"Stocks: Playing the Best- and Worst-Case Scenarios" - David Bogoslaw, BusWeek

http://www.businessweek.com/investor/content/oct2008/pi20081026_163762.htm?chan=top+news_top+news+index+-+temp_top+story

A bounce off recent lows? Another plunge through key support levels? A long slog near current prices? Experts tell BW strategies for each

For most people, this feels like a very uncertain and dangerous time to be invested in the stock market. Even as the U.S. government becomes more clear about the capital infusions earmarked for a growing number of banks, and credit spreads show encouraging signs of narrowing, equity market volatility continues to head skyward. There appears to be little buying to counter overwhelming selling pressure by hedge and other funds desperate for cash to cover impending redemptions.

Making things even more treacherous for stock investors are a heap of unknowns—from how effective the worldwide financial rescue efforts will prove to be, to the duration and depth of the recession that is taking hold of the global economy.

It's precisely in this kind of environment that technical charts—ones that track patterns in price and volume activity for stocks and indexes—can offer market participants some semblance of order. Two weeks of relentless selling culminated on Oct. 10, when the three major U.S. stock indexes all hit intraday lows before bouncing modestly into safer territory.

With market players now seemingly attaching little, if any, importance to business fundamentals, those technical support levels have become key points of focus for experienced investors. On Oct. 24, the Standard & Poor's 500-stock index fell to within 14 points of the intraday low of 839 it hit on Oct. 10 before rebounding to finish at 876.77, below its closing price of 899 exactly two weeks ago.

HITTING BOTTOM?

What do investors need to do in the current situation? The recommendations equity strategists have been giving tend to be more confusing than comforting if you don't know their underlying market and economic assumptions. To provide some clarity, BusinessWeek ran three basic "war game" scenarios by a select group of investment professionals to get their views on how to navigate through these treacherous market waters.

If the broader market were to retest the Oct. 10 lows and hold, that would be an encouraging sign, but it wouldn't necessarily be conclusive that a bottom has been reached, says David Joy, chief market strategist at RiverSource Investments (AMP). What it would prove more than anything else is that there is some reliable buying interest at those levels, he says.

The market activity of the past couple of weeks has been strong enough that at an ad hoc meeting of its quarterly asset allocation committee on Oct. 17, RiverSource decided to start slowly rebuilding U.S. equity positions, after having gone to an underweight allocation in June, says Joy. But the firm is so far buying only equity indexes, not individual stocks. The most attractive sectors right now, he believes, are energy, industrials, technology, and—from a contrarian standpoint based purely on low valuations—consumer discretionary stocks. Joy believes that traditionally defensive sectors such as utilities and health care are overvalued and wouldn't reward investors on the upside if a "snapback" rally in stocks were to occur.

BUYING AT A RECESSION'S MIDPOINT

Jim Dunigan, chief investment officer at PNC Wealth Management (PNC) in Philadelphia, says he would take a retest and hold of the Oct. 10 lows as reason to resume buying, but advises sticking to high-quality names in the consumer staples, health care, and information technology sectors. The forced liquidations by hedge funds strongly suggest that some high quality individual stocks have been oversold, and their elevated dividend yields are an indication of just how cheap they are now, according to Dunigan.

Determining when the U.S. economy began to contract—and how long the recession is likely to last—can also help investors figure when to start buying stocks, says Linda Duessel, equity market strategist at Federated Investors (FII) in Pittsburgh. She believes the recession started at the beginning of 2008 and may be over by the middle of 2009. Since stock prices start to recover long before a recession ends, investors have historically gotten good returns if they bought sometime after what they estimated to have been the midpoint of a recession, she says.

Duessel suggests starting with small-cap companies and cyclical stocks that depend on the economy improving. Over the longer term, she urges a return to emerging-market stocks and commodity-based stocks, which she sees as an ongoing bull market.

If stock indexes were to break meaningfully to new lows, however, Duessel says to "get out of the way"—not by reducing your own exposure to equities, but by just not buying anything. Duessel and other strategists warn that the 14% gap between the S&P 500's 899 close on Oct. 10 and the next level of support, around the intraday low of 768 on Oct. 10, 2002, calls for great caution among investors who plan to stay in the market.

CAPITULATION SCENARIOS

Phil Orlando, chief equity market strategist at Federated Investors in New York, sees the range around 768 on the S&P 500 as the key technical support area that has to be retested before a sustainable rally can materialize. "What's happening here is the market's realization of [768 as the important support level] and pricing in the reality of near-term recession," he says. In his view, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry M. Paulson Jr. "have taken the Armageddon scenario off the table" for the U.S. financial system, but the S&P 500 needs to shed another 100 points to force out the remaining equity selling that hedge funds will have to undertake to fund redemptions.

For PNC's Dunigan, a break for the S&P 500 below the intraday low of 839 of Oct. 10 would force investors to reevaluate how much money they're willing to keep in equities. During panic-stricken times of capitulation (the term technicians use for a climactic period of selling in a market downturn), the chief concern is to preserve capital. Dunigan doesn't advise people to completely close their stock positions because they might miss the market's turn to the upside.

Under that scenario, he recommends investors sell their more speculative stock picks—those they bought based on low valuations with the hope of seeing a positive catalyst carry them up again. Those companies, whose balance sheets are typically overloaded with debt or otherwise strained, are most exposed to further economic decline, he adds.

If the market doesn't retest recent lows anytime soon, and has to muddle through an extended period of sideways trading, the best choice is to go after yield by buying dividend-paying stocks, as well as high-grade and even high-yield bonds, says Federated's Duessel. "History says yield outperforms [the broader market] for about a quarter before the stocks do," she says.

SIDEWAYS RELIEF

The highest-yielding stocks have typically been financials and utilities, but pharmaceutical stocks also pay high dividends. In a sideways market, the only real concern is whether your chosen companies will cut their dividends, she says.

Joy at RiverSource said he would welcome a period of sideways trading, as he hopes it would allow for the volatility—and the elevated anxiety among investors behind it—to recede slightly and "provide an environment where you can put cash to work in a more orderly fashion without worrying about what kind of execution [on price] you're going to get."

A protracted sideways period wouldn't influence his sector picks, but might suggest to investors that the damage to the market is being repaired and that recovery is near. This, he says, might reinforce the sectors they want to invest in once they're convinced a recovery is underway.

Regardless of whether or not technical support levels are retested soon, Joy believes the relentless selling pressure since the start of October is due to deleveraging by hedge funds—a process that's likely to be concentrated in the first month of the fourth quarter. "If you're a hedge fund and you get redemption orders, you're not going to wait to deleverage," he says. "You're going to want to get as much done as quickly as you can" because prices may be much lower by the end of the quarter.

STOCK FUNDAMENTALISTS

Other portfolio managers such as Don Hodges, president of Hodges Capital Management in Dallas, base their decisions not on technical trading patterns, but on fundamental analysis—diligent research of individual companies—and they wait for the prices to drop to what they consider bargain levels.

For Hodges, the Oct. 10 lows were an opportunity to pick up a handful of industrial companies his firm had been watching for a while, including Texas Pacific Land Trust (TPL), which he bought at 20.06 a share, vs. a price in the low 30s just a few days earlier. The stock closed at 31 the day after he bought it.

"[We bought] things we know something about, that we've researched and that are on our radar screen, but the price they reached is what prompted the action," says Hodges.

Technicians and fundamental analysts may not see eye to eye on how to value stocks, but they would probably agree that an end to the the Great Liquidation of 2008 can't come soon enough.