Where the Market Is Headed Next

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Worried about the market? Let me share a few news clippings with you:

• "Banking companies continue to be mauled in the financial markets as investors worry about rising losses from real estate lending and the growing risk of defaults on other loans. Five of the 10 most active stocks on the New York Stock Exchange yesterday were banking companies, and all of them declined. Some of the sharpest drops were for California banks, as some analysts warned that losses on real estate loans in that state will soon begin to rise." (The New York Times)

• "Investment advisers have become downright bearish. ... Talk of recession is rampant, with many market players cautioning investors not to do anything rash -- to take no new positions, sell on rallies, and be heavily invested in cash." (The Denver Post)

• "'The continued weakness in [the purchasing managers' report] signals no relief in the near future,' said Robert J. Bretz, chairman of the association's business survey committee and director of materials management at Pitney Bowes. 'Coupled with sharply rising prices for petroleum-related products ... the immediate outlook appears to be the worst of all combinations, a declining economy with rising inflation.'" (The New York Times)

These words paint a bleak picture for the market, and we all want to know what's going to happen next.

Here's my prediction
What's going to happen next is this: The market will rise 350%.

Sound crazy? Think we're due for a prolonged bear market? You're wrong.

See, I have the benefit of hindsight. All the above news reports were written in ... October 1990. That 350% return is precisely what the market has produced from October 1990 through today.

In other words, if the savings and loan scandal and stock market malaise scared you into selling (as at least one of those reports advised), you would have missed a tremendous bull run. The better move, of course, would have been to buy.

Blood, meet streets
Since no investor will call the bottom exactly, you need the discipline to save and invest regularly ... even when other investors are fleeing the market. That, after all, is when the best deals are to be had.

If you're looking for serious blood in the streets right now, look no further than small caps. While the past few years have seen small-cap stocks outperform the broader market, the beating that stocks have taken recently has hit the little guys worse than everybody else. As of the close of the markets yesterday, the Russell 2000 Index, which tracks small caps, was down nearly 20% from its July high.

Many of these small caps have deserved their fall from grace. Some -- such as China Finance (Nasdaq: JRJC) -- were trading for outlandish valuations. Others -- such as Impac Mortgage (NYSE: IMH) and WCI Communities (NYSE: WCI) -- saw business deteriorate thanks to ties to the real estate and mortgage markets.

Although all three have dropped precipitously in the past three months, none look cheap to me today.

Where it gets interesting
Leaving the sensible declines behind, there's still some gold buried in this here small-cap carnage. We're devoted to finding precisely those opportunities at our Motley Fool Hidden Gems small-cap investing service, and we start sifting through the rubble by looking for companies with:

1. Strong balance sheets (so they can weather the current credit crunch).
2. Sustainable competitive advantages (so they can gain market share as weaker competitors go under).
3. Tenured executives with ownership stakes (so we know that management is aligned with us and that the company is being built for the long haul).

Four stocks to watch
Here are some candidates that fit that bill:

Company	Drop Since July	Long-Term Debt	Return on Equity (TTM)	Insider Ownership
Biovail (NYSE: BVF)	(52%)	$0	26%	13%
Acme Packet (Nasdaq: APKT)	(23%)	$0	26%	26%
Palomar Medical Technologies (Nasdaq: PMTI)	(59%)	$0	33%	6%
Jamba (Nasdaq: JMBA)	(74%)	$0	25%	10%

These are all worthy candidates for your further-research list. For more ideas, you may also want to check out today's new issue of Hidden Gems. Our two picks are both down more than 40% over the past three months, yet both are poised to rebound strong. Advisors Tom Gardner and Bill Mann also rank their top stocks for new money now.

You can see all those stocks by joining Hidden Gems free for 30 days. Click here for more information. There is no obligation to subscribe.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy would like to thank Google's news archive for indexing these reminders of past stock scares.