Association for Investor Awareness - Week of 10/16/2008

The Biggest Danger Now Is A Series Of Bear Traps
The Financial Crisis Has Further To Run
Some Bear Market Investments Have Promise
How Long The Bear Might Stick Around
A Contrary Economic Outlook
Another Shameless Plug For Blue Chip Stocks
The Bottom Line This Week

Stock volatility has become so extreme, we had to redraw the charts. Although there have been up and down days as large as those we have seen recently, never before have they come in such quick succession.

Last week, as everyone from New Guinea to New York must know by now, the Dow and the Nasdaq fell 18.2% and 15.3% respectively. That would have been tough enough by itself, but what made the week even more hectic is it contained a 679 point jump that many investors believed was the start of a reversal. 

The market leaped forward again this Monday with a breath taking 936 point surge when U.S and European leaders decided on a coordinated financial rescue plan. Stocks took a breather on Tuesday. Then it plunged 733 points the next day on poor consumer spending data. We must expect more whiplash days as the credit crisis continues to unfold. 

The Biggest Danger Now Is A Series Of Bear Traps

Although big market swings aren't much fun, they do show that investors are reluctant to quit the game. As we mentioned last week, however, bear markets rarely hit bottom until investors become so discouraged that they want nothing more to do with stocks. Until then, rebounds are likely to be traps for the unwary. Only when rallies become rare, can we begin to feel confident that the bear market has run its course.

The Financial Crisis Has Further To Run

The biggest reason we are not expecting a sustained stock market recovery any time soon is the credit crisis is far from over. Even with the billions (and possibly trillions) of dollars the government plans to inject into the financial service system, a turnaround will take months. In the meantime, more banks, S&L's, and hedge funds are likely to fail. The losses will almost certainly kill any stock rebounds that may get started.

The best strategy to use in a bear market is to buy high value stocks when the market is falling, and sell any lower value stocks when it is rallying. That way, when the bear cycle finally comes to an end, your portfolio will be heavily weighted with stocks that are likely to perform well during the next expansion.

Some Bear Market Investments Have Promise

More aggressive investors can also find profits while the market is dropping. Selling stocks or ETF's short is one way to go, but the strategy is risky. If the market goes up rather than down --and it gets away from you-- losses can be very high. If you do make short sales, you must be certain to protect your positions with stop-loss orders.

For most investors, the safest way to dance with the bear is with a fund that is structured to move contrary to the S&P 500 index. We think the most attractive is the Rydex Inverse S&P 500 Strategy Fund (RYURX) When Wall Street sinks, the Inverse S&P Fund will make you smile.

The ProFunds UltraBear Fund (URPIX) is equally broad in scope as the Inverse S&P Fund, but it is much more aggressive. UltraBear also acts contrary to the S&P 500 - but it seeks to double the size of the moves. The fund uses the same investment vehicles as its more conservative cousin, but it purchases more of everything to gain extra leverage. Of course, the lever swings both ways: The UltraBear fund will decline quickly if the S&P 500 index rises. Neither of the Rydex funds charge a load.

The best strategy to use with a bear market fund is to buy it during the first big rally and hold it for the duration of the downturn. Trying to jump in and out of the fund with each market change is rarely successful. Staying with the dominant trend almost always pays the greatest rewards.

How Long The Bear Might Stick Around

As we said earlier, we doubt that the bear market will be going away anytime soon. But just how long might it be before the bull returns? More importantly, how long is it likely to take before the bull replaces the bear's losses?

In an attempt to shed some light on the subject, value investor Ali Khan took a look at the four biggest bear markets we had over the past 30 years. We put his research into a table that shows what we might expect from the current tug of war between the bear and the bull.

Bear Market Duration Percent Decline Time To A Full Recovery
Jan 1973 - Oct 1974 21 months 57% 3.5 years
Aug 1987 - Dec 1987 105 days 35% 21 months
9/11 Terror Attack 28 days 21% 105 days
Mar 2002 - Sep 2002 173 days 29% 15 months
Average of first 4 234 days 35.5% 20 months
Oct 2007 - ? 264 days so far 40% so far ?

As you can see, the current bear market has already lasted 30 days longer and has fallen 4.5% deeper than the average. However, the crisis that triggered the current downturn was far greater in monetary terms than the previous four. It is most comparable to the severe bear market of 1973-74 when the market dropped 57%. If we see a repeat of that tough downturn, stocks will drop another 17%.

Of course, history rarely repeats itself. However, as Mark Twain observed, it often rhymes.

A Contrary Economic Outlook

You may recall that on several occasions during the past year we remarked that the economy was doing better than analysts expected. Even during the third quarter, when a recession was a forgone conclusion by nearly everyone, we noted that mainstream America was actually doing fairly well.

A few days ago, Casey B. Mulligan, a professor of economics at the University of Chicago, made a similar observation when he said, "...the economy doesn't really need saving. It's stronger than we think."

Prof. Mulligan made the case that "The non-financial sectors of our economy won't suffer much from even a prolonged banking crisis, because the general economic importance of banks has been highly exaggerated." He pointed out that pension funds, university endowments, venture capitalists, and corporations also provide large sums of money to businesses.

In addition, the average corporation gets about 25% of the funds it needs from its own cash reserves. If necessary, companies could get as much as three times that amount by cutting their dividends.

The professor also pointed out that banking services aren't about to vanish. To be sure, some banks are failing - but others are taking their places. If the survivors don't loan money, they won't last very long themselves. In any event, most businesses won't be hurt if the credit freeze lasts for a few quarters.

We think Dr. Mulligan is correct about the economy. His outlook certainly fits the pattern we have been seeing ourselves. If his prediction is correct, the stock market rebound could come a lot sooner than almost anyone expects.

Another Shameless Plug For Blue Chip Stocks

Whenever good times return, we are confident that the blue chips we have been recommending will be at the head of the Wall Street parade. As we have been reporting throughout this difficult period, many of our leading stocks are already doing better than expected.

Three of our companies that surprised investors over the past few days were General Electric (GE), Intel (INTC) and IBM. GE's profits fell 22% but they were above expectations. Intel turned in a 12% profit jump. IBM also said it will soon report an earnings increase.

But, as we mentioned earlier, wait to buy until rallies collapse and prices drop from the bargain basement to the liquidation table.

The Bottom Line This Week

Although the economy appears to be doing better than is generally believed, a recession seems likely that may last into the first quarter of 2009, and possibly further.

Rather than grumble about the slowdown, we think investors should use it to their advantage. Bear market funds such as the Rydex Inverse S&P 500 Strategy Fund look good for the near and medium terms. When their time at bat ends, many multinational blue chips are likely to score home runs.


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Posted 10-16-2008 12:12 PM by Research & Editorial Staff