No quick cure for the market's ills

By Tim Middleton

If you're licking your wounds after last week's market crunch, stock up on bandages. The market's about to rap you upside the head.

Some months from now, novice investors will be dumping everything they own and buying certificates of deposit. That capitulation, as it's called, will be an enormous buying opportunity for the rest of us. But we'll have to wait for it.

Five months into this downturn, we investors can learn a lesson from Dr. House, the television diagnostician who impatiently unravels medical mysteries by distrusting everything, including the patient. "The patient always lies," Dr. House growls -- and nobody ever accused the stock market of straight talking.

This market just told its equivalent of a whopper, struggling upward from its Jan. 22 low, only to tumble even lower March 6 (and again March 7 and 10). So what does this relapse portend?

Well, forget about a soft landing and the fig leaf of a correction. We've got a recession and a naked bear market.

"The U.S. is shrugging off bad news -- bad news about housing, about the fall in consumer spending, the banking-sector woes -- with a surprisingly mild reaction," notes Robert Arnott, the chairman of Research Affiliates. "So it wouldn't surprise me at all to see one or two more down legs, (continuing) six to 12 months."

Mark Arbeter, the chief technical strategist for Standard & Poor's,says, "I have some longer-term technical indicators that I use to determine whether the market is in a bull or bear phase, and all of them tripped into bearish territory in January."

A big, bad bear indeed

Simply put, the market is down because the economy is. The economy is almost certainly in a recession, which probably began in December, two months after the bear market began. Optimists hope the current mess will most closely resemble 1990, when both the market and the economy turned down in July. The market bottomed just four months later, after losing 19.2%; the economy bottomed the next March.

But recession-induced bear markets are the worst ones, and 1990's was the mildest such market in history. The typical recession-induced bear lasts more than 16 months and takes the S&P 500 Index ($INX) down more than 27%. We're down 17% since the high of last October, so history suggests we have much more damage to suffer.

The safest path through a bear market is defensive. That favors bonds over stocks, large stocks over small, growth stocks over value, and consumer staples and utilities over consumer discretionary stocks and financials.

And in the current market we've got a wild card: the prospect of stagflation, or rising prices despite rising unemployment. During periods of stagflation, the biggest winners are commodity funds, including energy, materials and agriculture.

In addition to these strategies, today's mom-and-pop investors can employ a technique long limited to professionals: selling the market short. An exchange-traded fund, UltraShort SmallCap600 ProShares (SDD, news, msgs), shot up more than 55% between October's peak and January's low for the S&P 500.

A market bounce in the spring?

Although there's widespread agreement that what we're experiencing is neither a soft economic landing nor a simple market correction, there's less consensus on how low we'll go and how long we'll stay there. Sam Stovall, S&P's chief market strategist, says we are "more than halfway" through a bear market that will take stocks down an additional 10% but no more. And he doesn't think it will stick around long.

"Twelve months after the start of interest-rate cuts, the market has been higher in 11 of 12 observations" since World War II, he notes, "with 2001 being the only time in which an aggressively easing Fed did not bail out equity markets." The Fed began cutting rates last September.

Stovall's guess is that "the recession will be backdated to December of 2007 and will probably end in the third quarter of 2008."

Since the market typically rebounds several months before a recession ends, that would put the bottom of the bear in the spring.

Continued: Where to hide

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