Getting Ready for the Bottom: What to Buy and What Time to Buy Them

The biggest question on investors’ minds is when will it be safe to buy stocks again. It seems that every time the stock market surges higher, there is some bit of news or some event that sends investors heading for their bunkers once again. But then again, that’s what a bear market is all about.

Rather than trying to time the bottom, investors would be better served to let the market take care of that on its own. The good news is that when the actual bottom gets near, the market also will generously provide many signs to tell us. We won’t be able to pick the absolute bottom but we’ll get in fairly close – and with much less risk.

One of the better observations made about the stock market came from Sam Stovall, chief investment strategist at Standard & Poor’s. He observed that during certain portions of the business cycles, different sectors of the stock market outperform the others. For example, during the early growth phase, technology tends to lead the pack, and it makes sense as corporations ramp up their investment spending.

When we overlay to business cycle over stock market performance in general, we can prove what most investment professionals already know – that the stock market tends to top and bottoms several months before the business cycles tops and bottoms. What this means is that technology stocks, for example, will start to improve many months before the economy actually starts to expand.

For those attempting to forecast when recession turns to expansion, the observation of when the stock market moves from bear market to bull market will give them a time frame for the economy’s change. A stock market bottom in late 2008, for example, will suggest that the economy will show great improvements by mid 2009.

But investment professionals and investors alike are not concerned with the economy’s bottom. They want to know when stocks are bottoming and clearly we cannot do that by observing the economy. Let’s state the obvious: we cannot predict the present using the future.

Stock market investors are luckier than those playing bonds or commodities. There are so many cross currents in the stock market and ways to slice and dice it that there are multitudes of clues to use to figure out what is going on. Sector rotation analysis, where we examine not just which sectors are making gains but which ones are leading and lagging the others is one of the more forward looking.

Where we are now?

Let’s put the sector rotation model into practice in today’s world. As anyone with an interest in the stock market knows, financial stocks were disasters for investors in 2007 and early 2008. In contrast, basic materials and energy were hot. Steel, fertilizer, gold, oil and coal all did quite well, not only beating the S&P 500 by wide margins but also making healthy absolute gains. In other words, they were leaders while banks and brokers were laggards and that is just what we’d expect to see as the general stock market is peaking.

In June 2008, as the stock market was already caught in a bear market, basic materials and energy hit their respective ceilings and began to fall at a severe rate. Their leadership role evaporated and they actually began to underperform the market.

In troubled market times, and a bear market certainly qualifies, investors tend to move their money into so-called “defensive” areas that are less dependent on the economy and enjoy more stable demand and cash flow levels. Healthcare and consumer staples, a.k.a. consumer non-cyclicals provide that “shelter from the storm” and indeed both the Select Sector SPDR healthcare and consumer staples exchange traded funds (ETFs) began to outperform the market in June.

July saw the continued strength of selected health care groups as relative performance turned into absolute performance (tangible price gains). The iShares Trust Nasdaq biotech ETF moved higher from its trading range at the start of the month and by month’s end it had gained 12%. Not bad in a bear market!

It’s not a perfect road map but it does point us in the right direction in terms of stock selection. And it helps us in our goal of determining when it might be time to start looking at a broader approach to the stock market as it begins the bottoming process.

What changes as a bottom approaches

As the bottom approaches, poor performance in financials becomes more benign. While it still may lose value, it moves from a market laggard to a market performer to give us a sign that things are beginning to change.

Of course, the extreme conditions in the financial sector over the past year have thrown us a curveball. Their accelerated decline culminated in a selling climax in July, which is significant because this sector is no longer underperforming. However, because there was so much damage done here we cannot think that it is ready to simply start its next bull market without a long period of healing.

The performance change in the financial sector basically happened early but nonetheless it did happen and that is a positive sign. It will just take longer to have an effect on the overall stock market.

And at the bottom

If the model holds true then at the bottom we should also see life in technology stocks. The usual suspects, such as semiconductors, should begin to firm and even though the stock market may still experience another bout of selling the tech sector should not be follow suit, at least not to the same degree.

What to buy

By now, the reader should have surmised what the proper areas in which to mine opportunities will be. Financial and technology sectors should be the areas leading the market out of the gate and while more cyclical sectors such as industrial and consumer cyclicals are likely to participate in the new bull market it should be financial and technology that lead the pack.

It is difficult to assess what individual stocks or even industry groups will be the ultimate leaders in advance as so much of that analysis depends on these areas actually starting to outperform. Since we cannot know that in advance, we must use a broad-brush approach and start nibbling on sector proxies. The financial and technology sector ETFs would be good vehicles to use to start. From there, we can focus on industry groups as we drill down to specific leaders.

To get an idea of how the start of the recovery might look, we can examine how the last bear market transitioned to a bull market. Since the bear of 2000-2002 was technology driven while the current bear has been financials driven, we can look at how the technology ETF recovered in 2002-2003 in order to get an idea of how the financial ETF might perform in the coming months.

In September 2002, just a few weeks before the Nasdaq bottomed, the tech ETF began to outperform the market. But as we know it was not straight up from there and the ETF, and the market, chopped around for months.

But in June 2003, when the ETF was able to climb above its initial upside reaction off the October market bottom, we got a confirmed signal that a bull market was underway. I would expect the current market to show similar performance when the financials are able to break free from whatever trading range forms now, keeping in mid that it will likely take months to develop to repair the carnage we’ve seen in this sector.

Michael Kahn writes the twice-weekly “Getting Technical” column for Barron’s Online and edits the daily Quick Takes Pro newsletter. He is also the author of three books on charting, the most recent being “A Beginners’ Guide to Charting Financial Markets.” Read his blog at www.quicktakespro.com/blog.