Watch This Sector During the Upcoming Bear Market Rally

Tune into the financial media and you’re guaranteed to hear an “expert” call the stock market’s bottom at least once a day.

They just can’t help themselves - which I suppose isn’t surprising, since they don’t really have much to lose by doing so.

The way they see it is: If they’re wrong, chances are we won’t remember anyway. And if they’re right, they can crow about it for years.

They are in fact wrong. But they’ll probably claim victory in the next few weeks or months. Sentiment is so bad that many are claiming this contrary indicator signals the bottom is in.

Current Investor Confidence- All Hail The Doom

In recent weeks, we’ve seen two confidence surveys that paint a pretty grim picture…

• Last month, the Consumer Confidence Index reached the lowest point in its 42-year history.

• The American Association of Individual Investors (AAII) Bull/Bear survey showed over 55% of respondents are bearish, while only 30% make bullish claims.

And countless financial articles have proclaimed the death of buy-and-hold investing.

Typically when sentiment is at extremes, markets move in the opposite direction, catching most investors unprepared.

If you were getting jittery and ready to sell some of your stocks, you may want to think about hanging on a bit longer and sell into a rally rather than dumping them in a panic.

Okay, Mr. President… What Now?

Despite its bold rescue and recovery proposals, the Obama administration’s rhetoric hasn’t impressed the market one bit. The White House knows it. And while it won’t necessarily be pandering to investors, Obama’s team must know that with every brutal selloff that makes headline evening news, the very hope and confidence that it’s trying to inspire in Americans is eroded a little further.

Because of that, I wouldn’t be surprised to see some steps taken to lift the spirits of market participants. Something much more substantive than Obama telling American investors that it was a good time to buy, that is. Here are two things that could happen…

1. A reinstatement of the uptick rule, which requires short sellers to wait for an uptick in price before they can sell short.

2. The suspension of mark-to-market accounting, which would free up the balance sheets of financial institutions. Or it could possibly be something else completely unexpected.

But mark my words: Whether it’s a government-sponsored rally, or just a natural part of the cycle, be prepared to see a strong surge upward. Bear market rallies are notorious for featuring fast and sharp moves higher.

However, should such a rally occur, be sure to keep the bigger picture in mind. Don’t get swept away by the positive emotions… only to lose out as the market recedes again.

We may see a rally, but they’re not called “bear market rallies” for nothing. Bear markets don’t generally end, and bull markets don’t generally start, with big moves higher in the market. It’s almost always a much more gradual process.

So Where Is The Bottom, Marc?

Talk about the $64,000 question…

I’m not going to be one of those guys that attempt to call the stock market’s bottom. At least not yet. Why?

Because it’s a mug’s game, and I believe this drastic selling won’t end until the S&P 500 is trading at a single-digit P/E multiple. Here’s why…

My friend John Roque, who works for Natixis Bleichroeder, discovered a scary fact…

Going back to 1881, the four times that the P/E ratio of the S&P 500 rose above 20, it eventually turned around and didn’t stop falling until it hit single digits. The average of those four trough valuations was 6.4.

The P/E ratio of the S&P 500 peaked at 44 in 1999 and has been falling since then.

Earnings for the S&P 500 this year are expected to be $48. But it’s quite possible that this figure will dip even lower if the economy continues to slide. For example, Goldman Sachs’ (GS) estimate is $40. But for the sake of our argument, let’s use the much more optimistic $48 target.

If we assume that the P/E ratio will drop to 9 - a number higher than any of the previous trough levels - that would suggest an S&P 500 of 432. Unfortunately, that’s another 37% drop from current levels.

So What Can We Do?

Simply put, if we see a strong bear market rally between 10% to 20%, I’d sell some of the more expensive names and get some capital ready for what I believe will be one of the biggest buying opportunities in at least a generation.

Next, make a stock watchlist of companies you want to own. Which ones? Start by looking at cheap stocks with stable dividends. Firms that fit the bill here are Bristol-Myers Squibb (BMY), a member of our Xcelerated Profits Report portfolio and Boeing (BA), which already sports a P/E of 8 and is suffering through extremely negative sentiment.

Here’s another sector that could benefit, even if the market continues to slide…

Biotechnology.

I think the biotech acquisition boom will finally occur. That’s because small-cap biotech names will be so cheap that it will be tough for Big Pharma companies to resist those low valuations.

In summary, the next 6-9 months will not be for the faint-hearted. I think a 450-point reading on the S&P 500 is a very real possibility. And when that occurs, I’ll be backing up the truck to load up on all of my favorite names.

I’ve given you a couple of names and a sector to watch for here, but I’ll be sharing many more with you in the pages of the Xcelerated Profits Report. And if you want a piece of that action, now’s is the best time as any to get in. What are you waiting for?

Hoping your longs go up and your shorts go down.

Disclosure: None

Comments

[pelican:]

"Going back to 1881, the four times that the P/E ratio of the S&P 500 rose above 20, it eventually turned around and didn’t stop falling until it hit single digits. The average of those four trough valuations was 6.4."

I'm not sure four is a big enough sample size. I may flip a coin four times and it may come up heads each time. Also, I'm not sure what the time frames are here. The P/E fell from above 20 in the past to single digits but does that mean the market was lower? If earnings grew 10% annually, then you could have had a 20 p/e market become a less than 10 p/e/ market in eight years with no change in price. Just food for thought.

Mar 06 06:09 AM

[ferguson:]

Altering the mark to market rule should be a subject for accountants, mathematicians and policy makers. Since I am none of the above, I have complete license to make a fool of myself by suggesting a direction.

Here it is. Adjust the basic principle to read something like this.

"The value of an asset on the books which is difficult to assess as a result of infrequent trades shall be no higher than the sum of the original value on the books of the owner and the most recent traded price divided by two."

All better informed pundits can now explain why this is a stupid idea and would not work.

Mar 06 08:33 AM

[reluctantQuant:]

This is a very good article (nice work, author). Two points to throw in:

In effect, it seems the "p/e above X eventually goes to p/e below Y" is mean reversion theory. As the Nobel-touting wizzards at LTC showed us ten-plus years, yes, Virgina, there is mean-reversion. But over what time frame? Noooobody knows the time component, Ginny.

The "recent" ride on the SPX P/E train, in context for this +100 year study, goes something like this:

1987 - when the spx p/e flirted up above 20, we know what happened - BUT it hasn't fallen below ten YET (darned close now, I know).

I've had a lot of ups and downs since then, but I've also harvested a lot of profits and had a good quality of life. Good thing I didn't follow that entry / exit strategy - I'd still be waiting for the bottom. Maybe the sidelines would have been better, but a rough calc says total return on SPX since 1Q87 to 4Q08 wa 7.75%annual and TBills was 4.74% annual. I'll take the extra 300bps over 21 years.

--rq

Mar 06 08:37 AM

[reluctantQuant:]

while I kinda like this approach...


On Mar 06 08:33 AM ferguson wrote:

> Altering the mark to market rule should be a subject for accountants,
> mathematicians and policy makers. Since I am none of the above, I
> have complete license to make a fool of myself by suggesting a direction.
>
>
> Here it is. Adjust the basic principle to read something like this.
>
>
> "The value of an asset on the books which is difficult to assess
> as a result of infrequent trades shall be no higher than the sum
> of the original value on the books of the owner and the most recent
> traded price divided by two."
>
> All better informed pundits can now explain why this is a stupid
> idea and would not work.

there's one problem that I can't reconcile - If the asset in question is really, really garbage - as if even my little old gray haired mother could see that it was worth absolutely zero (think Stanford CD)... one could still carry it at 50. And that's not OK for an investor trying to size up the current value of a financial company...

--rq

Mar 06 10:06 AM

[CGP:]

The problem with mark to market is all the derivative instruments, the CDO's and CDS's. Nothing there is as simple a relationship as the one for one you have with one house, one mortgage. Everything is pooled together and then sliced and diced once and then sliced and diced again and then mushed together; the baloney was cut up and put into a casserole. If you're sitting there with the casserole how do you put it back together to figure out how much the cow or the pig was worth? (If in fact that was what the baloney was made with)

Mar 08 02:36 PM

[oncap:]

It's comical when a writer/analyst quotes another analyst that lifted work from another. Mr. Lichtenfeld please note that this chart that Mr. Roque peddles is from Robert Shiller. This is now the second time (Barron's being the other) that Mr. Roque has been given press for research that was done by someone else. I am fine with Mr. Roque commenting on someone else's work but please do your research and reference the source (obviously he doesn't mind the confusion that it is indeed someone else's work). I follow Shiller's research and no one familiar with it needs Mr. Roque to point out the obvious when viewing p/e history. In addition, please note that the p/e chart he lifted from Mr. Shiller is a smoothed p/e ratio.

Mar 26 01:14 PM