History Shows It’s Time To Buy

The market can be frustrating. Just a few weeks ago it looked like the markets were about to reach lows we haven’t seen since the early 90’s.

The commodity bubble was bursting, hedge funds were imploding, and it seemed like the selling would never stop. To add fuel to the fire, unemployment was getting worse, consumers started saving again (seemingly all at the same time, which isn’t very helpful), and practically every week another bank failed.

It was disastrous. The government was handing out cash to banks and guaranteeing private companies’ commercial paper while putting trillions of dollars it doesn’t have at risk. It seemed like a depression wasn’t out of the question. But all that’s starting to change.

Consider what’s happened over the past few weeks. Citigroup (NYSE:C) practically failed. It has become painfully obvious one of Detroit’s Big Three is going to go away either through merger or bankruptcy despite a multi-billion dollar bailout. Retailers reported the sharpest holiday shopping season declines in decades. The unemployment rate is climbing faster and faster.

There’s almost no good news, but the market is still up. Sometimes it just doesn’t make any sense. But it could be telling us something. The recent rally could be a giant signal the worst is behind us.

All the Signs of a Market Bottom

A few weeks ago, we looked at the five telltale signs of a market bottom. At the time, we saw four of the five of them but were waiting on one more to start seriously considering a market bottom.

The first four signs a bottom was nearing were confirmed. Investors were baling out of mutual funds at record pace, the VIX set new highs, more than 90% of closed-end funds were trading at a discount (much higher than normal), and a perma-bear like Jeremy Grantham was turning bullish.

We were just waiting on one more: the market to react positively to horrible news.

Over the past few weeks we’ve seen just that. When Citigroup declared it was about to go under, the market went up. When the market learned 533,000 jobs were lost in November (much more than even the worst-case expectations), stocks went up. The market is skipping right past otherwise horrible news.

That’s not all. Although we’ve got all five signs of a market bottom we’ve been waiting for, there are quite a few more reasons to start turning more positive on the markets.

Discounting the Future

The market is supposed to be a forward-looking discounting machine. It’ supposed to price in what’s expected to happen over the next few months and years.

Is the market perfect at this? No. If it was, there would be no opportunity to really do well in it.

The market is, however, very good at incorporating what the masses expect for the future. It does it all in one quantifiable place. And right now, those expectations are for a turnaround to come sooner than later.

The recent rallies have shown the market is anticipating the economy to stabilize and possibly begin its recovery in a matter of months. Just take a look at what is happening.

Goldman Sachs’ research department (yes, I know, who would listen to them after all that’s happened between a $200 oil forecast and the credit crisis and all?) released some historical precedents on how the market anticipates a recovery. In their defense, predicting the near-term future is darn near impossible, but these are historical facts. According to the bank:

The S&P 500 tends to bottom:

One quarter before the GDP bottoms
3 months before the ISM manufacturing survey bottoms
7 months before the peak unemployment rate
4 months before the largest decline in non-farm payrolls and
4 months before the bottom in consumer confidence surveys

If the market truly did hit rock bottom in November, we can expect a genuine economic recovery somewhere between March and June of 2009.

Believable? I wouldn’t bet on it, but it’s certainly possible. So here’s what to do.

Where Do We Go From Here

If history is any evidence, it’s time to buy stocks.

The five signs of a market bottom are in. All the investment legends have turned bullish: Buffett, Grantham, Heebner, etc. We also got the market starting to anticipate this recession ending in less than a year. (Granted, I’m still concerned too many people are watching for a bottom to actually happen).

Of course, I’m still hesitant on calling “the bottom.” Trying to time the bottom is a fool’s game. Even though, it’s certainly tempting to do so after watching the market climb for two days. Frankly, there are still a lot of unanswered questions posing a lot of risk.

When will the housing market hit bottom? How will overleveraged commercial property companies fare? How bad will this holiday shopping season really be?

There are some even bigger questions we have to deal with. Like, how high will the unemployment rate go? I’m still expecting it to top out over the summer in the 8% to 9% range. From that point, an economic recovery will take quite a bit of time to really get going again.

The government isn’t helping matters either. For instance, when will the government stop borrowing hundreds of billions of dollars from the banks (T-bills currently yield 0.01%) and trying to figure out why the banks don’t have the extra cash to lend to profit-seeking businesses? How much capital is going to override market forces and determine the best place for investment? Will it be roads and bridges, alternative energy, or electric cars?

There’s just too much uncertainty out there right now to go “all in.” I still recommend sticking to the plan of buying stocks consistently over the next year. You’ve got to keep enough cash on hand to live and just in case an even better buying opportunity comes along to pick up stocks even cheaper. For now though, I’m still buying stocks and sticking to the plan.

The Three Places I’m Buying

There are three places that I really think some great returns can be had in the next few months and years. They are:

Biotech: Over the next 10 years stem cells will change the world we live in. Every week a new development is made and the research is ongoing. It’s reaching that point where stem cells are at the verge of going mainstream.

There are already some amazing stories cropping up about the effectiveness of stem cells and there are only going to be more and more over the next few years. Stem cells are making miracles happen and the last 20 years of research are starting to pay off.

Here at the Prosperity Dispatch, our FREE E-Letter, we fully expect biotech (stem cells in particular), after years of underinvestment, to have all the legs of a major bull run and the real possibility of forming the next bubble. It’s only a matter of time until the market realizes it.

China: Over the past few months, shares of Chinese companies have held up remarkably well. This time around, the China boom is going to look a lot different. The last decade has been led by China building infrastructure and working aggressively to become the manufacturer to the world.

The next boom in China will come from the maturing of the economy as it starts to slowly move away from the highly cyclical manufacturing industries and into less-cyclical service industries.

If China is where the U.S. was at 100 years ago, there are many great years ahead. And if the U.S. is where the U.K. was at 100 years ago, I’d definitely continue to look outside the U.S. for long-term opportunities.

Gold: Although we’ve taken the past few days to look at gold and when (and if) a bull market will resume, and a few different ways to get in on what could be a big bull run for gold, there’s one thing that really has caught my attention recently.

The XAU/Gold ratio is a measure of index of leading gold mining companies (XAU – Philly Gold and Silver Sector Index) relative to gold price. Over the past 25 years, the XAU/Gold ratio has been 0.25. That means the XAU index would be about ¼ the price of an ounce of gold.

Yesterday, the XAU closed at 94 while gold closed at $760 an ounce. This makes the XAU/Gold 0.124. That’s less than half the ratio’s long-run average and just off the 25-year lows.

It’s either a very bullish sign for gold stocks or a very bearish signal for gold. Something has got to give and I’m currently working out a short gold/long gold stocks trade to capitalize on it.

Those are three of the best places I can find right now to start looking for what to buy during this market downturn. All signs point to a bottom, at least in the near term. In a market like this though, it all could change in a matter of minutes.

A single warning of more trouble ahead for China, another surge in unemployment, or more disastrous retail spending in the U.S. could easily put the brakes on any rally.

There are a lot of concerns still facing the market and two strong up days like we’ve just had can easily create a false sense of confidence, but if you develop a plan, buy top-quality stocks in sectors which have exceptionally bright futures, and are willing to go in for a couple of years, you should be just fine.

By Andrew Mickey

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