Waiting out the bear? Safety first

By Jim Jubak

Bear markets in stocks give investors two chances to lose their shirts. Get ready for your second shot at big losses.

First, you can take a huge hit in a bear market if you stay in stocks too long. If you sold out near the Oct. 9 high for the S&P 500, the past nine months have been a non-event. If you held on to what you owned then and maybe even bought more as the stock market rallied in September and October from its August slump, you may be down 20% or more.

Second, you can devastate what's left of your portfolio by getting back in too early. The S&P 500 started the bear market of 2000-02 with a gradual drop from its then-all-time high of 1,527 on March 24, 2000. By Sept. 1, the index was down just six points to 1,521. And then the carnage began, sending the S&P 500 down to 1,103 on April 4, 2001. That was a drop of 28%.

Woe to anyone who thought that was the S&P's bottom, though. A rally to 1,313 -- that's 19% -- in May 2001 was enough to pull many investors back into the market. (I remember vividly because I was one of them.) And then the bear roared back. By Sept. 21, 2001, the S&P was down to 966, 26% below the May 21 high and 12% below the April 4 low. The final bottom didn't come until the index hit 777 on Oct. 9, 2002.

(In this column, I'll tell you how to avoid a second set of losses in today's bear market. So far I've done OK at ducking this bear. For the first half of 2008, for example, my Jubak's Picks portfolio was up 4.9% against a decline of 14.4% for the Dow Jones Industrial Average ($INDU) and a drop of 12.8% for the Standard & Poor's 500 Index ($INX). To see how I've done in the bear over the past quarter, the year to date and longer periods, see my quarterly performance report for Jubak's Picks at the end of this column.)

Safer on the sidelines

So, no, I don't think the drop that, as of Monday, had taken the S&P 500 to a loss of 20.6% from the Oct. 9 closing high -- a 20% decline that marks the official definition of a bear market -- is a bottom. I don't think it was a signal to buy -- unless you're a very nimble trader. And I'm still looking for the kind of washout that sends an "all clear" signal after a market like this.

I wish I could give you a date for that all clear. I'm sitting on a 33% cash position in Jubak's Picks (as of July 1), and frankly, I'd rather have the money at work making money than sitting on the sidelines. But at the moment I think the important rule is still "safety first."

That's especially true because this bear market and this economy have been -- and will continue to be in the near term -- a slow grind lower. We haven't had the sharp decline in either realm that sets up the sharp rebound of the typical "V" pattern. This bear market in stocks has been extremely slow to develop. It hasn't been short on big drops, but decent rallies have followed the declines so that the overall effect has been one of grinding lower. We haven't had a really terrifying flush that's left everybody rushing to sell. And because we haven't, that's left investors curiously optimistic for people looking at a loss of 19% in the index. For example, short selling in the Nasdaq exchange-traded fund, the Nasdaq-100 Trust (QQQQ), is up, according to Erlanger Squeeze Play, to a ratio of slightly over 1, but the short ratio was four times higher in 2003. If investors were truly afraid, they would be betting far more heavily on stocks to fall.

The economy has slowed, but here again we haven't moved from a slowdown to an official recession. Companies haven't been hiring, so the number of new jobs is low, but they've been hanging on to the workers they have for the most part rather than laying them off. That's kept the unemployment rate from soaring. The official rate has climbed to 5.5% in May, up a full percentage point from May 2007, but that means the U.S. unemployment rate is still below the average annual unemployment rate since World War II. In the recession of 2001, unemployment hit 6.3%. In the 1990-91 recession, it climbed to 7.8%, and in 1981-82, it rose to 10.8%. Workers who are still working keep on spending, and that has kept the economy on the growth side of the ledger.

I think both the market and the economy are likely to grind lower from here. The news on both fronts is likely to be negative, but I don't see anything so negative that it will lead to a panic.

Continued: Financial markets

In the financial markets I expect more of the same. Oil prices will continue to move upward. Big Wall Street banks will announce another round of billion-dollar write-offs. Earnings season will be marked with more than its usual number of disappointments as rising raw materials and energy costs cut profits. (For more on this, see my July 1 column, "Why Pepsi can rebound but GM can't.") Inflation will continue to creep upward, and the Federal Reserve will continue to threaten to raise interest rates.

In the economy, expect more of the same but a little bit worse. The credit crunch has moved down the pecking order until it has hit community banks, which are now cutting back on lending. Gasoline selling above $4 a gallon sent car sales to a 10-year low in June, and optimists are looking for a turnaround in sales in 2009. Every retailer but the deep discount giants such as Wal-Mart Stores (WMT, news, msgs) is reporting sales growth below projections.

And worst of all, it now looks like employers are finally starting to cut jobs rather than just reduce hours. Goldman Sachs (GS, news, msgs) is projecting that unemployment will top out at 6.4% in 2009. At the end of 2007, the consensus among economists was that unemployment would peak at 5.6% or so near the end of 2008. Goldman's most recent forecast, then, calls for a slowdown that is slightly longer -- an extra six to nine months -- and slightly deeper.

Waiting for the end of the bear

I don't see the end of the world in any of this. Sure, stocks are likely to be lower in two months than they are today, but I don't put the odds of a big stock market crash at more than 10%. Why so low given all the problems? Because all the problems are pretty much out there. Investors -- and the CEOs at banks, insurance companies and mortgage lenders -- are in denial about the extent of the problem, but they're not going to get blindsided by any of this.

What the markets will witness is a continued flow of grudging admissions by company executives and investors that the problem is bigger than they've let on. A typical one might say: "I know we said that last quarter's $2 billion write-off was the end, but this quarter we really mean it. This $4 billion write-off is absolutely the end of the problem."

And will anybody be really surprised if after all this time, the economy really does slip into an official recession? All the experts have predicted a recession so often that the actual arrival of the beast is likely to be anti-climactic. And how big a difference is a shift from 1% growth to a 1% decline in the size of the economy going to make? We're not talking Great Depression here, OK?

What I am talking about though is a market where the overall market and the major indexes will continue to grind lower. That will make it hard to make money by putting your money in investments that track the general stock market. At the same time, low returns from the general market will make it hard to recover from a loss, so the return on risky investments isn't likely to justify the risk. This is a time to be extra picky with your stock choices and to concentrate on just a few companies in circumstances that make it likely they'll outperform the average stock in a slow economy.

But I do think there is some good news in this scenario. We aren't at the bottom yet for the stock market, but patient investors don't have all that long to wait. The stock market always starts to recover before the economy does: The market prices stocks on the anticipation of future growth or earnings or dividends. That lead time is on average about six months. If the economy makes a bottom in 2009, the stock market could be expected to anticipate any recovery as early as the end of 2008.

Right now I'm starting to see a lot of advice saying that we could see the bottom in stocks as early as the historically weak months of August, September or October. I think that's early. Watch out if that prediction becomes the conventional wisdom. That would be a setup for one last bear market rally, the last good chance to lose money in this bear, and then a final washout.

For the next few months as I wait for the bear to grind toward a bottom, I'm going to concentrate in Jubak's Picks on:

• Keeping my powder dry. I've got 33% of the portfolio in cash now, and I'd like to have about that much cash on hand when I'm sure it's time to buy.

• Improving the quality of what I do own by weeding out the underperformers that aren't headed toward a profitable comeback.

• Using the funds from that weeding to buy a few stocks that I think are likely to be the leaders of the next market, that are selling at reasonable prices now and that have limited downsides.

This last task will be difficult, but I'm willing to sink some time and money into it to reduce the odds that I'll do something big and stupid. Doing nothing, even when it's the right thing to do, is really, really hard on an investor. I know that from past experience.

In a market like this one I'd like to do just enough to make my portfolio better and to fend off any case of itchy trigger finger that might lead to a temporary collapse of discipline with painfully expensive results.

Continued: Developments

Developments on past columns

"A safe-money bet? Think Canada": Shares of Thompson Creek Metals (TC, news, msgs) haven't been exactly safe lately, I'll admit. On July 7, the stock was down 31% from its 2008 high of $24.45 on May 19.

Some of that is a result of the general decline in shares of raw-materials producers in recent months on profit-taking and fears of a global economic slowdown. Shares of big Brazilian iron and nickel producer Vale (RIO, news, msgs) are down 26% from their May high, for example.

But part of the problem is specific to Thompson Creek. When the company reported first-quarter results May 8, it missed Wall Street earnings projections of 48 cents a share by a huge 9 cents. Investors were in no mood to cut the company a break and have punished the stock ever since. (It also didn't help that Thompson Creek announced May 12 that to raise capital, it would sell 10 million new shares, a huge number for a company with just 113 million shares outstanding. Existing investors are never happy when their stakes in a company and its earnings get diluted by about 10%.)

But on the company-specific issues, investors are being a bit shortsighted. Most of the earnings miss was a result of timing issues: Unit costs for production came in above expectations as a result of lower molybdenum production in the fourth quarter of 2007. Production soared in the first quarter of 2008, climbing to 5.6 million pounds of molybdenum from 3.4 million pounds in the fourth quarter, but revenue didn't keep pace because there's a lag of about two months from production to the actual sale of a pound of molybdenum.

The realized price per pound climbed to $32.69 for the quarter, up from $31.08 a pound in the fourth quarter of 2007. The company repeated its forecast for 2008 of 23 million to 24.5 million pounds of molybdenum and for 2009 of 34 million pounds. I don't see any reason to radically change by target price because of anything going on at the company, but I am going to stretch it out and trim it a bit to reflect falling valuations in the sector. As of July 8, I'm setting a new target price of $29 a share by December 2008, down slightly from my prior target of $30 by October 2008. (Full disclosure: I own shares of Thompson Creek in my personal portfolio.)

"Can tech stocks spark a 2007 rally?": Things have gone from bad to worse at SiRF Technology Holdings (SIRF, news, msgs), and it's time to look for the best exit prize possible. When a technology company's business is going well, each quarter the company sells more units and reaps the cost savings from increased production at a rate that keeps it well ahead of the expected decline in average selling price.

But things aren't going well at SiRF. The company is seeing a huge decline in average selling price for its products because of cutthroat competition and a slump in consumer demand for personal-navigation devices. At the same time, the company is losing market share, so it's selling fewer units and seeing costs remain stubbornly high.

Much of the slump in unit sales is due to a shift in the market toward adding navigation to cell phones and other devices and away from single-purpose navigation devices. SiRF has been slow to develop new products for that wireless market -- it is just now reporting design wins -- and even slower to turn those products into revenue.

The company continues to believe that if it can just turn out new and better products, it can turn the situation around. But it will be extremely difficult to generate enough sales volume from new products quickly enough to tackle the cost problem.

Management has been reluctant to talk about the topic in recent conference calls, but a sale of the company is quite possibly the best outcome now. I think a sale could bring a price of $7 to $10 a share, depending on how long management lets current problems eat away at the company before striking a deal.

As of July 8, I'm setting an exit price of $7 a share and looking for a deal in 2008. (Full disclosure: I own shares of SiRF Technology in my personal portfolio.)

Second-quarter performance for Jubak's Picks

That was one tough second quarter. Among the big three indexes, only the Nasdaq Composite ($COMPX) managed a gain. That index was up 0.6% for the quarter. In contrast, the Dow Jones Industrial Average fell 7.4%, and the Standard & Poor's 500 Index declined 3.2%.

By keeping a big percentage (a third or more) of Jubak's Picks in cash and staying overweighted in oil, natural gas, gold and other raw materials, I was able to play not only good defense during the quarter but also to show a decent gain. For the second quarter of 2008, the Jubak's Picks portfolio was up 8.62%. (All these numbers include dividends, and the performance of the Jubak's Picks portfolio reflects all commission costs from buying and selling positions.)

Continued: First quarter

That was a big improvement from the year's first quarter, when Jubak's Picks outperformed the major indexes but still wound up in negative territory. In the first quarter, the Picks portfolio lost 3.45% versus a 7.6% drop in the Dow industrials, a 9.9% fall in the S&P 500 and a 14.1% tumble in the Nasdaq Composite.

For 2008 to date, Jubak's Picks is up 4.88% compared with a loss of 14.4% for the Dow, a 12.8% loss for the S&P 500 and a 13.5% drop in the Nasdaq Composite.

That not bad performance for what has turned into a bona fide bear market, but the quarter could have been even better if I'd been more successful at doing nothing. This bear market won't last forever, and it's tempting to look ahead and buy this or that stock in order to position my portfolio for the next market. The problem with that, of course, is that bear markets have the ability to claw big wounds in a portfolio even after six or nine months of declines. So my efforts to add some growth to a portfolio that is heavy in natural resources and energy stocks, while sound in the long run, sure cost me money this quarter. USBancorp (USB, news, msgs), Middleby (MIDD, news, msgs), Apple (AAPL, news, msgs) and Gorman-Rupp (GRC, news, msgs) will all pay off later in 2008 or in 2009, I remain convinced, but this quarter they fell 17.6%, 28.4%, 6.6% and 15.3%, respectively.

The only one of this quarter's picks to make money this quarter was natural-gas producer Chesapeake (CHK, news, msgs), up 20.5% since I bought it.

I think the third quarter of 2008 is going to be even tougher. Yes, the stock market will be closer to a bear market bottom, but we're not there yet, and the energy and natural-resources sectors that led this market in the first and second quarters -- and that enabled Jubak's Picks to show a profit even as the market as a whole slid lower -- look like they've rolled over in the past week or two. When oil stocks don't go up even though the price of crude is soaring, you know that the sector could be in for a correction. I don't see any clear-cut sector winners for the third quarter.

For the next quarter, I'm going to stay heavily in cash -- my goal is about 33% -- and to buy very selectively and only as I raise cash from selling my current positions. I still think that the next market will reward owners of growth stocks in general and owners of the best of the sector consumer and financial stocks in particular, but I don't want to take too much punishment now to build those positions.

The odds are that this downturn in the economy and stock market will last longer than most of us now expect, and it's smart to keep the possibility of that kind of a nasty surprise in mind. As has been true for the past two quarters, in the third quarter the safety of a big cash position continues to outweigh the risk of missing out on any bear market rally.

Jubak's Picks versus major averages:

Index	Second quarter, 2008	This year	Past 12 months
Jubak's Picks	8.6%	4.9%	13.6%
Nasdaq Composite Index ($COMPX)	0.6%	-13.5%	-11.9%
Standard & Poor's 500 Index ($INX)	-3.2%	-12.8%	-14.9%
Dow Jones Industrial Average ($INDU)	-7.4%	-14.4%	-15.4%

Longer-term performance:

Index	3-year return*	5-year return**	From inception***
Jubak's Picks	79%	211%	399%
Nasdaq Composite	11%	41%	72%
S&P 500	7%	32%	55%
Dow Jones Industrial Average	10%	26%	58%

*Close on June. 30, 2005, through close on June 30, 2008. **June 30, 2003, through June 30, 2008. ***May 7, 1997, through June 30, 2008.

All returns for Jubak's Picks deduct costs of commissions. The returns for the Picks and the indexes all include dividends.

Editor's note: Jim Jubak, the Web's most-read investing writer, posts a new Jubak's Journal every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment, see Jubak's portfolio of Dividend Stocks for Income Investors. For picks with a truly long-term perspective, see Jubak's 50 Best Stocks in the World or Future Fantastic 50 Portfolio. E-mail Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Apple, Chesapeake Energy, Middleby, SiRF Technology Holdings, Thompson Creek Metals and USBancorp. He did not own short positions in any of the companies mentioned.