Where the Market Is Headed Next

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 advisors 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 330%.

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

See, I have the benefit of hindsight. All of the above news reports were written in ... October 1990. That 330% 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 exactly call the bottom, 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 in the past few years small-cap stocks have outperformed 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 on Friday, the Russell 2000 Index, which tracks small caps, was down nearly 14% from its high in July of last year.

Many of these small caps have deserved their fall from grace. Some -- such as Jones Soda (NASDAQ:JSDA) -- were trading for outlandish valuations. For others -- such as IndyMac Bancorp (NYSE:IMB) and Colonial Bancgroup (NYSE:CNB) -- business deteriorated thanks to ties to the housing and mortgage markets.

Although all three have dropped precipitously over the past year, none look appetizing to me today.

Where it gets interesting
Leaving the sensible declines behind, there's still 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:

Data from Capital IQ and Yahoo! Finance as of June 10, 2008.

These are all worthy candidates to put on your list of companies to further research. For more ideas, you may also want to check out the most recent issue of Hidden Gems, which features two stocks poised to charge ahead.

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

This article was first published Jan. 24, 2008. It has been updated.  

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