant it remains.

What we see is the classic case of 'herd instinct', or the mentality in which an individual lacks unique decision-making and simply acts in the same way as the majority around them. In finance, this means investors gravitating towards buying and selling the same investments at the same time. "Following the trend" investing is the cause of significant rallies or sell-offs, and most of the time is extremely irrational.

So who is buying when everyone is selling?

Investors who can remain cool when everyone else is panicking. These investors are called contrarians and are value investors who go against the grain, buying stocks that are performing poorly and selling when performing well. Some of the most renowned super-investors are contrarians, Warren Buffett can attribute the majority of his wealth to taking advantage of the masses.

“The time to buy is when there’s blood in the streets.”

We have heard this saying a million times, first coined by Baron Rothschild, a notorious war profiteer. But when exactly is the right time to buy? For this, we retrieved data from Kenneth French's data library, looking at country, industry, and sector data all the way back to the 1920s and calculated the returns after steep declines.
What we found was anyone who is brave enough to buy when the markets are down 60%, 70%, 80%, and 90% will be rewarded.

An industry is a group of companies operating in the same business. The average three-year nominal return after a significant decline indicates that the value remains despite the drawdown. After a decline of -60%, 70%, 80%, and 90%, the returns are 71%, 96%, 136%, and 115%, respectively.

There appears to be a greater reward when buying a basket of stocks within the same country after a significant drawdown. After a decline of -60%, 70%, 80%, and 90%, the returns are 107%, 116%, 118%, and 156%, respectively.

Lastly, the greatest return is realized after a significant drawdown is buying a sector, an area of commerce in which companies share a related good or service, like mining or energy. After a decline of -60%, 70%, 80%, and 90%, the returns are 57%, 87%, 172%, and 240%, respectively.

When a market is hammered, the average three-year return thereafter is higher than the sell-off.
One market that has been experiencing such a sell-off is the TSX Venture, which is primarily composed of the mining sector and is currently down ~75%.

Just like the results from French's data, the bull market following every bear has returned investors significantly more than what they lost. In the history of the TSX Venture, there has only been one bear market that has lost more than where we sit at right now, the 2008 Financial where in 408 days the Index lost 79% of its value.

We have been scraping the bottom in the current bear market for over 1,075 days and everything is screaming to buy now for enormous gains.

But do you have what it takes to be a contrarian?