Jon Markman

SuperModels8/16/2007 12:01 AM ET

5 strategies for a sinking market

We ask a handful of Wall Street analysts and observers who have offered good advice in the past about what investors should do now.

By Jon Markman

As stocks swirl like ticker-tape confetti on a windy day, the chill of twilight on Wall Street is increasingly palpable. Share prices aren't down much yet, just 7% from their mid-July highs. And the Dow Jones Industrial Average is actually still up for the year, by around 3.5%. Yet investors can't shake the sense that something is wrong -- desperately, stealthily, strangely wrong.

One reason for the disconnect between the feeling of a real problem and the appearance of no problem is mundane: The way that the major market indexes are designed, the Dow($INDU) and Standard & Poor's ($INX) can remain buoyant when less than 10% of their constituent stocks are rising.

Yet at present, the disparity is actually worse than that, as market breadth -- the difference between the number of all stocks that are rising versus the number that are falling -- has fallen off a cliff in recent weeks. After a four-year bull market in which investors allocated more and more of their money to the shares of small and medium-sized companies, this narrowing of the market has hit many individual accounts like a fall from a 20-story building.

It doesn't do you much good to know that the Dow is enduring a modest correction if you're down 23% on a popular stock like XM Satellite Radio (XMSR, news, msgs), 50% on printer maker Lexmark International (LXK, news, msgs) or 77% on homebuilder Beazer Homes USA (BZH, news, msgs).

To make sense of this condition, which is beginning to look like a slow-motion crash, I've turned to five analysts and observers who have provided a lot of great advice to readers over the past decade. I'll start with the most bearish and work my way toward optimism.

P, as in pessimism

Let's start with Mr. P, a veteran East Coast hedge-fund research director who has anonymously offered brilliant guidance here from time to time since 2000 -- most famously when he recommended going heavily long the market two weeks after the Sept. 11, 2001, terror attacks, and also for a recommendation to buy steel stocks in 2004.

Today, Mr. P wants investors to know that credit crises like the one afflicting the markets now are like slow-moving brush fires that persist for long stretches despite repeated efforts to knock them down. He believes that although Bear Stearns (BSC, news, msgs) is already down 32% this year over its losses in mortgage-backed securities and affiliated hedge funds, it could suffer much more damage over the rest of the year as customers and counterparties lose confidence in its ability to fulfill its obligations.

He reminds us that Enron was not actually felled by fraud, although in the fullness of time we learned that there was plenty of illegal activity there. It was knocked down when it admitted it could not accurately value many of its assets, failed to find counterparties with which to trade and lost its lines of credit. Through the first quarter, Bear was reportedly the prime broker to about a fifth of the world's $1.5 trillion in hedge funds. If a material number of those funds take their business elsewhere due to a lack of confidence in Bear's ability to mark its assets appropriately and find liquidity -- and there's little doubt the exodus has already begun -- then the company's condition could spiral downward quickly.

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Steel © Chris Knorr/Corbis
Steel is back
Jon Markman shines the spotlight on the burgeoning steel industry.

Mr. P further notes that hedge funds that received redemption notices in July and August have until Sept. 30 to raise money to return to customers. A rush in September to sell stocks and bonds could get out of control, precipitating crashlike conditions, he warns. If selling does explode, he thinks the Federal Reserve will step in to cut rates by as much as 100 basis points in a short period of time, launching a swift snap-back stock rally and crushing the dollar in a repeat of the 1998 reaction to the central bank's bailout of beaten-up debt and emerging-market investors.

Continued: Wait for a real rally

Wait for a real rally

Paul Desmond, head honcho at Lowry's Reports, the oldest and most distinguished technical analysis research firm on the Street, has an equally pessimistic point of view. His firm looks strictly at proprietary measures of buying and selling pressure in the market. His team was sanguine on stocks right into the highs, but began to get nervous when buying pressure and breadth narrowed in June. By mid-July he was warning clients to cull laggards from their portfolios, sell winners into rallies and hunker down into defensive positions.

He persists in that view today, noting that even on positive days in the market, buying pressure has fallen and selling pressure has risen. He also observes that financial stocks in particular have already entered a vicious bear market that is unlikely to find relief until the Federal Reserve really unleashes liquidity with a massive rate cut, not incremental injections of money or the purchases of troubled mortgages.

His bottom line: Sell during rallies, and don't get lured back into the market by minor upturns until another big down day is followed by a massively strong up day in which 90% of stocks are up and 90% of total volume is up. That would signify that stocks are cheap enough to attract bargain hunters in a big way.

Matt Feshbach, a value-focused "activist" hedge-fund manager in Florida, has made a fortune by buying very large positions in a handful of deeply out-of-favor, brand-name companies like Midas (MDS, news, msgs) and holding until management works its way out of a jam.

He believes that gigantic funds focused on statistical arbitrage, such as ones run by Barclays Global Investors, quietly became the biggest owners of small-cap value stocks in the past couple of years and are now in the process of dumping them wholesale in response to unexpected performance troubles. Once the mass selling is complete, which he expects will be by the end of September, he thinks the market will catch its breath and re-evaluate the prospects of individual companies again.

Feshbach believes investors should pay less attention to the big picture and just focus on finding value wherever it may lie -- even in the ravaged residential-real-estate complex. His biggest new position is in upholstered furniture maker La-Z-Boy (LZB, news, msgs), a beaten-up industry icon with a super-low price-to-book-value ratio of 1.1. The company is in the process of cutting costs, shedding unprofitable divisions and improving its marketing. He thinks it can earn as much as $1.80 to $2 per share in 2010. Put its historical 15 to 20 price-earnings multiple on that, and you have a triple or better on the $9.50 stock.

The bull case

In the more bullish camp, consider the views of Tom McClellan, a veteran market timer who along with his parents has developed numerous models for understanding when stocks are seriously oversold or overbought. He was very bearish going into mid-July and early August, expecting an important decline in stocks. Now that a serious plunge has transpired, pushing his oversold indicators to extreme levels, he has turned strongly bullish. He says his cycle and technical research suggest that while recent lows might be tested again once or twice, we are likely will look back on this zone three months from now as an "important" low, not a waypoint to even more profound depths.

And finally we come to Robert Drach, who writes a modest, weekly two-page newsletter out of Tallahassee, Fla. I've come to consider him the best "bottom picker" in the country over the past decade, as he has shown an uncanny ability to pinpoint the right moment to put funds to work in conditions that at the time seem absolutely horrid. He was bearish for the first three months of the year, with no allocation to stocks, then recommended investors go long with 50% of their funds right into the March bottom. He kept that allocation until two weeks ago, when he recommended a 100% long position, and then after declines in the past week he upped his recommendation to 125% long and 150% long -- about as bullish as he can get.

Video on MSN Money

Steel © Chris Knorr/Corbis
Steel is back
Jon Markman shines the spotlight on the burgeoning steel industry.

Drach believes that the Fed has created the current mess by jacking up interest rates to destabilizing levels and will soon be forced to reverse itself in a big way, launching a big rally. He considers the market a wealth-transfer mechanism devilishly designed to encourage small, naïve investors to hand cheap stocks over to wealthy institutions during periodic panics. Drach's typical methodology is to buy the highest-quality, most-heavily discounted stocks into these panics and then sell them after achieving a 10% to 20% gain in a short period of time -- and then go to cash while waiting for the next event.

It's always fascinating to discover that five intelligent, successful investors can have such divergent views based on virtually the same evidence. I'll follow them over the next year and report back.

Fine Print

To learn more about Robert Drach, check out his commentary at the PBS Nightly Business Report Web site. . . . Matt Feshbach's fund company, MLF Investments, is also a major holder of luxury-cruise provider Ambassadors International (AMIE, news, msgs) and retailer Delia's (DLIA, news, msgs). . . . To learn more about Lowry's Reports, visit its Web site. . . . To learn more about McClellan's work, check out his excellent daily and biweekly timing newsletters, The McClellan Market Report, at the McClellans' Web site. They not only provide great insights but also are often pretty humorous, a rarity among investment letters.