Bracing for the Selloff

• ByTim Melvin, RealMoney.com Contributor
• On 1:00 pm EDT, Thursday July 23, 2009

Watching the stream of earnings reports gives one a lot of insight into the market and the economy. Family Dollar had a huge quarter as cost-conscious consumers increasingly towards discount retailers. Boeing had a strong quarter as the Department of Defense continues to spend money.

There appears to be a strong trend in operating results. If you sell to the government, especially the Department of Defense, or can save consumers money, business is pretty good. In every other area revenue is down and any profits are the results of cost-cutting measures. People are buying less of everything from soda pop to washing machines.

Of course, does not include the bank stocks. A steep yield curve is giving the banks higher revenues and profits almost across the board so far. The problem is that any gains on the income side are going out the balance sheet door.

I have heard a lot of discussion about banks earning their way back to financial stability and I find that notion ridiculous. Loan losses are rising across the board and we still have Alt-A mortgage resets and a rapidly worsening commercial market to deal with in the second half of the year. Bank stocks are going to get very interesting in the weeks ahead as earnings season gives us an idea of where the bargains are and which banks are just too toxic to touch.

Where does all this leave investors? Staying cautious and observant is the best approach right now. Long-term investors are better off to miss a trade or two to prepare for long-term opportunities being created. This is a time to be watching and studying to be prepared when the market does sell off.

I am aware of all the reasons some folks think it will not go down but I feel more strongly than ever that it will. Prices do not reflect what we are seeing in earnings reports and stocks are discounting a recovery far too soon. When asset prices begin to reflect reality, it will be a once in a generation opportunity.

I have talked a lot about what I think will happen with regional and community banks. This will be a trade that can change your life. Right now it is too soon to buy but it is not too soon to be reviewing the balance sheets of banks and talking to the community bankers in your city or town about their outlook.

Pay attention to where insiders are buying and where they are selling. Look for those banks with low loan-loss ratios and high equity to asset ratios and be ready to buy when the price does come down.

It is also a good time to go portfolio digging. Read the latest reports and filings from noted investors like Bob Rodriguez at FPA or Martin Whitman at Third Avenue. I also run a simple search at the SEC Web site every day for any form 13D filings indicating an activist or value investor has taken a large position in a particular company. In a few weeks the 13HF floodgates will open and we will start to get an idea of what some of the value hedge-fund operators like Seth Klarman and David Einhorn have been up to in the quarter.

It is time to be a shopper not a buyer for the most part. There are some net-net stocks that should just be purchased regardless of market opinion and I would limit my buying to those areas. Stocks like Adpatec, Action Semiconductor and Imation that are far below book value with large cash balances relative to share price are the type of situations that fall under too cheap not to buy.

Beyond those situations I would be reluctant to establish a large position right now. You will probably get a chance to buy them cheaper.

Patience can pay right now as we work through the flow of earnings reports and economic releases. We have had a tremendous rally off the lows and some settling down or selling-off is far more likely than a continued climb into the stratosphere. There are there enormous themes developing and I want to have cash on-hand to take advantage of them for the long term.

One is the banks; the other is what I think will be a long-term change in consumer spending habits. Companies that offer discount shopping or home entertainment alternatives are going to do very well for the next five years at least.

Counter-intuitively, companies that operate in what I call the addictive-lifestyle groups will do well. When the economy stabilizes and begins to recover, boaters, golfers and other addictive-lifestyle enthusiasts will return to their hobbies with gusto and stocks like West Marine and Calloway Golf could well soar from their current depressed levels. It is not happening yet as unemployment and real estate keep a damper on all but the most addicted and well-off.

All three of these trends contain the seeds of large profits. They key is to be standing and flush with cash when the tide begins to turn. Patience right now will pay off for the next decade in my opinion.

Buzz up!