Real Rally or Bear Market Trap?

With the ongoing market turbulence, I'm sure you have many pressing questions. When will the market bottom? When will it be safe to go back into stocks? What can I do to start rebuilding my wealth now?

To answer these questions, read on to learn about important events that affect the market and your wealth.

Why Hasn't a Bottom Been Set?

The one question I routinely get from friends and acquaintances is "when will the market hit bottom?" I'm sure you want the answer too.

Months ago, I said the Dow Jones Industrial Average ($DJI) would hit 6,300. At the time, that sounded like a shocking prediction. I even followed my prediction by saying "I hope I'm wrong."

Unfortunately, it looks like I was pretty darn right. The market dipped to 6,500 on March 9. And the recent rebound is nothing more than a bear market rally.

But will 6,300 be a bottom?

I wish I could look you in the eye and say yes it is. But the data gives me reason to be cautious. I don't know what fair value for the Dow or the S&P 500 (SPX) is. And neither does anybody else.

Can't Buy What you Can't Price

My target assumed the average P/E multiple for the Dow would fall close to single-digits, something that has not happened since the mid-1980s. (The major indexes have traded at single-digit P/Es during various periods throughout market history, often in response to economic peril.) The math works if I know approximately what earnings are going to be. But I don't have much faith in the current profit forecasts, and neither should you.

The reason is that brokerage analysts continue to cut their full-year forecasts across the board.

Let me give you an example. Last November, the 2009 top-down S&P 500 consensus earnings estimate was $93.73. Now, the consensus estimate is $61.22. That's a 35% reduction in a period of just 4 months.Is the consensus forecast going to go lower? Yes. How much lower? One analyst is saying $40 per share, but a few months ago, the most pessimistic analyst said earnings would total $75.20.Knowing this, do you blame me for being cautious?

Going back to the math, P/E is price divided by earnings. We can figure out the price by looking at a quote page. But what do we divide the price by? $61.22? $40? The lack of visibility is perplexing even to those paid to make earnings forecasts.

Put another way, suppose you walked into a store and saw a shirt you liked, but there was no price tag. Naturally, you would ask a sales person to look up the price. But what if she couldn't tell you the price? You would either try to buy it for what you think is a really cheap price or walk away.

This is what is happening with stocks. Nobody wants to overpay, but they can't figure out how much stocks are worth. It's frustrating for everybody.

Bargain Hunters Skittish Too

Adding to the frustration are the constant new lows for the major indexes.
Ever since Bear Stearns went down, the market has been establishing lower highs and lower lows.

For investors trained to buy on dips, this is painful. Every failure of the market to rebound causes another bargain hunter to lose money. This results in a downward cycle where would-be buyers keep their toes out of the water, causing stocks to fall further and force even more investors to the sidelines.

At some point, prices will get so low that investors will set their fears aside and start to buy stocks. This day will happen without any foreshadowing. We will all wake up and realize that the bottom has been set.

So your strategy is to maintain exposure to stocks while managing your risk. How do you this? We'll have to go back to 1934 for the answer.

Invest with a Margin of Safety

In the midst of the Great Depression, Warren Buffett's mentor, Benjamin Graham, published Securities Analysis. In this nearly 800-page book, Graham advised looking for stocks trading at low enough valuations to provide a cushion in case things got worse.

It's good advice that holds true today. Take a look at what analysts are forecasting and ask yourself - if those estimates were 10% lower, would you still consider the stock to be a bargain? The idea is not to find the absolute cheapest stock, but to find a good, stable company that is now "on sale" thanks to the market.

In other words, you're assuming that the forecasts are too high, but you are still getting a good enough deal on the stock that it doesn't matter.

The Other Key:  Watch for Earnings Estimate Revisions

You should focus on companies with earnings estimates that are holding up reasonably well, or are rising. Avoid companies with profit forecasts that are falling. The reason is that earnings estimate revisions are the single most important factor to impact stock prices, as a discovery made by Len Zacks in 1978 proves. His ground breaking research found that positive revisions result in better returns and negative revisions result in lower returns. Len, who holds a PhD in mathematics from M.I.T., established the Zacks Rank to harness the power of the earnings estimate revisions to classify stocks into five groups, ranging from "Strong Buy" to "Strong Sell". Since 1988 the Zacks Rank #1 stocks have returned +27% per year. That triples the average S&P 500 yearly gain.You are invited to learn more about earnings estimate revisions and the power of the Zacks Rank that uses this data to forecast the direction of stock prices. Click here for details.Since 1988 if you invested $10,000 in the S&P 500, it would have moved from $10,000 to $57,221. But if you focused on Zacks #1 Rank picks, your $10,000 would have exploded to $1.4 million. Click here to start your free trial.

Whether this is a real rally or, (more likely), a bear market trap. Zacks Rank investing offers the best stock investment opportunity for substantial stock gains.

Wishing you prosperity,