Danger! 25 stocks to avoid now

By Jon Markman

If the stock market were a Western, right about now an Army scout named Clem would look up from the campfire to remark that something didn't seem right. And the camera would pan back to show a line of Sioux just about to swoop down from a hill in full war dress -- bows cocked, arrows nocked.

November is typically one of the best months for investors, and right now there is a lot of cash in money-market funds just yearning to be put to work in cheap stocks. Yet among many professional investors, including longtime bulls, there's a gnawing unease with the market that doesn't seem to fit with the fact that most major indexes are trading near highs. Three pros with strong long-term records told me that in recent rallies they had unloaded most of the stocks they'd bought over the past five years.

Now you don't want to be jumping at ghosts, especially around Halloween, and these investors could easily change their minds on a dime, or in a quarter, and be back in the market in a heartbeat. But you might as well at least have a good idea about the types of stocks that they are shunning. Because your success over the next 12 months might be better characterized by the companies you managed to avoid than the ones that you held on to.

In the 2000-2002 bear market, after all, you would have been smart to own small-cap real-estate investment trusts, regional banks, and breweries, which defied the broad trend by going up, but you would have been just as successful by simply steering clear of Internet, software and semiconductor stocks.

So today I will take a break from chronicling the misdeeds of banks, home builders and derivatives junkies and consider instead a list of seven sectors and stocks to avoid for the next six to 12 months.

Banks and brokers

Sorry, I just couldn't stay away from dumping on these miscreants, so after a nanosecond's break, let's get right back on their tail. You may recall that over the summer, Merrill Lynch (MER, news, msgs) told us its exposure to subprime-loan failures was minimal; then in September it said maybe its exposure was around $4 billion, and a few weeks later it said, "Um, make that $9 billion."

• Video: Discussing the risky business at Merrill

Well, folks, they ain't done yet. Because Merrill got into the mortgage-securitization game late and accelerated its business of underwriting collateralized debt obligations, or CDOs, into the bitter end -- like a driver who lead-foots his car over a cliff -- the broker simply cannot know the extent of its losses yet.

A peculiar characteristic of these highly leveraged instruments is that the more losses they incur, the more losses they incur. This vicious cycle occurs because CDOs were used as collateral for more loans when placed in so-called structured investment vehicles off the banks' balance sheets. So the more that the value of this collateral deteriorates, the more that banks must put up in real money to keep the rest of the structure from eroding and collapsing. To do that, they must sell other stuff they own -- stocks, bonds, business units, etc. -- at a time when buyers know that banks are under stress and will exploit their weakness to get rock-bottom prices.

This cannot be complete, as supposedly high-quality CDOs that were rated AAA by debt-rating agencies are still being downgraded by those same agencies to below investment grade, further eroding not just their value but also the value of anything for which they served as collateral. To use a more timely metaphor, they're like brush fires that spawn more brush fires. On Monday, for instance, Fitch Ratings announced that another $36.8 billion in CDOs face downgrades, which means that banks will have to announce more write-downs in coming weeks.

Another huge problem: CDO underwriting and structured investment vehicles generated massive profits for the banks and brokers over the past few years. Now there's a big, smokin' hole where those revenues used to be, and no replacement in sight. Until this fire runs out of fuel, you must continue to avoid major bank and brokerage stocks like Merrill, Lehman Bros. (LEH, news, msgs), Bear Stearns (BSC, news, msgs), Bank of America (BAC, news, msgs), Citigroup (C, news, msgs), Washington Mutual (WM, news, msgs), KeyCorp (KEY, news, msgs) and Wachovia (WB, news, msgs). Also avoid debt-ratings agency Moody's (MCO, news, msgs) and McGraw-Hill (MHP, news, msgs), parent of rating agency Standard & Poor's, as the agencies were dupes in the financing wars.

These companies will shrink as they jettison damaged divisions and fight off lawsuits, and investors will be confused as to the companies' true worth. Eventually these proud institutions with long histories at the center of modern capitalism will find a bottom and trade sideways for half a year -- and they will make great bargains. But for now, mark them A for Avoid.

Continued: See the likely losers in transportation and more

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