The Light at the End of the Tunnel

The market looks really bad right now, doesn't it?

There's scary economic news everywhere, with food and oil prices at record levels, bank problems left and right, and dark rumors swirling around old guard Wall Street firms like Merrill Lynch (NYSE:MER) and Lehman Brothers (NYSE:LEH) … times are tough.

It might get worse before it gets better, and that's a scary thought to contemplate.

But here are two things I'm pretty sure about. First, things will get better. Cycles like this one are just the nature of markets. We can't predict the timing of these cycles with any accuracy, but we can look at history and get some idea of the shape of the cycle.

Second, investors who are prepared for things to get better will make a lot of money. How do you prepare? By studying history.

A profitable history lesson
As it turns out, most bear markets follow roughly similar patterns. Legendary portfolio manager Ken Fisher has studied the historical patterns extensively, and his thoughts on the topic are well worth heeding. As he notes in his book The Only Three Questions That Count, nearly all bear markets get worse as they go and then turn abruptly.

By "turn abruptly," I mean that just when things look like they're going down the tubes once and for all, suddenly the bulls jump back in and boom, a new bull market begins. Fisher also warns that because the turns come when everybody is most pessimistic, they tend to happen sooner and faster than nearly everyone expects.

And after that turn? Bull markets have patterns, too. Two points in particular deserve consideration:

• Bull markets start off with very steep price climbs, and
• Small caps lead the way.

The power of small caps in a bear market
If you want to harness the power of that abrupt market turn, you need to have some small-cap stocks in your portfolio. They take off first and fastest, and it's easy to understand why: A small market cap means that a stock is more sensitive to shifts in investor sentiment.

But what small caps should we be holding? Here's my take on it: Seek value. By buying stocks that are trading at low prices relative to earnings right now, we could amplify the gains we make when the market turns and bullish valuations return.

Put it all together and it's clear that, right now, small-cap value stocks represent an extreme buying opportunity. So where do we find them?

Getting to the best of the bunch
Well, we could sift through the CAPS stock screener, looking for five-star small-cap stocks with low price-to-earnings (P/E) ratios and taking our research from there. I did that this morning and came up with several candidates, including these:

Source: Motley Fool CAPS.

They all look promising at first glance, but to be honest I don't know much about any of those companies. I'll need to do a lot more research before I make any investment decisions.

And that's the rub. Researching a beaten-up small cap isn't like deciding to buy in to a long-established blue chip like General Electric (NYSE:GE). Small companies tend to be obscure, and often face big challenges. You need to understand where the company is at, where it's going, where its key competitors are, where the market niche is… it's complicated. It's daunting.

This might be one of those times where a good mutual fund makes more sense.

Hire a pro, reap the profits
My fellow Fool Amanda Kish had the same thought recently. Amanda is lead advisor for the Fool's Champion Funds newsletter, and she loves uncovering great funds that aren't well-known. She wanted a small-cap value fund that was still small enough to be nimble -- and she found a winner.

In this month's issue of Champion Funds, available online at 4 p.m. ET today, she reports on her find. (Champion Funds is a paid service, but a 30-day free trial gives you full access, so click with confidence.) It's a terrific fund, with reasonable fees, strong returns over many years, and -- best of all -- a manager who had success both during and after the last big bear market in 2000-2002.

I won't name the fund here -- you should read Amanda's full report -- but I will say this: It's a hidden gem, surprisingly small given its track record. The time to get into this fund is now, before the market turns and it gets overwhelmed with new money -- or worse, closes. As Amanda notes, hidden bargains only stay hidden for so long.