Miss the Recent Market Bottom?

Is it safe to come out and invest again? It feels like years since anyone's bothered to consider that question. With the past month's meltdown and the ensuing rabid panic, anyone who had the audacity to suggest we were nearing that elusive "market bottom" would have been laughed off the talk shows.

But remember, just a few weeks back we were being told the worst was over. That was the gist of many a news story this summer. (At least, when it wasn't "Duck and Cover!") Around the world, pundits who had been telling us the sky was falling switched their story the next week to declare that all was well. Markets were back. Full speed ahead! The Dow, Nasdaq, and S&P all bounced back from July lows -- and then promptly fell off the cliff.

And once again, we're being told that the worst is over.

Oil is down! Housing sales are coming back! One theory du jour holds that investors believe the risk to the banking system is going away, now that world governments have pledged trillions of dollars in guarantees and direct capital injections. Not to mention Hank Paulson and Sheila Bair conspiring on yet another mortgage bailout: putting taxpayer guarantees onto your neighbors' failing debts.

Too good to be true?
Let's not get too excited about these alleged rallying points until we review a few facts. Oil has retreated, but the threat of a rebound is killing the carmakers. Housing sales -- the crutch on which our bubble economy did its limping -- are nowhere near normal. The latest new home sales "increase" trumpeted by ignorant headline-writers the world over was anything but good news. The "increase" wasn't big enough to overcome the margin of error in the numbers, meaning it's no increase at all. As the latest S&P home price index illustrates, prices are still falling at a record pace.

And then there are the big financials. Sure, no banks have failed in the past five minutes, but the writedowns continue, and the capital flooding in will continue to dilute current shareholders.

We've got somewhat less insanely expensive oil (for a while), a fake home-sales rally and a financial sector vote of confidence that isn't. Consumer confidence plunged to an all-time low in October, with cash-strapped consumers down on the economy.

All that's to say: I believe it's highly likely that the economy will get worse before it gets better. The question for us is: Given that, how should we invest?

What's a Fool to do?
Well, I'm buying, and have been throughout the summer doldrums and the recent panic. 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. (Look at the news this week.)
• Many stocks have been beaten down as if the economy will be this way forever.
• The long-term, sustainable, stock comeback (if this isn't it) won't be any more predictable.

And as the past few days 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. Nearly two dozen small caps trading on U.S. exchanges returned between 15% and 120% over the past week. Here are a few of the top performers.

Data and screening 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 -- where Vail and Chipotle (B shares) are recommendations, by the way. If you'd like a free look at all of our small-cap research and recommendations, now's a good time. We just released our semi-annual review issue, complete with a new Defense Rating, which lets you know, at a glance, which of our small caps have the strongest balance-sheet health and liquidity prospects. Just click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

Seth Jayson is co-advisor at Motley Fool Hidden Gems. At the time of publication, he had shares of Chipotle, but no positions in any other company mentioned here. Chipotle is a Hidden Gems and Rule Breakers recommendation. Vail is also a Hidden Gems choice. The Fool has a disclosure policy.