Capitalizing on Bear Market Rallies

What should you do when the market rallies in spite of itself? James Boric offers one possible answer…with a sound pedigree.

The year was 1939.

After several attempts at a come-back, the Dow Jones was still down 66% from its high in 1929. Most investors had given up the idea of making any money on the stock market. Trading volume was light – only spiking between 16 million and 17 million shares for an entire week of trading. Ten years prior, volume was consistently averaging over 20 million. And spikes were around 40 million to 45 million.

More than simply scared, investors were apathetic. But not John Templeton. In a decision that was fated for investment history – the veritable hall of fame – Templeton borrowed $10,000 from his boss with one goal in mind: to buy 100 shares of EVERY single small-cap stock on the major exchanges selling for under $1.

It was a risky plan. He didn’t care if a few of the companies he bought were on the verge of bankruptcy. He didn’t care if the fundamentals were poor. He bought following a hunch that when the markets rally, small-cap stocks will lead the way. And as history reveals, he was right. In four years, during some of the toughest market conditions of the 20th century, Templeton turned $10,000 into over $40,000.

Of course, times have changed since John Templeton quadrupled his money in the early 1940s, but the fundamentals behind that growth have remained the same. [As Jim Davidson maintained yesterday], the fastest way to grow your money – during and after a bear market – is still to own small-cap stocks. The proof is in the statistics. Templeton quadrupled his money in the recovery period following the Great Depression. Following the recession of 1973-4, small-cap stocks rose 349.2%. After the market collapse in 1982, small-cap stocks rallied a quick 37%. And when the brief recession of 1990-’91 ended, small-cap stocks soared over 51%.

Why are small-cap stocks so quick to rise?

It doesn’t take much for a $2 stock to hit $4. A positive earnings announcement, a new product launch or even a strong analyst recommendation can do it. Couple that with a recovering market and you have yourself the perfect situation to quickly multiply your money. But the great part of being a small-cap investor is you don’t have to wait for the market to fully recover to make significant profits.

For the last three years, we have been in a bear market. The Dow is down over 26% since January 2000 and the once- mighty Nasdaq has shed over 70% of its value since March of that year. The primary market trend is down. But that’s not to say every single week is a bad one. There have been many opportunities in the last few years to make double- and triple-digit profits going long on small-cap stocks. And despite what anyone may tell you, those opportunities aren’t hard to find.

Take the last five weeks, for example. The Dow is up over 19% since Oct. 9. And the Nasdaq is up more than 25%. Does this mean the bear run is over?

Probably not.

These last few weeks have exhibited the classic characteristics of what, I believe, is fierce bear market rally. Among other superficial economic news, investors have been temporarily bullish thanks to a slew of positive earnings announcements. As a result, they have dumped millions of dollars back into the stock market. That doesn’t mean the overriding problems in the economy have been worked out…but it does mean, if history is any guide to performance, small-cap stock investors have an opportunity to profit.

During a bear market rally, there are two types of companies you want to own. The first are the beaten-down giants of yesteryear. These are your AT&Ts, Sprints, Nortels, Sun Microsystems, Cienas and JDS Uniphases. Just a few years ago, these companies were trading for between $60 and $130 a share. A few weeks ago, you could pick up shares of Nortel for 46 cents, shares of Ciena for $2.46 and shares of AT&T for $8.68.

Are they fundamentally sound companies? Not in the least. And you don’t won’t to own any of these stocks for the long term.

But like it or not, these are some of the best-performing stocks in a bear market rally. People tend to buy what they know. And all of these companies have big-name…well… names. When investors think the market might be turning a corner, they gravitate to the companies they think will recover the quickest.

Let me give you a few examples. Had you bought shares of Sun Microsystems, Nortel and Ciena Corp. on Oct. 22, as short-term plays to capitalize on the recent bear market rally, and had you sold them no more than four weeks later, you would have pocketed a 30%, 37% and 54.5% profit.

Contrary to what many investors believe, you don’t have to own fundamentally sound companies to make a profit. And you don’t have to buy and hold for 10 years to realize a significant return. You just have to understand which asset class performs well in different market situations. And during a recovery period or a bear market rally, beaten- down giants selling for pennies on the dollar, generally, perform very well. [Editor’s note: as we’ve mentioned in these pages before, no bull market recovery has ever been led by the past market’s leaders…that’s another reason you don’t want to hold the has-beens for long.]

Again, this is not your long-term retirement strategy. This is making money by attempting to time the market. But when the fundamentals are this out of whack – careful timing of well-known sectors may be your only shot at doing so.

There is another class of small-cap stocks to look for during a bear market rally: fundamentally sound growth companies with impeccable balance sheets, heavy insider buying, rising net incomes and revenues and enough cash to sustain growth during down times. These companies are likely not only to stomach the current bear market, but also to emerge as the new market leaders when the next bull run hits.

Let’s look at a famous example: Microsoft. In 1985, Microsoft’s first year of operation, the company brought in $24 million in net income. In 1986, it brought in $39 million. That’s a 62.5% growth rate. Couple that with the fact that it grew its sales from $140 million in 1985 to $198 million in 1986, and it’s no wonder Microsoft led the way through the 1990s. These are sound growth numbers.

But guess what? No one knew what Microsoft was back in 1986 or 1987. It wasn’t making headlines in The Wall Street Journal. It was a small-cap penny stock. And the great thing about fundamentally sound penny stocks, like Microsoft was in the mid-’80s, is that they grow even when the rest of the market doesn’t.

Sounds counter-intuitive, I know. But the facts tell a different story. In 1987, when Microsoft was just getting off the ground, the Dow opened the year at 1,927. By the end of the year it had tacked on a whopping 11 points… closing at 1,938 on Dec. 31. For the entire year, investors made 0.57% on the big blue chips of the day. But the all- but-unknown Microsoft grew from 33 cents to 75 cents (split-adjusted). Investors more than doubled their money. The rest, of course, is history.

You may never find a Microsoft to invest in. Chances are, you won’t. But you can find plenty of fundamentally sound penny stocks that will double or triple in the coming months.

The bottom line is this: there are plenty of ways to make money in any market. But you have to be willing to take chances when others are afraid. John Templeton did it in 1939 and showed how successful you can be. You have the chance to do it now. And who knows, in four years you may quadruple your money.

Sincerely,

James Boric,
for The Daily Reckoning
November 29, 2002

Editor’s note: James Boric is the editor of Penny Stock Fortunes, a monthly investment advisory focusing on small- cap growth stocks. James is also the driving force behind the proprietary trading service, The MST Trader. If you’re interesting in learning more about trading small cap stocks through the bear market rallies, click here:

The MST Trader

Yesterday was a holiday on Wall Street, as in the rest of the nation. Fools and their money stayed together, like married couples when the divorce courts are closed. Not necessarily because they liked each other any better – but what else was there to do?

What has been curious lately has not been the separations, but the reconciliations. We understand why the fools and their money parted company; they had no business getting together in the first place. So, it was not surprising to see them split up when the market headed down a couple years ago.

But now they’re getting back together. Tech investors, especially, are watching their money come back like prodigal sons or runaway wives. And yesterday, they got out their fatted calves and Butterball turkeys and celebrated.

This reunion probably won’t last forever, but it is fun now.

When you reduce S&P stocks to their ‘core" – that is, real earnings, with options and other legerdemain properly accounted for – stocks are very expensive, trading at an average P/E greater than 45.

You would only pay that much for a stock if you thought its profits were going to rise quickly enough to justify the price. That is, if earnings were to go up by 200% in the next 12 months, a stock could be bought at 45 times earnings and be reasonably priced next year.

In the last quarter, GDP rose at a 4.63% annual rate. Productivity has been rising at 4.8% annually. Wow. The top end rising nicely….and businesses squeezing more productivity out of every dollar they spend…this has got to be a great time for profits, right?

Hey, what’s this? Profits actually fell at a 6.6% annual rate in the last quarter.

What businessman is going to want to hire new employees when his profits are falling? Who is going to build new factories or buy new equipment? How are companies going to grow if they can’t make any money? Finally, why would anyone in his right mind want to buy these stocks at 45 times earnings? (One possible answer, if not the best, is offered by our guest essayist, below…)

But the fools and their money have at least gotten back together for the holidays, and we’re not going to complain about it. Still, we can’t help but wonder how long it will be before they get fed up with other and one of them walks out.

But let’s hear from our own Ann Landers on Wall Street, Eric Fry.

———–

Mr. Fry, fresh from the feast…

– The U.S. financial market shut down for the Thanksgiving holiday, and no group of investors had more to be thankful for yesterday than short-sellers – thankful that the stock market was closed for business. Skepticism toward the stock market has become an increasingly expensive – or at least embarrassing – attitude to hold.

– One stockbroker I know, who happens to share our skepticism that a new bull market began on October 9th, says that some of his clients are starting to grumble a bit. Early in October, my friend’s caution had served his clients well. Their accounts were only down a little bit for the year, while most of his colleagues’ clients had lost a lot of money. The S&P 500 itself had tumbled more than 30% year-to-date, immediately before the latest rally began.

– But now that stocks have been climbing non-stop for two months, his caution is not playing as well in Peoria. Instead of joy over losses avoided, some of his clients are beginning to feel a bit resentful about profits foregone.

– It’s always this way; once the market starts rallying, the speculative juices start flowing. Most investors quickly forget how painful it was to lose hard-earned money, and they begin to feel pain only about profits foregone. With every day that this manic market moves higher, caution and prudence seem – to many investors – like recklessness and imprudence.

– If we had to guess, prudence is still prudence, even if, for a while, it doesn’t pay as well as imprudence.

– While investors giddily try to recreate a new bubble on Wall Street, the folks out on Main Street are trying to grapple with the bursting of the old bubble. "Nearly every state is in fiscal crisis," the National Governors Association reported this week.

– "Plunging tax collections and soaring medical costs have created the worst fiscal problems for states since World War II," says the New York Times. It’s not a pretty picture. "In its ‘Fiscal Survey of States,’ the governors association found that the amount of money states had on hand at the end of the most recent fiscal year had fallen to $14.5 billion, from a peak of $48.8 billion in 2000," the Times continues. "Total state tax collections fell by 6% last year and declined in every quarter, even as spending grew by 1.3%."

– Falling revenues and rising expenses is not exactly a great combination, and the biggest states in the Union have dug some very big holes for themselves. Here in New York, the state will face a budget shortfall of $5 billion to $10 billion next year. Out in California, the deficit in the coming year could exceed $21 billion…Tax hikes are all but certain.

– The new taxes that will surely be coming down the pike – whether they are sales taxes, property taxes or some other sort of tariff – will likely take a big bite out of consumer spending.

– Whatever else the massive state deficits might be, we doubt they are bullish for either the economy or the stock market. "As long as America’s post-bubble headwinds continue to blow," remarks Morgan Stanley’s Stephen Roach, "it will be exceedingly difficult for the U.S. economy to mount a self- sustaining, vigorous cyclical recovery…The U.S. economy remains stuck in a sub-par growth channel, at best…Restrained by the headwinds of excess debt, sub-par saving, excess capacity, a massive current-account deficit, and the lack of pent-up demand."

– Sounds about right…are these the reasons why the stock market is going up?

————

Back in Paris…

*** "We are in a process which doesn’t happen every 50 years," explained Kenneth Courtis, Goldman’s #2 man in Asia. "It is only every 3 or 4 hundred years when something this big, this all-embracing happens."

What has Mr. Courtis thinking in such epochal terms is the rise of China, about which we hear so much we’re becoming suspicious.

It was not long after the 20th century began that America became the leading economic power in the world. A century later, China is widely advertised to be taking America’s place – if not as the largest economic power, at least as the dominant one.

Recently, Premier Zhu Rongji said he hoped China would quadruple the size of its economy over the next 20 years. At current growth rates, anything seems possible, for China’s GDP is increasing at 8% annually.

Visitors to China come back astonished by the pace of development. Chinese workers hump, buss, and schlep around the clock 7 days a week. There are few holidays, rigid workforce discipline, no labor unions, and a supply of willing workers that is nearly inexhaustible.

China has hundreds of thousands of U.S.-trained engineers, as well as abundant capital and know-how resources from millions of overseas Chinese. It also has access to a globalized market that seems ready to provide anything China lacks and buy everything it makes.

As a consequence, U.S. manufacturing is in a slump that might be both permanent and fatal. Companies can’t make any money because the Chinese undercut their prices. And low-skill U.S. workers – who compete with the Chinese for factory jobs – have watched their incomes go down for the last 30 years. In 1999 dollars, a man working on a U.S. assembly line in 1979 would have earned $677 a week. Twenty years later, he would have earned only $646.

How could he maintain his standard of living? His wife went to work, he worked more hours…and he borrowed money. Does this sound to you, dear reader, like the road to riches? It doesn’t to us, either…rather, we think it is the road to ruin.

But this little note is about China, not America. Will China come to dominate the world economy in the 21st century the way the U.S. economy dominated the last…putting much of America and Europe out of business? Will Americans eventually travel to China, not as tourists, but as waiters and busboys, hoping to catch a few crumbs as they fall from Chinese tables? Or will China blow itself up first? We will see…

*** "These GDP numbers you talk about," commented my friend Michel at Wednesday’s lunch, "you know they’re all nonsense, I hope? I don’t know how they do it in America, but here in France they include the salaries of government employees. I mean, how can you measure the output of government employees? You can’t, because there isn’t any. So they put in the cost of government rather than the result of it. Government is such a big part of the economy that the resulting GDP number is preposterous.

"GDP tells you nothing about what really matters anyway. It doesn’t make women any more attractive or my chicken any tastier…"

*** Poor Henry. Henry, 12, does well at everything. He is a model child and a model student. But yesterday he got into trouble.

"I didn’t think they would be dumb enough to leave the switch right there where kids could play with it," he said, explaining why he had two hours of detention on Saturday morning. "I thought it must be an old switch that wasn’t working any more."

Horsing around with other kids, Henry pulled the switch. Lights went out all over the school.