We're Almost in the Bargain Basement

 | May 17, 2012 | 12:30 PM EDT
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JPM HES

We are almost there. The decline in the stock market has now reached about 8% in the S&P 500. Since putting in the highs back in March, we have dropped pretty steadily. We had one attempt at the highs, but selling has taken over, and we are getting closer to that 10% drawdown area where I start thinking about doing some bargain-hunting.

The market has one peak-to-valley decline of between 10% and 15% just about every year, and it looks like we are working on the initial decline for 2012. It may or may not be one of those occasions where we keep moving down and get a serious decline of more than 20%. I will look for bargains when we get down more than 10%, and buy what is safe and cheap, and wait to see what happens. For me, the money is made by reacting, not predicting.

I find it informative to start thinking about what is leading the market lower. Much as the market leaders in a rally are the ones that move the fastest on the way down, the biggest losers in a decline often fall to bargain levels and lead the rebound in a recovery rally. Stocks have historically shown strong signs of mean reversion, and those that move too far too fast in one direction will eventually move the other way. Valuation is still the key to picking stocks, but looking for cheap stocks that have made sharp moves down has been profitable for me over the years.

The big money-center banks are leading the way lower right now. Bank of America (BAC), Morgan Stanley (MS) and Citigroup (C) are all down more than 20% in the past month. JPMorgan (JPM) is flirting with a 20% decline, as it has dropped a little more than 19% in the past four weeks.

Given the negative publicity and the fact that traders are leaning on their positions right now, JPMorgan is likely to see a larger loss and lower stock price in the weeks ahead.  We will hear a lot of talk about these stocks as traders predict a recovery rally in financials or a disaster in the bank stocks as the market moves lower. Rather than guess the path of least resistance, I am going to apply a simple rule to these stocks. I will apply my distressed-bank rule and buy the large money-center banks only when they trade at 40% of tangible book value or less.

One stock that has sold off sharply catches my eye as a potential bargain issue. Shares of the oil and gas producer Hess (HES) are down 20% this month and more than 40% over the past year. Hess is involved in all aspects of the oil and gas business, from exploration and production to refining and marketing. For a few quarters, the company has fallen short of analyst estimates, and the stock has fallen below tangible book value, something it has not done in over a decade.

Hess has invested heavily in both the Bakken and Utica shale fields, and this should lead to higher production and profits going forward. Insiders must think so, as CEO John Hess and several others have been buying stock recently. If the economy firms in the second half of the year, this stock could easily rally by close to 50%. The stock trades at levels that have marked important lows in the past, and it's cheaper than it has been in more than a decade on an asset basis. The stock is becoming too cheap not to own.

We are not down 10% yet, but we are close. It is time for even a hands-off value guy like me to pay a little more attention to the overall market.

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