A Panic Portfolio for Nasdaq 1400 - TheStreet

One afternoon last week, hedge fund manager Mr. P emerged briefly from his research in an East Coast college town and was lavishly feted in New York by clients grateful for his timely advice on bonds. Far from returning to his office flush with feelings of self-satisfaction, though, he told me later that the table conversation had left him disturbed, for the talk among the experts confirmed his own souring view on stocks.

After a six-month period in which he felt certain that tax cuts and rate cuts would outweigh investors' fears and bolster equities, he said he believes we now stand at an uncertain crossroads where prices and prospects are in a dangerous disequilibrium.

"What I learned at the lunch is that everyone is confused, not just me," he said. "We agreed that stocks are overvalued here, and overbought technically -- and we just wonder what the trigger is that takes them down."

Down for him means a

Nasdaq Composite

under 1500 -- but we'll get to that in a minute, along with a list of stocks to play for a rebound.

First, though, you need to know that his record on these calls is pretty good so far this year.

Back on Jan. 10, I introduced Mr. P to readers in a column in which he said the bear-savaged market had reached a level at which the smartest long-term investors would buy. Leveraging his advice to look for companies that had excelled for the past decade but were clobbered in the prior 12 months, I screened our database to find 10 stocks he agreed to endorse. They have delivered with a gain of 12% through Friday, vs. a 3% decline in the S&P 500 index, led by a 49% advance in MoneyCentral's parent company, Microsoft . (Click here to see the list.)

The next time Mr. P showed up here was Feb. 28, when he advised my readers that stocks would continue the month's sickening slide at an increasing pace. They did.

Three weeks later, with stocks still plummeting, he relayed his intention to cover shorts and go long soon after March 20, and he offered downside targets of 9575 for the Dow Jones Industrials, 1750 for the Nasdaq Composite and 1130 for the S&P 500. Close enough. Those proved to be near the lows for the year.

Pull a Little Money Off the Table

If you took his advice on these calls, nice going. Now book the profits, he says, and stand aside -- as he believes recent volatile market action suggests that major trend-following traders are shifting sides from bullish to bearish and could take the Nasdaq -- but maybe not the Dow or the S&P 500 -- beneath prior lows. He's targeted 1650 for the Nasdaq, followed by a brief bounce and a final plunge to the 1400 area.

One reason: For the past month and a half, he says, a hidden but powerful catalyst for equity prices has been professional fund managers' shift from bonds to stocks to meet the asset-allocation requirements of their charters or investment policies. A buoyant "feeling" articulated by major brokerage analysts that the technology business had bottomed provided a light news overlay to that subterranean shift.

But Mr. P believes optimism for a strong third-quarter recovery for tech business is misguided. And he thinks reality will swamp share prices at a time when few positive catalysts remain to encourage buyers, a Democrat-controlled

Congress

appears intent on upsetting

Bush

administration plans, the

Fed seems ready to stop slashing interest rates after one more 25 basis-point cut and the Mideast looks increasingly to be on a war footing.

"Where's the good news going to come from to take stocks higher?" he asks, rhetorically. "Everything we felt sure would happen this year has already happened. We knew that there would be tax relief, and that's done. We knew the Fed would cut rates, and that's done. We didn't know Bush would lose the

Senate

, and that's a big concern. Now we don't know what the encore is. And if I'm having trouble seeing forward, then everyone else is, too -- don't let them kid you. Without any real visibility, the market -- the mutual funds, the pension funds -- is overconfident at this level. Valuations are back to the crazy places they were before. To justify these prices you have to believe companies are going to start growing 40% to 50% a year again right away. I don't see that happening."

What should you do? Here are five practical suggestions, in order of increasing aggressiveness:

Do nothing. Just close your eyes and wait for this coming wave of pain to pass. It may not last long.

If you have borrowed money to leverage current long positions, get back to flat.

If you are up this year at least by the 12% margin noted above, take the equivalent of three percentage points' worth of your gains and buy puts on the Nasdaq Composite as insurance against losses.

Buy puts outright on the tech-heavy index.

Put in "crazy bids" for technology favorites at prices much lower than the market, with the expectation that they could actually get hit during the summer.

The last recommendation sounds like the most fun, so let's see if we can figure out the right stocks and the right prices.

Setting Our Targets Low

To start with, Mr. P likes the semiconductors because he sees them as already inexpensive on a relative historical basis, though they could still get cheaper because business remains lousy. He also likes consumer cyclicals, such as auto-parts makers, again because of their relative cheapness and potential to rebound later in the year. He doesn't like the financials or energy complex, which he believes are near the top of their valuation cycle. And he perennially likes biotechs, because he believes they'll be the source of the economy's next great growth spurt in a few years.

Leaning on these ideas -- as well as groundwork laid in other columns on relative valuation this year by myself and the Niederhoffer-Kenner duo -- I developed a new screen for the S&P 500 that I'll call my "Panic Portfolio." First, I fired up MSN MoneyCentral's Stock Screener and displayed the distance between all S&P 500 component stocks' current prices and their respective 52-week lows and highs. I then measured the stocks' valuation relative to their peers by comparing their

price-to-sales ratio with their industry average. I speculated that in a general market decline most of these stocks would get close to their March or April lows, so I exported the screen results to Excel and created a column that calculated prices 10% above those lows.

For stocks that were already relatively cheap vs. their peers (with a price/sales ratio less than average), that price became my target. For stocks that were relatively expensive vs. their peers, I cut the target to a level that would bring their valuations in line. To make my final cut, I eliminated all stocks that were not already at least 50% off their 52-week highs. You can do your own further analysis on the following list of 45 stocks, and if you agree with this speculation you would then put in a limit order at your brokerage for stocks at these prices. If you want the whole list of 500 stocks, write me at

jdmmail@microsoft.com.

For all I know, very few if any of these limit orders will get triggered. But if any do, you will at least have the satisfaction of buying unquestionably good companies at what appear to be rock-bottom 2001 prices. For my own tracking, I am going to pick a random, smaller sample out of this group by taking 15 in order by lowest target price. Here's my list:

Novell

,

Xerox

,

Sapient

,

ADC Telecom

,

PG&E

,

Conexant

,

American Power

,

Motorola

,

Circuit City

,

Network Appliance

,

Power-One

,

Nortel

,

Sun Microsystems

,

Cabletron

and

Cisco

. I would hope to hold for at least five years, but I'll take it six months at a time.

At the time of publication, Jon Markman did not own or control shares in any of the equities mentioned in this column.