For anyone who has money in the stock market, this year is turning out to be another year you wish you didn't. The Dow Jones industrial average has fallen almost 20% since the ringing in of the new year, Standard & Poor's 500-stock index has dropped 27% and the war-torn Nasdaq has cratered more than 38%. That's a pretty pathetic showing for stocks in just ten months, and it comes on the heels of negative returns in both 2000 and 2001.
But before you swear off buying stocks altogether, remember: History shows that the best time to buy stocks is when no one else wants to. There are plenty of good stocks whose only crime is sinking with the rest of the market. The trick is knowing how to spot them.
Signs of the bottom
But before you buy, you may need a little more convincing. A look back at one of Wall Street's worst bear markets, from 1973 to 1974, can tell a lot about what's likely to happen as this one winds down. (Because declines in the S&P 500 then and now are nearly equal, the two bears look a lot alike.)
According to a report from Merrill Lynch, investors who bought stocks during the "market bottom," in October 1974, saw 24% monthly gains, on average, over the next 18 months. Inflation was very high back then, so real returns of that magnitude aren't as likely this time around. But it's something to think about.
Problem is, no one can say with any certainty when the market will touch bottom. And even when the indexes do finally turn back up for good, no one will know until later.
But there are some signals telling us bottom is probably near, says Tobias Levkovich, director of U.S. institutional equity strategy for Salomon Smith Barney. Among them:
- The majority of investors feel pessimistic about making money in stocks and sell on any rally.
- Investors pull their money out of stock funds and put it into bond funds, real estate or cash investments.
- Index losses rival or equal those of past bear markets.
- Layoffs at investment firms become rampant.
- Corporate earnings start to recover and industrial production improves.
All those factors are in place right now, but you don't see a mad rush to buy stocks. "People tend to have a herd mentality on Wall Street," says Romeo Dator, co-manager of All American Equity fund. "And what you get is a lot of investors chasing performance."
That's what some market watchers are saying is happening now as investors rush into bonds -- where yields are hitting 40-year lows and pushing up prices.
Bargain or bust?
How do you know if you're getting a stock that's on sale or one that could be discontinued altogether? Look for companies with businesses that are easy to understand, with solid financials and that consistently earn what they say they'll earn. For example, now would not be the time to make huge bets on "the next new thing."
Besides earnings growth, says Dator, "look for revenue growth and margins that are improving across the board." "If you stick with companies that are growing revenues and earnings -- and have strong balance sheets -- you're less likely to get killed in the market," adds Michael Corbett, manager of Perritt Microcap Opportunities fund. And it goes without saying that you need to diversify, he says.
Corbett looks for companies that are profitable and generating lots of cash -- and preferably companies that don't have a lot of debt. But if they do, he says, it might be okay, so long as they're not paying sky-high interest rates on it.