'Maximum pessimism' is the time to buy. But have we reached it?

Markets bottom out when investors are at their gloomiest and all hope seems lost, but how do you tell when that is? John Stepek sheds a little light – and tips the best sector to invest in at the moment.

The best sector to invest in right now

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The late Sir John Templeton always advised that you buy at the point of "maximum pessimism". It sounds like great advice, but as Julian Marr points out in The Telegraph this morning, it's actually not that helpful.

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After all, if you think about it, it's self-evident that you should buy at the point of maximum pessimism. If everyone in the market has hit the moment when they are as gloomy and depressed as can be, and they have sold as much stock as they're ever going to sell, then things can only get better from there.

The trick isn't knowing to buy at the point of maximum pessimism. It's knowing when that point has arrived

How to gauge how everyone in the market is feeling

There's a wide range of sentiment indicators that can help investors gauge just how everyone in the market is feeling. My colleague Tim Bennett covered some of these in one of his investment strategy pieces in MoneyWeek a few weeks ago. Subscribers can read the piece here:How high are the market's fear gauges? (If you're not a subscriber you can get your first three issues free by clicking here: subscribe to MoneyWeek magazine).

These indicators include things like director deals, how small investors are reacting, or how fund managers feel about the markets. These all give a veneer of science to the idea. But my favourite indicator is still the gut feeling I get from reading the papers and other commentators discussing the economy.

Here's an example. The corollary of Sir John Templeton's "buy at the point of maximum pessimism" idea is "sell at the point of maximum optimism." We reached that point in the credit bubble early last year.

By that point, the credit boom was on its last legs. But it had gone on for so long that most of the bears were exhausted. None of their arguments for why it should all be going wrong seemed to be coming to fruition. At one point, Morgan Stanley's well-known bear Stephen Roach even tentatively suggested that things might actually end up being OK.

As many people myself included noted at the time, that was a good contrarian signal that the end of the good times were nigh. By spring 2007 you could barely find a bearish word in the City pages. London was riding high, there was no way the stock or property markets could fall because a flood of money from sovereign wealth funds in Asia and the Gulf would keep British blue chips and prime residential properties floating on air. All the talk was of mergers and acquisitions, and the FTSE 100 hitting 7,000 before the end of the summer.

We're not sure where the myth that rich people are not price-sensitive came from. But it wasn't true. Bear Stearns' hedge funds imploded, the bears rapidly regrouped, realising they'd been right after all, and down came the property and stock markets.

Have we reached the point of maximum pessimism yet?

So when will we know that we've reached the gloomiest point? Well, you'd expect that to be when even the most normally upbeat commentators start to say that there's no trigger in sight to end the gloom. Just as the crash only came after most of the bears had exhausted their downside arguments, and almost everyone had turned into an optimist, so the true upturn will only come when all the bulls have exhausted their "glass half-full" arguments.

This certainly hasn't happened yet. It takes a long time to change people's attitudes. There are still plenty of commentators calling for an upturn by the end of the year, or suggesting that the US housing market might be bottoming out, or even suggesting that the fact we've not fallen into recession yet is in some way a good sign, even though GDP figures are notoriously subject to later revisions.

So although things might seem to be pretty pessimistic by the standards of the good old days (well, the past few years or so), I reckon we're still far from Sir John's "maximum pessimism" buying point.

I'd be looking for high-profile "Why property prices will never rise again"-type articles, or "why stocks aren't for private investors". I'm thinking about the point where people are thinking "it's different this time," only on the way down.

The best sector to invest in right now

In the meantime, going back to the question I started with is there anything worth investing in now? Well, there's one sector that's still seeing plenty of M&A action, where the big companies have piles of cash and no real fears about the credit crunch and that's pharmaceuticals.

As I point out in this week's cover story (subscribers can read it here Big pharma: cure for a downturn?), big pharma has its own woes. There's competition from cheap copycat drug makers, and there's also the fact that new drugs are hard to come by.

But big pharma isn't taking this lying down. More and more of the big players are doing deals with generic groups to allow them to issue copycat versions of their own drugs once they go off-patent.

And on the pipeline side of things, the big players are snapping up smaller biotech players with promising drugs in production. The latest deal has seen vaccine maker Acambis agree to a takeover by drugs giant Sanofi-Aventis. The 190p a share deal sent Acambis's share price soaring by around 60% yesterday.

One fund worth taking a look at

Who'll be next? That's the tough part - it's hard to say. But the good thing is you don't have to pick and choose. There are a few ETFs which track the pharma sector we mention them in the cover story. But another fund you might be interested in taking a look at is the International Biotechnology Trust (LSE:IBT). The group invests in both quoted and unquoted biotech stocks and currently trades on a discount of 14.5% to its net asset value. It's rallied in the last few days, but with M&A action likely to continue, the fund could still have a good way to go.

Turning to the wider markets

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UK shares dropped again, with the FTSE 100 index losing 40 points, or 0.8%, to 5,313. Financial stocks again led the market down, with the banks in the forefront. Lloyds TSB slid 4% ahead of results, over fears its dividend may be cut. HBOS fared even worse with a 7.3% plummet as break-up rumours faded, while Barclays slipped 5% and Royal Bank of Scotland 4%. Elsewhere, Rexam lost almost 7%, again ahead of results, while pub groups Mitchells & Butlers and Punch dropped 9.5% and 7% respectively. But miners had a good day, with Antofagasta rising 7% and Vedanta 5%.

Shares also declined in Europe, with the German Xetra Dax shedding 1.3% to 6,351 as consumer confidence hit a five-year, while the French CAC 40 lost 1.2% to 4,324.

US stocks plunged as renewed financial sector fears spooked traders, with the Dow Jones Industrial Average losing 240 points, or 2.1%, to 11,131. The wider S&P 500 fell 1.9% to 1,234 and the tech-heavy Nasdaq Composite dropped 2% to 2,264.

Overnight the Japanese market also declined, easing 194 points, 1.5%, to 13,159 while in Hong Kong, the Hang Seng lost 484 points, 2.1%, to 22,203.

This morning Brent spot was trading at $126, spot gold at $932, silver at $17.58 and platinum was at $1768.

In the forex markets this morning, sterling was trading against the US dollar at 1.9950 and against the euro at 1.2661. The dollar was trading at 0.6347 against the euro and 107.52 against the Japanese yen.

And this morning, oil major BP has reported forecast-beating second-quarter profits based on what else? soaring oil prices, despite a slump in profits at its refining unit. Oil prices averaged $120 a barrel over the second quarter.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.