Miss the Recent Market Bottom?

The worst is past. That's been the gist of many a news story this summer. (At least, when it's not "Duck and Cover!") Around the world, pundits who had been telling us the sky was falling switch their story the next week to declare that all is well. Markets are back. Full speed ahead! The Dow, Nasdaq, and S&P have bounced back from July's lows, and Wall Street looks set to rally again.

Oil is down! Is that the catalyst? Housing sales are coming back! Another popular theory holds that investors believe the risk to the banking system is gone, now that Hank Paulson has pledged unlimited taxpayer funds to rescue Freddie Mac (NYSE:FRE) and Fannie Mae (NYSE:FNM), and their shares have also rallied, and may even be worth more than a Happy Meal by the end of the week.

Too good to be true?
Let's not get too excited about these alleged rallying points before we review a few facts. Oil is still so expensive that it's killing the carmakers and pushing up producer prices (a record gain last month) and consumer prices.

Housing sales -- the crutch on which our bubble economy did its limping -- are nowhere near normal. This week's sales "increase" trumpeted by the National Association of Realtors and parroted by headline writers the world over was anything but good news. It was a monthly anomaly (an atrocious one) that reflected a historic rise in foreclosures being purchased from distressed sellers (the banks). It still wasn't enough to lower home inventories. Year over year (the number that matters) showed another drop in sales activity, and prices are falling at a record pace, as this week's S&P home price index illustrates.

As for the big financials. Sure, no banks have failed in the past five minutes, but the writedowns continue, managers are being sacked at places like Wachovia and AIG, and many of these supposed powerhouses are still scrambling for capital, and paying a lot of money to get it, or not getting it at all, and hoping to survive the week. Just ask Lehman Brothers.

So, we've got somewhat less insanely expensive oil, a fake home-sales rally, and a financial sector vote of confidence that isn't. Consumer confidence plunging to multi-decade lows, 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 the past few weeks have 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 decent on the upswings, look at what happened to small caps over the past few weeks. More than 85 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, 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 , a top-20 Motley Fool CAPS player, is co-advisor at Motley Fool Hidden Gems. At the time of publication, he had no positions in any company mentioned here. The Fool has a disclosure policy.