Miss the Recent Market Bottom?

Is it safe to come out and invest again? It feels like years since the doom and gloom ended. With the past year's meltdown and the rabid panic, anyone who had the audacity to suggest we were nearing that elusive "market bottom" would have been laughed off the talk shows a few weeks back, but now, the brave (or crazy) emerge every day. When the Sunday newspapers start telling us to consider putting a toe back in the market, you know two things: Sentiment has turned, and that newspaper needs a new headline writer.

Around the world, pundits who have been seeing only bad news and falling skies have switched stories, now declaring that all might be well. Markets are back. Full speed ahead! The Dow, Nasdaq, and S&P have bounced back from last month's lows.

So what's going on now? The answers we're getting aren't too different from those we were hearing a year ago -- when I first penned this article.

Housing sales are coming back! Another recycled 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, and now that Treasury's Tim Geithner and the FDIC's Sheila Bair have conspired on yet another mortgage bailout: putting your 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. 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. Prices are still falling at a record pace, as the latest 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, and the capital flooding in will bring dilution to current shareholders, along with changes in control that may not bode well for the long run

So, a fake home-sales rally and a financial sector vote of confidence that isn't. Consumer confidence has bounced back a little, but with unemployment at 8.5% and rising, I believe it's highly likely that the economy will continue to worsen. The question for us is: How should we invest accordingly?

What's a Fool to do?
Well, I'm buying, and I have been throughout the doldrums and the recent panic. Yes, the same guy who thinks things will get worse again has been buying. My 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 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 900 small caps trading on U.S. exchanges returned between 15% and 200% over the past month. On the low end, that's a good year's return. On the high end, it's cocktail-party braggin' rights.

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 has been the case over the past year. But when they roll back, they roll back big.

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're likely to 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 Under Armour and Logitech are recommendations, by the way. We're so sure that buying now is a good idea that we're putting $250,000 of the Motley Fool's money to work on these small-cap ideas.

If you'd like a free look at all of our small-cap research, past recommendations, and what we're buying (before we buy it), you can take a free trial, on me. There is no obligation to subscribe.

Click here for more information.

This article was originally published on Oct. 30, 2008. It has been updated.

Seth Jayson , co-advisor at Motley Fool Hidden Gems. He doesn't own shares of any companies mentioned in this article. Logitech is a Hidden Gems pick. The Fool has a disclosure policy.