Even Terrified Bears Should Be Buying Now

I'm terrified that the stock market is going to crash.

Housing prices are still above the long-term trend line. There's still immense leverage in the system -- consumer debt and debt payments as a percentage of income are still near all-time highs. Mortgage-backed securities are looking worse every day, despite the Fed's panicky rate cuts. And we've had a run on the bank that's basically put Bear Stearns (NYSE: BSC  ) , the fifth-biggest investment bank in America, out of business.

It's hard to imagine things could get worse. But it's also hard to imagine how they'll get better anytime soon, with a recession on the horizon and the continued existence of significant imbalances in the system.

So I'm almost as bearish as I've ever been. Yet I still have most of my portfolio invested in the stock market.

Am I insane?
A bearish outlook doesn't mean we should avoid the market, because the market doesn't care whether we're feeling bearish or bullish. People are terrible at predicting short-term market movement at the best of times, and predictions are particularly bad during a crisis.

And there's a lot to be bullish about. The Fed is injecting piles of liquidity, yields have come down, and the yield curve is finally sloping upward, all of which should help banks. Mortgage rates are falling, which should support house prices and help over-leveraged consumers. Plus, the declining dollar is making American businesses more competitive internationally. What's not to like here?

What I do know
So, instead of focusing on the short-term bear and bull arguments, it makes sense to focus on what you do know.

First, over the long term, stocks consistently outperform bonds and Treasury bills. Even if it's not clear whether stocks will outperform in any given year, historical data shows that in the long run, stocks have excellent returns. So it generally makes sense to be invested in stocks.

Second, stocks jump around a lot. When the market's particularly jubilant, like during the tech bubble in 1999, you'll often see stocks trading for significantly more than their fair value. When pessimism abounds, you'll find stocks trading at a discount. But ultimately, they seem to converge on what they're actually worth.

As an investor, you can exploit that volatility. When the market seems overwhelmed by bad news -- as it is these days -- you can buy excellent companies cheaply. Though a recession may already be here, it won't last forever. And undervalued companies will eventually return to their fair value.

That's why I'm comfortable holding stocks right now despite my bearish bias. While I'm not confident that I know where the market's going, I'm confident that the stocks I own are extraordinarily cheap.

Lucrative returns
What's more, the returns from value stocks coming out of a bear market can be high. The first bounce can be particularly lucrative, as the atmosphere swings from negative to positive.

For example, the bottom of the last bear market was in October 2002. In January 2003, Philip Durell, an expert value investor, started a $250,000 public stock portfolio. A year later, he posted the results.

Stock

Cost

2004 Price

Gain

MBIA

$14.85

$24.85

67.3%

MGIC Investment (NYSE:MTG)

$39.46

$56.94

44.3%

Home Depot (NYSE:HD)

$21.35

$35.49

66.2%

General Dynamics (NYSE:GD)

$59.185

$90.39

52.7%

Philip Morris (NYSE:MO)

$32.738

$54.42

66.2%

Limited Brands (NYSE:LTD)

$11.25

$18.04

60.4%

Merck (NYSE:MRK)

$43.33

$46.20

6.6%

       

Average Pick

   

52.0%

Total Portfolio Return*

   

38.8%

S&P 500

887.3

1111.9

25.3%

*Including weighted cash position.

So, in the year immediately after the bear market lows, the S&P 500 index returned an impressive 25.3%. But value stocks did even better. Philip's portfolio achieved a 38.8% return, even though almost a third of the portfolio was in cash. In fact, if you look at the stock picks alone, they returned more than twice the market averages.

The Foolish bottom line
These days, Philip is the advisor of our Inside Value newsletter. Who knows if his returns coming out of this bear market will approach the level that he achieved after the last bear market, but you don't want to miss the bounce when the economy starts recovering.

Philip recently noted that in the time that he's been running the newsletter, he's "never seen so many excellent companies trading at such cheap prices." That's a good omen. If you're interested in seeing the stocks that Philip's recommending today, you can read all of his analyses with a 30-day free trial of Inside Value.

Fool contributor Richard Gibbons also considers the entrails of the banana he just ate to be a good omen and a tasty snack. He does not have a position in any of the stocks discussed in this article. Home Depot and Limited Brands are Inside Value recommendations. Limited Brands is also an Income Investor pick. Never feed the Fool's disclosure policy after midnight.


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