Three Biotechs Join Stocks Under $10 Watch List

The major indices surged yesterday on some positive news from the Federal Reserve, and we wanted to share our outlook. Also, we are adding a few biotech stocks to the Watch List in the Stocks Under $10 model portfolio.

We updated our subscribers to the Stocks Under $10 service yesterday but the news is very applicable to readers of TheStreet.com. (If you would like to receive our alerts, click here for a free trial to TheStreet.com Stocks Under $10 service.)

Now let's take a look at this market. Yesterday morning, the Federal Reserve announced that it would expand its securities lending program -- offering up to $200 billion of U.S. Treasury securities -- to primary dealers in an effort to increase liquidity. This will essentially allow dealers to swap their mortgage-backed securities for Treasuries.

The news sent stocks -- and most of our model portfolio names -- sharply higher, and while we applaud the Fed on this move, the bigger picture indicates this rally could be short-lived.

Looking ahead over the next three to six months, we are likely to see negative news in terms of economic data. It's difficult to believe that unemployment, manufacturing, retail and overall consumer spending -- which account for more than two-thirds of U.S. GDP -- will gain momentum as oil and gasoline prices continue to push through record highs and the housing market continues to deteriorate.

On the earnings front, we are likely to see few companies raise guidance when recent surveys suggest that there is more than a 50% chance the economy will be in a recession this year. Also, while financials are rallying today, over the past two months almost every sell-side firm has revised its earnings lower in this sector. This leads us to believe that the downturn could last well into 2009.

In addition, the reactions to stocks that report better-than-expected results represent another negative indicator. On Monday, McDonald'sMCD reported a huge jump in same-store sales only to see its stock rise just 3%. On the flip side, when companies fall short of estimates, we are seeing declines in excess of 10% -- and sometimes more than 20% -- leaving many stocks with an unfavorable risk/reward profile.

AeropostaleARO is another example of a company that reported same-store sales that beat expectations. But Citigroup greeted this positive news with a downgrade to sell. On Thursday, CienaCIEN reported solid earnings that were well ahead of estimates, yet the stock was downgraded the next day by three separate firms.

Based on these examples, it seems as if most analysts and investors refuse to hold stocks long term -- even those with strong underlying fundamentals and growth profiles. We believe this will change, albeit in time, or when there is evidence that the recent stimulus packages from the U.S. government are actually working.

This could be in the form of fewer writedowns and margin calls, but ideally we would prefer to see a steady wave of positive economic data. Until we see these signs, we remain cautious, as there is no short-term solution to fix the current credit and housing crises.

As for stocks priced below $10 a share, following the huge selloff in this group over the past few months, one area that does have a favorable risk/reward is small-cap biotech. Many quality biotech names that trade under $10 have been pushed down during the early part of 2008, creating opportunities for investors looking for long-term gains.

We've watched speculative stocks in many different sectors trade lower as the market's appetite for risk has virtually disappeared. Despite its recent declines, we believe biotech is one of the areas where there are opportunities for double-digit percentage gains, as sentiment will likely improve in the coming months.