Big rally doesn't mean all is well

Going forward, we should assume that many of the recent charge-offs and write-downs were not what accountants call nonrecurring, or one-time slip-ups. Most banks that reported losses in subprime-mortgage bets for the third quarter, such as Fannie Mae (FNM, news, msgs) and Washington Mutual (WM, news, msgs), are very likely to do so again when reporting on the current quarter in January and February. When you consider that earnings estimates for 2008 are still positive -- with analysts expecting as much as 15% to 30% profit growth at Bank of America (BAC, news, msgs), Wachovia (WB, news, msgs) and other major banks -- you can tell there is a room for big disappointments ahead.

You may have heard some bullish investment managers contend that Standard & Poor's 500 Index ($INX) stocks' valuations are cheap compared with their 2008 prospects, trading at a forward price-earnings multiple of around 14. Yet that is true only if you believe companies are done dropping bombs. If profits fall as much as they typically do in the early stages of earnings recessions, then the forward price-earnings multiple for the S&P 500 today is more like 25, which is very rich.

• Discuss on Jon Markman's message board: Are you buying now or waiting?

As a group, investors are pretty clever and typically do a good job of anticipating a trough in earnings and a peak in valuation. That's why stocks tend to bottom out well before companies' results do. But my research suggests the bottom for earnings is still at least six to nine months away, as home builders, automakers, retailers, banks and semiconductor manufacturers are not even finished with the denial phase of their grief progression, much less in midstride with cost-cutting programs.

Waiting for the false rally

With stocks extremely oversold now, a relief rally related to any whiff of good news could take the market indexes within spitting distance of their October highs. Catalysts such as the Abu Dhabi expression of confidence in Citibank (C, news, msgs) or hints that the Fed's rate-cutting days are far from over can spur rallies like this week's two-day, 500-point burst for the Dow Jones industrials ($INDU).

Other moves higher could commence on the heels of any hint that the government may propose a solution to the mortgage crisis along the lines of the Resolution Trust Corp. program that cleaned up the S&L mess. Moreover, the Federal Reserve and the European Central Bank could cause a multiweek rally by injecting liquidity into the markets, much as they did in 1999 in anticipation of a Y2K crisis.

• Video: Citigroup's Abu Dhabi Deal

Yet neither government nor central bankers can actually create earnings power for companies in 2008, and that is why any near-term rebound in the market is likely doomed. If the script plays out as other pre-recessionary episodes have in the past, the time to put new money to work in the market with the least amount of risk will occur when stocks are off their peak by as much as 12% to 15% amid expanding waves of pessimism. That could occur toward the end of the first or second quarter of next year.

If you want to play this view in an aggressive way, wait for the Dow to rally back to the 13,600-to-14,000 range and then buy an exchange-traded fund such as the ProShares Ultra Short Dow 30 (DXD, news, msgs), which returns two times the inverse return of the Dow.

Fine print

To learn more about David Rosenberg, click here. He was right on top of the housing bubble in 2005, warning investors and home buyers to beware of an overly frothy market. See this International Herald Tribune article from September 2005. . . . Standard & Poor's provides a lot of stock analysis and tools at its equity research Web site. Check out its free daily videos on this page; they're timely and educational. There's more free news and commentary here. . . .

To learn about the Resolution Trust Corp., first get an overview by visiting this Wikipedia entry, then dive into a report at the Federal Deposit Insurance Corp.'s Web site called "Politics and Policy: The Creation of the Resolution Trust Corporation" (.pdf file). . . . To refresh your memory on the Y2K crisis, visit this Wikipedia entry.

Meet Jon Markman at The Money Show

MSN Money's Jon Markman will be among more than 120 investment and finance experts sharing buy-and-sell advice at The World Money Show in Orlando, Fla., Feb. 6-9. Invest four days dedicated to planning and refining your portfolio by attending the event's more than 320 workshops and panel presentations. Admission is free for MSN Money readers.

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At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column.

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