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What if the Market Doesn't Get Better?

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June 18, 2011 - What if the Economy and Stock Market Don't Get Better? - By Zacks Investment Research

By: Steve Reitmeister

What if we head back into a recession and stocks tumble -30, -40, -50%?

What if the economy has bottomed, but things don't really get better for years?

What if the worst is behind us and we start a new generation of growth and prosperity?

If you are 100% confident that you know which of these scenarios is correct, then you are just kidding yourself. The economy and the stock market are simply too complex for anyone to know with such exact certainty. Meaning that not you, nor me, nor Cramer, nor Buffett, nor anybody has this one down pat.

The best we can do is roll through all the "What if?" scenarios. From that we will discover the tell tale signs of which case it will be. Then align our portfolios to maximize profits in that environment. And yes, we can make profits in each and every one of these environments. So, let's get started.

What if this is Just a Bear Market Rally?

This is the worst case scenario for the economy and society as a whole. But with our government trillions in debt and stimulus dollars drying up, we have to assume it's a real possibility.

Here are the signs to look for:

General Economic Weakness: There are a number of key economic indicators to look out for. Since consumer activity accounts for 70% of the economy, then deteriorating retail sales is a very bad sign. Also watch the employment figures. If they erode further, then it spells trouble. And yes, May's employment report was heading in the wrong direction. Hopefully it's just a soft patch of numbers before more improvements are made. But, if indeed the jobs picture worsens, then stocks are likely to follow suit.

Corporate Earnings Trouble: This has been the strongest area of the economic recovery and earnings so far in 2011 are set to make all time highs. If that story changes and earnings estimates start to head lower, then that bodes ill for stock prices. (Gladly that is not now the case).

More Banking Trouble: We swept a lot of bad loans under the rug and haven't heard a peep from that group in a long time. If the government's stress tests were not adequate or there are more bad loan boogeymen looming about, then we are right back where we started with this mess.

Deflation: Meaning the cost for goods start getting cheaper. It sounds nice on the surface, but it's a deadly economic disease that took hold of the US during the Great Depression. It's also spelled disaster in Japan during the 1990s, which they call the "Lost Decade".

Clearly any of these items coming to the surface would result in renewed panic and a tumbling market. Here is how to profit in this environment:

Sell all small cap, aggressive or speculative stocks: These stocks go down first...and they go down the most.

IF you are going to own any stocks, then they need to be the bluest of blue chips with large dividends in defensive industries like food, healthcare, utilities etc.

Short the Market: I believe the best way to do this is with inverse ETFs that allow you to profit as the market goes down. There are also "Ultra" inverse ETFs that can give you extra exposure to amplify your potential profits (and potential losses if you guess wrong).

Nothing wrong with having a lot of cash on hand. Or gold as a safe haven.

The odds of you seeing these signs clearly and perfectly timing your way into the proper trades is very low. Just realize that it's better to be a shade late to the party, then not show up all. That should put you in the right frame of mind.

What if Things Don't Really Get Better for Years?

Here we have the scenario where the economy doesn't get any worse...it just doesn't seem to get much better either. This is commonly called the "Muddle Through Economy", which is one step above recession and one step below robust growth.

The signs to notice this situation are easy. Essentially all the indicators of the economy (GDP, retail sales, manufacturing etc.) just get stuck at the recent modest levels and don't improve much further.

The market, however, can follow two very different paths during these times. And each requires radically different tactics to be successful.

Path 1 - Range Bound Market: This would entail the market, just like the economy, going basically nowhere for an extended period of time. We often call this a range bound market as it just trades within a narrow 10-15% band.

These markets are actually easy to profit in. That's because most companies will have modest earnings growth. But the few that are growing at a rapid pace will attract investor attention and rise in price. You will find these stocks by concentrating on the best stocks in the best industries. The best industries are those with the healthiest earnings outlooks (easily found with the Zacks Industry Rank). And then you pick the stocks with the best earnings outlooks within those industries (using the Zacks Rank for stocks). Also in this environment you shouldn't try to be too aggressive. Concentrate on mid-cap and large-cap stocks, which provide a bit more safety.

Path 2 - Volatile Market: Here you have a market that keeps misreading economic signals. You will see big 20-30% run ups on renewed hopes of economic improvement. This is followed by an equal sized downturn as people discover that the growth prospects were just a mirage. At the end of the day the market goes nowhere like Path 1, it just keeps flying above and below the breakeven level.

This environment is trickier, but can be tamed. You just need to apply market timing with a dash of common sense. If the market tumbles and it seems overdone, then buy up good stocks like noted in Path 1 above. When stock valuations get overextended above the current reality of economic growth, then take your profits. Rinse and repeat as many times as needed.

What if this is the Start of a New Generation of Economic Prosperity?

This is the one we all hope for, but fear is too good to be true after all the recent devastation. Yet it is possible that the coordination of Government actions around the globe have thwarted a 2nd Great Depression and that we can start to enjoy a prolonged era of economic growth and well being.

Here we have the inverse of the first scenario. All the main economic growth indicators are headed higher with the unemployment rate heading lower. Inflation stays in a normal 2%ish range. Consumer and manufacturing indicators show even more improvement and GDP numbers continually come in at +3% or better.

This is the easiest environment in which to profit in the stock market as most everything will rise. However, small caps and high beta stocks, which consistently blow away their earnings estimates, will significantly outperform. Again, the Zacks Rank is an excellent guide to find these likely winners.

What Do I Think Will Happen?

Which scenario do I believe in right now? And what's in my portfolio to profit in this environment? I'll give you a hint. Right now I think the most likely outcome is the 2nd scenario, which some might call a "Muddle Through Economy". However, I do sleep with one eye open that all those bad loans and government printing press actions may come back to haunt us down the road. So I do have contingency plans in place to switch to scenario 1 if necessary.

For more specifics on how you can profit in this environment, I invite you to check out the portfolio I manage for the Zacks Reitmeister Trading Alert. Since the depths of the Great Recession, it has generated more than 70 double-digit stock gains.

I invest my own money in this portfolio and can't share the recommendations with everyone. It has been closed to the public for more than four months, but now, for a brief time, we are re-opening the doors. So if you are interested to learn more, then be sure to do so now since the service will close again Sunday, June 26.

Wishing you great financial success,

Steve

Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks and all of its leading products for individual investors. He is also the Editor of the Reitmeister Trading Alert.

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