This was the cruelest quarter. Which actually gives me just a bit of hope for stocks in the second half of 2002.

Still, the just-concluded second quarter's 21%

Nasdaq

decline wasn't the worst record turned in during the current bear market. During the third quarter of 2001, the Nasdaq Composite plunged 31%.

But I'd argue that this latest quarter's performance hurt the most, even more than that 31% drop. And for two reasons.

First, the bear reasserted itself in the quarter, dashing hopes that we had finally put in a bottom. After the strong rally off the Sept. 21 low and a pullback in early January, the strong rally that began on Feb. 29 convinced many investors that the long downturn was finally over. Cruel hope. By March 8, that rally had petered out, setting up a pattern of short rallies that led to lower lows.

In the just-concluded quarter, the rally from April 11 to April 16 failed at 1,817, and the rally from May 6 through May 17 failed at 1,741, ushering in the tumble that took the Nasdaq down to 1,423.99 on June 25. That low was just eight-tenths of a point above the Sept. 21 closing low at 1,423.19.

Second, this quarter it wasn't just Nasdaq stocks taking body blows. By the end of the quarter, even the sectors and styles that had been going up in 2002 had joined the downward plunge. Just look at a chart for the three major indices from Jan. 2 to now.

Bear Claw Sandwich
Indices on a roll downhill

Dow Divergence Disappears

Start with the Nasdaq Composite. As I've noted above, after peaking at 2,059 on Jan. 4, the index began a fall -- interrupted by rallies in March, April and May -- toward 1,424 on June 25. (The

S&P 500

followed the same pattern.)

Next, add the

Dow Jones Industrial Average

. After starting at 10,073 on Jan. 2, the index actually managed to gain ground through March 8. On that day, which marked the highpoint of the Nasdaq's March rally, the Dow closed at 10,572. As of March 8, the two indices already showed a substantial diversion. At that time, the Nasdaq Composite was down 2% for the year, but the Dow was up 5%.

The divergence proceeded to widen through the middle of May. On May 17, the peak of the Nasdaq's May rally, the index was down 12% year to date. The Dow, in contrast, was up 3%.

But investors who had decided to move money from the plunging Nasdaq to the safe Dow were disappointed by what happened in the last half of the quarter. From May 17 to the June 25 low, the Nasdaq did indeed keep falling, down another 18% during that period.

But Dow stocks got chewed on by the bear, too. In the same period, they fell 12%. That certainly wasn't the kind of performance investors were looking for out of the cyclical Dow stocks.

Et Tu, Small-Caps?

Finally, for the small-company stocks in the

Russell 2000, you'll see the same pattern of early out-performance followed by end-of-quarter collapse. The bear turned its attention to the sector just about the time when every pundit was touting the virtues of small-caps over big-company stocks. After gaining 5% from Jan. 2 through May 17 -- better even than the 3% gain on the Dow -- the Russell 2000 fell by 11% from May 17 through June 25.

In the last half of the quarter, there was simply no place in the stock market to hide. And investors who tried to shift assets from risky sectors to sectors that had been holding up relatively well stood a good chance of getting in just as the performance there was deteriorating.

An all-long portfolio filled with only stocks and cash, such as Jubak's Picks, certainly didn't avoid the carnage. Even though Jubak's Picks ended the period with almost 18% cash, the portfolio finished the quarter down 17.6%. That compares with a drop of 21% on the Nasdaq, a decline of 11% in the Dow, a fall of 14% in the S&P 500 and an 8% retreat in the Russell 2000.

Jubak's Picks

This brings my total gain in Jubak's Picks since I started this portfolio on May 7, 1997, to 36.5%. In the same period, the Nasdaq is up 8%; the S&P 500, up 20%; the Dow, up 32%; and the Russell 2000, up 27%.

My goal entering the second quarter of 2002 was to produce a return closer to that of the Dow than to the Nasdaq, and in that I failed. The "whys" are pretty simple. The solid and steady cyclical stocks I picked to add to the portfolio in the period did manage to go up:

Tom Brown

(TBI) - Get Report

,

Watsco

(WSO) - Get Report

,

Hughes Supply

( HUG) and

J.C. Penney

(JCP) - Get Report

finished the quarter up 3% to 15% since I picked them.

But the riskier, higher-leverage cyclicals I'd added last quarter when the turn in this market looked closer took it on the chin.

Lamar Advertising

(LAMR) - Get Report

and

Continental Airlines

(CAL) - Get Report

are now down 12% and 49%, respectively, since I picked them.

And earlier picks that I was counting on to rebound with the economy, such as

E*Trade

(ET) - Get Report

and

AOL Time Warner

(AOL)

just didn't rebound, despite evidence that the economy is indeed looking better. No one really cares about the economy as the CEO follies continue to play out.

And while I've radically reduced my exposure to technology stocks, I still had enough to hurt me.

Genesis Microchip

( GNSS),

Amkor

(AMKR) - Get Report

,

Wind River Systems

( WIND) and

Icos

( ICOS) all took big losses in the period. The fact that I now believe most of these are deeply oversold is very cold comfort, indeed.

One That Got Away

Of the four stocks I sold this quarter, I think only one was a mistake.

Washington Mutual

(WM) - Get Report

is up 12.5% since I pulled the trigger on April 2. In that case, I simply misjudged the strength of the current housing market and believed that the boom in the sector would end sooner rather than later. The sales of

Merrill Lynch

( MER) and

Arch Coal

(ACI) - Get Report

have been a wash.

Atmel

(ATML)

is down 42% since I sold.

All this is history, of course, but history does offer some guidance to the question, "Where to from here?" To me it looks as if we've laid the groundwork for a solid, short-term rally. Relatively few companies have announced earnings warnings for the just-completed June quarter, and many Wall Street money managers know that past quarters have been so weak that this quarter's results are likely to show quarter-to-quarter improvement. And the fact that the Nasdaq Composite did bounce off of the Sept. 21 low -- rather than going through it in search of a new bottom -- has encouraged many technicians to call for some kind of rally.

At these levels, the potential reward for betting long exceeds the potential reward from putting on new shorts. And the professional shorts have pulled in their positions in recent days. Dan Sullivan, editor of

The Chartist

newsletter, notes that individual investors have been busy buying shorts while the pros have been reducing their exposure. Individual investors, Sullivan calculates, now hold 55% of all outstanding shorts. And that shift in shorting is often a sign that prices are about to turn. Other indicators such as the Volatility Index, or

VIX, and the

Investors Intelligence

bulls/bears sentiment survey also now point toward a rally.

Actual Earnings Could Foil Rally

But it's hard for me to see why any rally should last more than a few weeks. The rally, if we get one, will be built on hopes for decent earnings in the July reports and on technical indicators that suggest it's time to take some profits in shorts and wait for the next opportunity when prices are higher. By the time we get to the actual earnings reports, however, this fuel is likely to be all spent. And any rally is likely to stall.

Mind you, I hope this turns out not to be true. I'd like nothing better than to see a rally that took off from 1,424 on the Nasdaq and never looked back. And if we get surprisingly strong guidance from technology companies on their prospects for the September quarter, that could happen.

But I'm not expecting it. Technology companies have been indicating that demand is likely to be limp in September. I expect guidance to continue to set the stage for improvement, as companies say they see better visibility or improvements in the pattern of orders. But I think we're still a quarter or two, or more, away from seeing the kind of concrete improvement in reported corporate profits that this market needs for a lasting turn.

One More Washout

Longer run, I'm worried that we have one more washout to come. This last quarter was, indeed, deeply discouraging to many investors, and significant numbers of them left the market. A chorus of voices, seeking the last big selloff of the bear market, kept asking, "Is this capitulation?" If this bear market follows historical patterns, we'll only have reached a true bottom when almost nobody cares about the answer to that question.

None of this may seem especially hopeful, certainly, but the pattern that is now unfolding is exactly what happens historically when a bad bear market draws to a close. Even if I don't see anything that guarantees we've hit the bottom in this stock market, the odds are that we're in the bottoming process and that a final bottom could come as early as the last half of 2002. That's not especially optimistic, I grant you, but it does give me some hope: We continue to work through a recognizable bottoming pattern of the kind that has ended other bear markets. Exactly where and when that bottom may be, however, remains anyone's guess.

So I'm going to treat this rally, if we get one, as a chance to get rid of some more deadwood, meaning companies that I like in the long term but that don't look likely to do anything for two quarters or more, as well as companies vulnerable to accounting scandal.

In the third quarter of 2002, I'll be looking to add solid earners that can give me some upside if the economic recovery continues to chug along; it's important, though, that these companies not carry enough risk to scare anyone away in this market. I'll keep an eye out for true blue-chip stocks trading at historically depressed prices. I'll look to find stocks that can improve the energy hedge in Jubak's Picks against increased political instability in the Middle East. And I'll start building a hedge against a possible tumble in the value of the dollar against the currencies of our biggest trading partners.

Those are relatively modest goals -- but I think that this is a market for taking only modest risk in the hope of earning modest returns.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. ET. At the time of publication, he owned or controlled shares in the following equities mentioned in this column: Amkor, AOL Time Warner, Continental Airlines, E*Trade, Icos and Wind River Systems.