Miss the Recent Market Bottom?

The worst is past. That's the gist of many a news story this week. Around the world, pundits who had been telling us the sky was falling are now saying that all is well. Markets are back. Full speed ahead! The Dow, Nasdaq, and S&P have all returned between 6% and 8% over the past trading week, and Wall Street looks set to rally again today.

As I write this, National Public Radio leads its morning news with a line about a "rise" in housing sales that is responsible for the recent comeback. The other popular theory holds that everyone believes the risk to the banking system is gone, now that JPMorgan Chase raised its bid for Bear Stearns to $10 a share.

Too good to be true?
Let's not get too excited about these alleged rallying points before we review a few facts. The first one's a doozy. Housing sales are not "up." They are, according to National Association of Realtors, down 23.8% from the sales rate in 2007. (The NAR pulled this same down-is-up trick last year, and we know how awful that turned out.)

The Bear Stearns thing? That's an even more bogus excuse. The only reason JPMorgan Chase raised its bid was because its lawyers messed up the deal, Bear shareholders were threatening to bolt, and Ben Bernanke's Fed had already handed them a $30 billion ticket, so they had nothing to lose by risking another billion dollars when the taxpayers are standing by to pick up the tab if things don't work out well.

So, we've got a fake home-sales rally and an investment-banking vote of confidence that wasn't. On top of it, home prices tanked some 11.4% in January, and consumer confidence plunged to a five-year low, with cash-strapped consumers so down on the economy and buried in debt that they aren't even planning to spend their "economic stimulus" checks, according to a recent poll. That's why I believe it's highly likely that things are very likely to get worse again, perhaps much worse. The question for us is: How should we invest accordingly?

What's a Fool to do?
Well, I'm buying, and have been throughout the doldrums. Yes, the same guy who thinks things will get worse again has been buying. The reasons are simple.

• Stocks don't move in lockstep with the economy.
• Many stocks have been beaten down as if the economy will be this way forever.
• The real comeback (if this isn't it) won't be any more predictable.

And as this week has also shown, when a rally comes, there's no warning bell to let you know it's on the way. It will be unexpected, and it might be amazing. If you think the returns from the major indexes have been good, look at what happened to small caps over the past week. More than 340 small caps trading on U.S. exchanges returned between 15% and 70% over the trailing week. Here are a few of the top performers.

Foolish final thought
In tough times, when money is flocking to "safe" large caps or Treasuries, small caps get brutalized. That's been the case over the past few months.

That's why investors ought to be looking to increase their small-cap allocations while those stocks are out of favor. Of course, you need to be choosy, avoiding leveraged value traps in failing industries, such as homebuilder Beazer, or serial poor performers, such as retailer Talbots. You also need to make sure that the companies you buy have a capital structure (read: cash) that can survive a prolonged downturn ... because we may still get one.

In other words, you can't just plow in and buy. You need to look carefully to balance risks and potential rewards, and invest for the long term. Those are core values of the investing style we practice at our Motley Fool Hiddens Gems small-cap investing service. If you'd like a free look at all of our small-cap research and recommendations, including part one of our annual review issue (to be released this Thursday), click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

Seth Jayson, who was a top-10 CAPS player before this recent rally caught him virtually short, plays it long and strong with real money. He is co-advisor at Motley Fool Hidden Gems. At the time of publication he had no positions in any company mentioned here. JPMorgan Chase is a Motley Fool Income Investor recommendation. View Seth's stock holdings and Fool profile here. The Fool has a disclosure policy.