Coming Soon: Market Recovery

The worst is yet to come.

The stock market staged a nice rally over the last few weeks, but there's plenty more bad news to come. What's more, despite all the volatility, the market still hasn't fallen as much as I'm afraid it will. "I think there will be a lower buying opportunity within the next few months," says Sam Stovall, chief investment strategist at Standard & Poor's.

Even though last summer was rocky, the stock market recovered and set a new high last October 9 -- five years to the day after the bull market started. On January 22, Standard & Poor's 500-stock index closed 16% lower than that level. From there, the market rose 6% through February 26 before falling again. "I don't think a 16% loss is enough," says Stovall. "I think we have to go through a 20% to 25% bear market, which is similar to the average bear market."

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But we won't have to suffer long. The market will recover soon.

A bear market is generally defined as a decline of 20% or more in the major stock indexes. Stovall says he thinks the economy fell into a recession last December -- as do many economists. It's unusual to have a recession without a bear market.

Stovall compares the current market selloff to the 1990 setback, during which the S&P 500 lost 19.9%.

Then, as now, the problem was risky and unwise real estate loans by financial companies. In the early '90s, the savings & loans that had made these bad loans collapsed. The resulting mess ended up trimming more than 3% from gross domestic product. Before it was over, the federal government set up the Resolution Trust Corporation, which took over hundreds of bankrupt thrifts and sold off hundreds of billions of dollars of assets -- mainly real estate and mortgage loans.

Sound familiar? The current crisis is less contained regionally and is likely a little worse. But the stock market's 1990 ebbs and flows mirror closely what has happened this time around. The only thing we haven't yet had is a second swan dive -- and it may have started last Friday.

Stovall recommends holding more cash than usual and investing less in U.S. stocks than usual. He's more optimistic about foreign stock markets.

He favors classic defensive sectors: consumer staples, health care and utilities. People aren't going to skimp on those items even if the economy is in a recession.

Stovall is hardly predicting the end of the world. The stock market generally goes through a bear market every four or five years.

He predicts a recovery in just a few months. I think he's right: By late spring or summer, we'll likely be at the start of another bull market. The economy will still be weak and the news will continue to be bleak, but stocks almost always move before the economic fundamentals change. Usually, stocks start advancing about midway through a recession.

The Federal Reserve is doing everything it can to prevent the economy from falling into a recession -- or mitigating the damage if we're already in one. In a presidential election year, so is the rest of the government.

Just as important: Based on earnings, cash flow or sales, stocks are hardly expensive, even if earnings decline this year. And corporate balance sheets, outside the financial sector, are in good shape. Lots of companies are flush with cash. Look for them to spend some of it buying up shares selling at depressed prices, perhaps resulting in a new bout of merger and acquisition activity.

The most sensible approach to this market is to dollar cost average. That is, invest a regular amount every month or every few months. Step up the pace of your investment program if the market falls.

If you're already fully invested, I probably wouldn't try to time a short-term market decline. All short-term predictions about the stock market are guesswork. So it doesn't pay to get too cute.

I think it makes sense to put more than the usual amount in foreign stocks, maybe 30% of your stock money. Dodge & Cox International (DODFX) is a superb fund. Add a dollop, maybe 5%, to T. Rowe Price Emerging Markets (PRMSX) if you're a relatively aggressive investor. But about 15% of Dodge & Cox's stocks are in emerging markets.

In the U.S., my favorite remains Vanguard Primecap Core (VPCCX), which invests mainly in fast-growing large companies.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.