Lauren Templeton and Scott Phillips, coauthors of Investing the Templeton Way, continue their analysis of John Templeton’s 1945 letter on planned investment. A recent article in their newsletter to investors highlights the importance of planned investment:

Here’s an excerpt from the Maximum Pessimism Report (www.maximumpessimism.com):

One year and +72.9% after the March 9, 2009 bottom, investors have seen it all. Making sense of what they have seen though can prove to be a different matter.

If asked about the decline and rally in 2009, some investors might respond (with the great benefit of hindsight) that the markets had become far too cheap with many indices trading at or below 10x EPS. Others might say that inventories had been too heavily liquidated and that global growth was set to stabilize. While both responses are good and well reasoned, the permanent answer for the recent market crash and rally, as well as, those before and those to come, is that human behavior was running its normal course. The evidence of such behavior has been observed and recorded over centuries of financial history. In this answer, the role of human decision-making patterns is illuminating.

Incidentally, when humans are faced with a difficult question (i.e. to buy or sell), or a question where they lack the expertise to formulate an answer people often resort to a remedial form of decision-making sometimes referred to as social-proof. The idea behind social proofing is that in the absence of personally acquired information, humans observe the decisions of others as a basis for their own course of action. Humans acknowledge to themselves that they do not know the solution to the specific problem, but assume that others surrounding them are more knowledgeable and do know the solution. With this assumption in hand, and an ample fear of what they do not know (but suppose others might) people duplicate the decisions of their peers. This behavioral pattern can take on a cascading effect in the stock market. That is to say that one person’s decision can trigger another’s, then yet another’s, and so it goes.

The impact of social proofing for decision making is easy to observe in everyday life. Drivers stuck in a traffic jam tend to observe and follow other drivers down a side street or exit ramp, thinking the first knew a short-cut. People suppose a well-dressed man surrounded by beautiful women to be successful, popular or maybe both. In reality, it is possible he is neither. Canned laughter on TV sitcoms prompts live laughter by the viewer. McDonald’s tells us that “billions and billions have been served.”  Wine patrons equate more expensive bottles of wine with better taste and quality. All of these observations tap into the same human blind spot for decision making. Similar snap decision-making processes run rampant in the stock market, and is often referred to as herd behavior. It is a fact that many investors copy the investments made by Warren Buffett and other “smart money,” which can be seen as a form of social proof in decision making.

These decision-making patterns tell us a great deal about not only the large decline and rally of 2009, but also the pattern of returns found among specific stocks within the rally. In short, it helps us understand the junk rally that has led the market off of its 2009 bottom. In what is referred to as the “junk” or “lower quality” ranks of the market what we actually find in common in these names are smaller companies possessing short or inconsistent earnings records and/or limited analyst coverage. In fact, the earnings record is a strong basis for how Standard and Poor’s creates its quality rankings. Aside from the financials (which represented a different type of junk altogether), these low-quality stocks fell the hardest in price during the crash as their lack of information and lower liquidity fueled selling by investors struggling in the face of overwhelming social proof that they too should sell. Conversely, as the market rose off of its March 2009 low, these same stocks benefited the most after having been disproportionately punished. Simply put, the same lack of information that scared investors in late 2008 and early 2009 is now fueling heightened optimism as the economy continues to improve. Likewise, the heavy buying that ensued off of the bottom has gained steam as other investors observe their peers’ decisions. This buying activity in low-quality stocks, which is typical of the beginning of a bull market, has propelled far higher returns among these stocks twelve months after the bottom.

Around this time last year, with the entire stock market marked down over 50 percent off on a clearance sale, it was a bargain hunter’s paradise. That was last year. This year, valuations across the market are priced for business as usual, which is not necessarily a bad thing but the good bargains are less obvious. Still, despite the return of normal prices with the S&P 500 trading at approximately 15 times this year’s estimated EPS, there are relative bargains available.

What is peculiar though regarding some of today’s available bargain stocks are the sections of the market where they can be found. Most often, value investors are driven by a search for low P/Es and other valuation ratios to spend a great deal of their time shopping in the offbeat sections of the store. These sections contain aisles where goods are either marked down because of their sudden unpopularity with shoppers or because they are simply tucked out of the way and overlooked by most of the shoppers in the market. These out-of-the-way stocks can often hold a few attributes in common such as smaller market capitalizations, or a lack of market attention due to low profiles, uncertain forecasts, and minimal analyst coverage in the market. Incidentally, following the tremendous surge in stock prices off of last year’s low, the bargains normally found in these sections of the market have been thoroughly picked over. More specifically, the smaller cap stocks and the less established companies in the market have been bid up the most from a year ago. The phenomenon we are describing is familiarly referred to as a junk rally. So while this run-up and its label may have negative connotations, it should probably be thought of instead more constructively as the typical progression of a bull market. Historically, bull markets have shown a pattern of rewarding the riskier assets first in the initial run, while later the gains favor what are considered as higher quality assets.