How to Know When the Stock Market’s Hit Bottom

These four indicators, often overlooked, will help you decide when it’s smart to start buying stocks again.

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Forecasters disagree about whether the economy is falling back into a second recession or simply bumping along the bottom. But once it’s clear that the worst is past, there will be a strong case for buying stocks again. The Dow is off more than 10% in the past month, and blue chips look relatively cheap from a long-term perspective. The challenge for investors is deciding when we’ve finally hit bottom. Fortunately, there are some bellwethers you can watch.

No one can anticipate, of course, every possible global event that might hurt stock prices. Some experts think China could suddenly develop big economic problems, for instance. But two main investing risks are clearly defined, and there are readily available indicators that can help you decide whether those two problems are getting better or worse.

The most obvious risk is the U.S. economy itself. Growth has nearly ground to a halt, according to Friday’s downward revision of second-quarter GDP. And Federal Reserve chairman Ben Bernanke has adopted a wait-and-see attitude and postponed any additional monetary stimulus. In short, the economy is adrift, and although the stock market’s fluctuations have been violent, they lack any clear direction.

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There’s an even bigger danger, however, that doesn’t originate in the U.S. at all. The finances of the weaker European countries continue to deteriorate. Indeed, last week Greek banks had to borrow from an emergency fund. Fears are growing that a default by one of the countries that uses the Euro currency could cause a European banking crisis that would go global and lead to large losses at U.S. banks as well. The financial crisis that would follow – even if not as serious as the one in 2008 and ’09 – would most likely knock the American stock market down again.

Here are four indicators you can easily follow to keep track of both the global financial situation and the basic trend in the U.S. economy:

Vulnerable European banks. Certain large European banks are the institutions most directly exposed to any major defaults. Chief among them is the French bank Société Générale, Its share price on the Paris Stock Exchange has dropped in half in the past two months. BNP Paribas, another vulnerable French bank, is down by more than a third. Although not within the Euro currency zone, the Royal Bank of Scotland (RBS) holds a lot of European debt. In the past two months, the stock is down more than a third. The continuing deterioration of these bank shares would signal that the European banking crisis was worsening, while a rebound would indicate a significant respite.
U.S. bank preferreds. If you want to gauge the extent to which European banking worries are affecting American institutions, follow the exchange-traded funds (ETFs) that hold the preferred shares of major U.S. banks. These ETFs include iShares S&P US Preferred Stock (PFF) and PowerShares Financial Preferred (PGF). Both were more than 15% off their highs earlier this month but have since recovered somewhat, suggesting that investors think the problems in Europe may be containable. A drop in these bank preferred ETFs would mean that fears of global contagion were increasing.

Copper prices. For an indication of the health of the global economy, keep an eye on the price of copper, which is an essential raw material for electrical wire, pipes and other industrial products. As with oil, the price is determined by global demand, not just by the U.S. economy. Copper prices fell in early August, but have recently begun to recover a bit. You can also track the share price of Freeport-McMoRan Copper & Gold (FCX), the largest publicly traded copper producer. Or for a purer play, watch the shares of Southern Copper (SCCO).

Consumer stocks. So-called consumer discretionary goods and services – including hotels, restaurants and clothing stores – are more focused indicators of U.S. economic activity. The SPDR consumer discretionary sector fund (XLY) holds a broad range of such shares. It sold off in late July and early August and has not recovered much so far.

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At present, these bellwethers seem to indicate that the danger of a European banking crisis remains, but that fears it will spread to the U.S. have eased – at least temporarily. I still believe that the greatest risk for U.S. investors is a European default that rocks the global banking system. The world economy appears to be improving a bit, but the U.S. doesn’t seem to be participating at the moment.

While I consider consumer stocks and ETFs to be valuable chiefly as economic indicators, a few of them could be good buys in any major decline. Freeport would be an excellent holding if you need to add basic materials to your portfolio as a long-term hedge against inflation. And the two bank preferred ETFs, which now yield more than 7%, could drop in a banking crisis to a level where they paid 9% or 10%. If that happens, they would be well-worth scooping up, and a safer choice than bank common stocks.