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There are three times when a bear market is particularly dangerous:

  • At the beginning,
  • During,
  • At the end.

At or near the beginning, there is typically a waterfall on more than one occasion as investors rush to sell everything and anything. They’ve seen many, most, or all of their gains evaporate as the talking heads intone “this is just a normal correction.” Since most investors don’t join in the bull market until it’s already up 40% or 50%, by the time it’s “officially” a bear and declines 20%, they barely break even. (Starting at $100 to reach $140, then losing 20% of $140 takes them back to $112. And they still have a sizable decline ahead to donate the $12 profit to cooler heads…)

During the decline, there are many head fakes during which time the market soars ahead, making investors think the worst is behind them. They are called “sucker rallies” for a reason. Compared to the highs before the decline, things look cheap — but only compared to the highs. So people get suckered in, have their hopes dashed, after which we reach the final phase of the bear.

At the end, most investors give up on the head fakes and sucker rallies and tell their brokers to sell everything that remains before the market declines even further. And that blowout selling is my — and your — cue to start buying. Notice I said “to start buying.” Nothing goes straight down or straight up. There’s no rush. Panicked investors will be happy to sell to us on any new little blip down. It’s our job to accommodate them and begin accumulating when the worst is behind us.

During a bear, some sectors will emerge as investor favorites. If the bear is long enough, those trends can be played on the long side. This time around, it might be the energy stocks or the agriculture stocks. It could be timber or other basics as the emerging giants retrench, tighten their belts, then go for another round of growth. It might be precious metals, given our government’s insane headlong rush to devalue our once-proud dollar – though metals are a very crowded trade today. We won’t know where the pockets of strength are until we are there. The secret is to buy value cheap and to keep some cash available for buying more as we have corrections and confirmation of the strongest sectors.

I purchased “insurance” in 2010 in the form of inverse ETFs. I used them as a hedge against yet another major decline. As it happened – aren’t we all geniuses with the certainty of hindsight? – I would have made more money going long without any protective insurance. But the idea of insurance is that you are protecting yourself, while hoping you never have to call the insurance company. I recently unwound all these positions and will now use a cash buffer, buy intrinsic value companies, and stress the sectors I believe will do best going forward as our “insurance” rather than maintain any inverse ETF hedges. (Except one: I still believe the inverse Treasury play, whether via TBT or TBF will work out well for the patient!)

So what sectors are we nibbling at these days? Energy, especially natural gas. Agriculture and food companies bought right. Timber firms with fabulous real estate holdings and even a couple of deeply-depressed land companies in desirable demographic/geographic locations. Uranium firms and platinum metals group companies. Pollution control firms (desperately needed in nations like China and India). Companies that clean up filthy water (ditto). Regional financial firms. Health care companies. And the big engineering firms (and some utilities with deep experience and knowledge) that design and build coal, gas and nuclear plants for electricity generation and refineries for oil and natural gas. But let’s not put the cart before the horse. I’m not rushing into the market. Just trying to do what we always do – buy quality firms in unpopular sectors when their valuation indicates a low downside risk. If we can get good income that is at a payout ratio that indicates a good likelihood of continuing or even being raised, so much the better.

I do not believe the bear is toothless just yet. I believe 2011 will be a dangerous year to commit completely to one side of the market or the other. Smart, steady accumulation when others are uninterested will likely yield the best results. I expect the further sideways action that typifies bear markets (rather than the steady downward decline that most people envision) to continue into 2011. ((See more on this reality in the charts posted here.)) But I also believe that we are closer to the end of this bear than the beginning or the middle. If you agree, here are a few firms we are looking at that you may want to consider for your own due diligence, as well:

  • Encana Corp. (NYSE:ECA) 2 ½ points above its 52-week low. PE 10. Yield 2.8%.
  • ConAgra Foods (NYSE:CAG) ½ point above its 52-week low. PE 13. Yield 4.4%.
  • Plum Creek (NYSE:PCL) 3 points above its 52-week low. PE 34. Yield 4.6%.
  • Exelon Corp (NYSE:EXC) < 3 points above its 52-week low. PE 10. Yield 5.3%.
  • WestAmerica Bank (NASDAQ:WABC) 1 ½ points above its 52-week low. PE 15. Yield 2.9%.
  • CML Healthcare Income Fund (OTC:CMHIF) 2 ½ points above its 52-week low. PE 23. Yield 9.0%.
  • Chesapeake Energy (NYSE:CHK) 3 points above its 52-week low. PE 16. Yield 1.3%.
  • Citizens Holding (bank) (NASDAQ:CIZN) 2 points above its 52-week low. PE 13. Yield 4.5%.

And, for more aggressive portfolios / positions:

  • Eli Lilly (NYSE:LLY) 2 points above its 52-week low. PE 8. Yield 5.7%.
  • Petrobras (NYSE:PBR) < 3 points above its 52-week low. PE 9. Yield 0.5%.
  • China Agritech (OTCPK:CAGC) < 3 points above its 52-week low. PE 56. Yield 0.0%.

Author's Disclosure: We and/or those clients for whom it is appropriate are now long ECA, CAG,PCL, EXC, CMHIF, CIZN and CAGC. We are reviewing the others, and more, for possible inclusion in our portfolios.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Source: 2011: The Year of Living Dangerously?