Miss the Recent Market Bottom?

The worst is past. That's the gist of many a news story this month. 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 bounced back over the past few weeks, and Wall Street looks set to rally again.

Just like when I wrote about this last month, the press has recently resumed babbling about an "increase" in new home sales. Is that the catalyst? Another popular theory holds that everyone believes the risk to the banking system is gone, now that JPMorgan Chase (NYSE:JPM) rescued Bear and we haven't had another near-death banking experience.

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 were not "up." New home sales showed a tiny increase month-over-month if -- and only if -- you ignore the huge margin of error in the numbers. Year over year, new home sales show a 40-plus percent drop, still. (Since the business press doesn't like to report this boring reality, I discussed it here.)

As for the banks. Sure, none have fallen lately, but the writedowns continue and many of them are still scrambling for capital, and paying a lot of money to get it. Just ask Citigroup (NYSE:C).

So, we've got a fake home-sales rally and an investment-banking vote of confidence that isn't. On top of it, home prices are tanking at a 14% clip, and consumer confidence plunged to a 16-year low recently, 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 will get worse again, perhaps much worse. The question for us is: How should we invest?

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 few weeks. More than 130 small caps trading on U.S. exchanges returned between 25% and 200% over the trailing month. Here are a few of the top performers.

Data from Capital IQ, a division of Standard & Poor's.

Foolish final thought
In tough times, when money is flocking to "safe" large caps or Treasuries, small caps often 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. Rolling the dice on solar, for example, is a game many will play, but few will win. 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 Hidden Gems small-cap investing service. If you'd like a free look at all of our small-cap research and recommendations, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

This article was first published March 25, 2008. It has been updated.

Seth Jayson , a top-10 CAPS player, 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.