Find Stocks that Rebound After a Bear Market

Bear markets are scary. The good news is that they eventually end ... and unlike the bear markets of the 1980's, markets correct sharply and quickly. However, there are a few tried and true strategies that can help you navigate today's choppy markets.

A bear market is an excuse for spring cleaning. The worst portfolios I've seen are full of cash and unrealized losses. If you have stocks or funds that are down more than 40%, the odds are that they are never coming back. Don't be afraid to take the loss. Look at the bright side, by selling losers, you'll shield yourself of taxes on winners.

Finding the bottom There is an old saying that "the best buys are the hardest sells". When you're investing, the best time to invest is when you're scared to death -- by the pundits, the press and cocktail chatter. Stocks typically reflect what is expected 6-12 months in the future. Therefore, ignore what is happening today because that information is already priced into stocks. This doesn't mean you will not see some knee jerk reactions to news -- but few current news items produce more than temporary stock price movement.

So, if you've gritted your teeth and have mustered enough bravery to think about buying stocks or funds in the face of a snarling bear market, what do you look for? It's time to use a time machine to and think about what other investors will be thinking about in 9-12 months. We will have a new President. What will he or she be saying? What will this mean for the outlook of specific industries? Will health care and energy companies be under attack? Will the dollar be strong or weak? Will consumers be spending their tax rebates? Will home prices be rebounding?

I have found that the best places to look for good stocks is in the bargain bin. Find a sector that has been pounded the most. Check out online services or ask your broker to get analyst ratings on the quality of the companies in the sector. Pick one or two of the best managed companies in a sector that should be seeing better days in 9-12 months.

If you decide to buy individual stocks, your portfolio should be composed of at least 8 stocks. If you don't have enough money to invest to make this work, buy a 5 star rated mutual fund. This won't be as fun, but it will dramatically reduce the chance that you'll get electrocuted with bad luck (that happens to everyone). I'm not a big fan of ETF's because you take on the risk of owning an individual sector, but since the ETF owns every company in a sector, you have to own the good stocks along with the dogs -- and trust me, every sector has crummy companies that you would not want to own.

Your goal Mark Twain once said that "History doesn't repeat itself, but it does rhyme." Stocks typically follow this pattern as they emerge from a recession:

1) Wiped out large caps bounce off of their depressed bottoms (In this bear market, it was money center banks and as January ended even the homebuilders)

2) Quality large cap stocks that didn't go down much compared to the overall market. Stocks in this category have what is known as "positive relative strength". You can sort for high relative strength stocks on several web sites or you can pick up a copy of Investors Business Daily -- a paper that focuses on strong relative performers. The reason that these stocks do well is that on the way down, there were not as many sellers as other stocks and/or there were investors trying to nibble away as the stock became cheaper. When the market turns around, quality companies with positive relative strength move up early in the rebound. Mutual fund portfolio managers are like everyone else because they like to be around celebrities. For a PM, this means putting quality stocks into his or her portfolio. After all, very few people get fired for owning well-known quality stocks. Why not beat these people to the punch and get into the stock before they drive the prices up? Recently, companies such as GE, Boeing, CBS, Disney, Altria, Microsoft, Exxon and Freeport McMoran have been institutional favorites.

3) Small cap fast growth companies (small cap typically means companies with a market cap of $250 million to $1.5 billion). Growth stocks get higher valuations when interest rates are declining -- and rates almost always are headed down as a recession ensues. Again, focus on quality growth stocks.

4) "Hero" and turnaround stocks. These are the low dollar price stocks with problems. The company might be losing money or the firm might have some snazzy new product that will revolutionize the world. My only advice here is that every single turnaround that I have ever seen has take at least twice as long as I originally expected.