Three Stages of a Year-End Rally - TheStreet

Was that the bottom we hit this week? The grand rush down that washes out the last of the optimists and sets the stage for a sustained rally?

My best guess is that we haven't yet seen the last of this bear market. Typically at the bottom, no one wants to buy stocks. Can't give them away. There's just too much fear.

And right now, while the fear quotient is certainly rising, I know too many investors who are hoping for -- indeed, counting on -- an end-of-year rally. Too many investors with busted stocks aren't selling but are instead waiting for the turn. Too many investors with money on the sidelines are expecting an opportunity sometime in the next couple of weeks to profitably deploy those assets. Nope, as painful as it is, we've got more work to do on the downside before we've seen the last of this bear market.

But that doesn't mean we aren't going to get a tradable year-end rally. There is money on the sidelines, tax-loss selling by institutions is drawing to a close, the uncertainties of a presidential election will soon be behind us and, well, there is that optimistic belief that we've got to rally from here. I wouldn't want to bet the farm on it, but I do think the odds are better than even that we will have a significant rally to end the year.

Nasdaq 3700? Roll With It

Don't plan on it making your portfolio whole -- the rally will not be strong enough to take stocks back to their March, or even August, highs. But 3700 on the

Nasdaq Composite Index

is a real possibility. That would be a 22% gain from the Oct. 18 intraday 3026 low. But even that size rally would still leave the index down almost 10% from the Dec. 31, 1999, close of 4069 and a whopping 27% below the March 10 high of 5049.

We're also getting close to the short-term bottom that will provide the floor for that rally, too. Wednesday's reversal from the steep 185-point drop just shortly after the opening bell to close down just 42 points at 3172 didn't have all the ingredients of a short-term bottom. Worries about

Microsoft's

(MSFT) - Get Report

earnings announcement, due after the close, made it hard for investors to get too positive. But with that report now behind us -- Microsoft actually beat estimates by 5 cents a share -- the market is ready to stop its slide. Sometime during the next two to three weeks we'll be able to see that the market, in general, and for technology stocks, in particular, has turned.

That, of course, brings us to the practical question: What should investors do about a potential year-end rally?

That's a tricky question. No investor wants to miss a decent rally -- especially one that comes after so much pain. But on the other hand, if this is an end-of-year rally in the middle of a bear market for technology stocks, no investor wants to get caught in a bear trap, the kind of fake-out rally that tripped up so many of us -- yours truly included -- in August.

My suggestion: Roll with the rally -- but don't forget to roll out. End-of-year rallies have their own typical pattern -- a result of depressed prices from tax-loss selling meeting up with investors who have cash in their pockets and visions of December-quarter sugarplums dancing in their heads. Bear market rallies have their own pattern -- a result of greed and fear meeting head-on. Put the two together this year, and we'll see a rolling rally that takes up groups of stocks in a fairly predictable fashion -- but that is likely to be too tentative to do much for the truly battered equities of this market.

That predictability gives investors a chance to roll their way into this rally, buying groups as they get hot and -- this is critical -- to roll out by selling those buys into the rally as the next group of stocks starts to participate. This strategy should give you an opportunity to participate in the rally, yet give you some protection if the rally fizzles early and the bear market shows its claws again.

How does this roll in, roll out strategy work? It's the opposite of deciding to back up the truck and load up on stocks just because they're cheap. Remember that we've just suffered months of punishment, and we're all extremely gun-shy. This tide won't be strong enough to lift all boats.

Instead, investors will have their stock-picking hats on, and they'll be looking for specific kinds of stories. They'll be looking for stocks that have had the strength to go up while the market as a whole was selling off. They'll be looking for "bargains" in rock-solid market leaders that have sold off just enough to make their prices seem reasonable, but not so much as to suggest that there might be trouble with the merchandise. And they'll be looking for stories that combine high reward and low risk. Solid 20% earnings growth with

price-to-earnings ratios at or below the market average will seem an attractive combination to investors who haven't given up on growth stocks, but who are tired of taking it on the chin when a high-multiple equity disappoints.

The intensity with which investors pursue each type of opportunity is likely to change as any rally develops. At the beginning, investors will chase stocks that have kept their momentum even in a down market. If the rally gains any steam, they'll expand their buying to include slightly nicked, long-term, big-cap favorites. And, as confidence builds further, I'd expect GARP (growth at a reasonable price) stocks to gain a good share of the action.

Early Winners

Based on that general model, we can identify the stocks that will participate in the earliest stages of any year-end rally with a high degree of certainty. You can probably name some of these off the top of your head:

Juniper Networks

(JNPR) - Get Report

,

Brocade Communications Systems

(BRCD)

,

Extreme Networks

(EXTR) - Get Report

,

Mercury Interactive

(MERQ)

and

Ciena

(CIEN) - Get Report

. If you build a MoneyCentral stock screen, you can increase your universe by adding names such as

Network Appliance

(NTAP) - Get Report

,

Ariba

(ARBA)

and

Research in Motion

(RIMM)

. While these high-risk, high-momentum names are likely to be solid winners in the early stages of a rally, be sure you sell when the momentum starts to flag. If I'm right and the bear has more bite left, these are also the names most at risk as the market hits its real bottom.

But the momentum leaders' gains will build confidence as the rally progresses. It will seem safe to a larger group of investors to venture a foot back into the water. In most end-of-year rallies, the first stocks that institutions seek after they've finished their tax-loss selling are any big, high-quality names that have taken a ding or two. This is a chance to add these stocks at "reasonable" prices. (But don't look for the institutions to take a chance on a stock that's ready to be earmarked as a "past" leader or if there are questions about the core earnings story.) Look for stocks that can promise higher-than-market average earnings growth with some protection from whatever is most worrying investors.

Here's an example of what I mean from Wednesday, Oct. 19.

Prudential Securities

gave

Xilinx

(XLNX) - Get Report

, a chipmaker trading near $61 at the time, a strong buy and a price target of $115. The analyst cited Xilinx's strong earnings report of Oct. 16 -- the company grew earnings per share by nearly 90% from the same period in 1999 -- and its lack of exposure to the risks troubling the rest of the semiconductor sector. Xilinx, the analyst said, doesn't sell into either the PC or wireless handset markets, so questions about growth in those sectors won't trouble the stock.

What are some other stocks like this? In the current market, that means big-cap names such as

Broadcom

(BRCM)

,

Nortel Networks

(NT)

,

Oracle

(ORCL) - Get Report

,

Sun Microsystems

(SUNW) - Get Report

and

EMC

(EMC)

, and mid-cap names such as

PMC-Sierra

(PMCS)

and

Vitesse Semiconductor

(VTSS)

.

On to Small Caps, GARP

In a normal end-of-year move, the rally next expands to include stocks with smaller market caps, less-familiar names, great growth stories and shockingly attractive valuations. I think that's likely this year, even in the midst of a bear market. Stocks that score high with a GARP strategy should do especially well in this stage. The combination of a low multiple and strong growth is attractive at any time, but especially so when risk is at the top of many investors' minds. Three stocks that I mentioned in that article look especially attractive for this stage:

Cypress Semiconductor

(CY) - Get Report

,

California Amplifier

(CAMP) - Get Report

and

Atmel

(ATML)

.

The year-end rally would typically continue to expand beyond the GARP group to include the tumbled and humbled: stocks trading at multiyear lows such as

WorldCom

(WCOM)

, which has retraced its gains in price all the way back to February 1998. But it's not at all certain that this year's rally, taking place in the middle of a bear market, will be strong enough to lift these boats.

In trying to assess these battered stocks, it's worth dividing them into at least three groups.

First, there are those like WorldCom or

Dell Computer

(DELL) - Get Report

whose earnings growth is clearly positive, but it's also clear that growth won't be as positive as it was in the past, and it's still unclear how much of a slowdown the company is facing. These stocks are cheap enough to rally with the general market. But it's unlikely they'll move up strongly and permanently until it's clear what the growth trend is. For them, the issue is the predictability of growth. Other stocks with a similar problem include

Motorola

(MOT)

and

Lucent Technologies

(LU)

.

Second, there are truly busted stocks. These are companies that have lost their way, where growth is at least far below projections and maybe even negative. At the worst, the market entertains serious doubts about the long-term viability of the underlying companies.

Xerox

(XRX) - Get Report

fits this bill. So, too, does

Amazon.com

(AMZN) - Get Report

, shockingly. If the rally is strong enough, it could tack a few bucks onto the prices of these shares. But there is so much uncertainty around them that there simply isn't enough of a reason for most investors -- who already have all the risk they can handle -- to buy these shares.

And, third, there are the "baby with the bath water" stocks. These are stocks that have the bad luck to belong to sectors that the market currently hates, often with a reason. To take one example, investors are rightly concerned about cash flow at many start-up telecommunications service providers. These companies could run out of cash before they've completed their networks and be forced out of business if they can't raise the dough they need. Even if they can raise the capital, the cost may be so high that investors face plunging stock prices from unexpected dilution.

But that's not a reason to selloff well-capitalized telecommunications companies such as

Metromedia Fiber Network

(MFNX)

, which has $2 billion in cash and enough revenue coming in from dark fiber leases to cover the capital costs of its build-out.

A stock in another sector that shares a similar problem is semiconductor equipment maker

Novellus Systems

(NVLS)

. The company has a leadership position in the new copper-chip technologies that should shield it from the worst of any possible capital spending slowdown. In the PC sector,

Nvidia

(NVDA) - Get Report

is driving hard into the non-PC market for 3D graphics chips, and that could be enough to offset any slowdown in sales of PCs.

In my experience, though, it's difficult for investors to look beyond the troubles in a sector to single out promising stocks. The "baby with the bath water" stocks are definitely the most interesting among the humbled and tumbled of this market. But it's too early to tell if the rally will be strong enough to let investors give these stocks their due. They're worth watching, though, and we'll know more about the opportunities in the group once we've had a chance to gauge the strength of any year-end rally.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: America Online, Ariba, Atmel, Broadcom, EMC, Extreme Networks, Microsoft, Mercury Interactive, Nokia, Nortel Networks, PMC-Sierra and RF Micro Devices. He welcomes your feedback at

mctsc@microsoft.com.

More from

MSN MoneyCentral

Rowland's Start Investing Portfolio

Jubak's Picks

Markman's SuperModels