When the economy gets tough, the tough get buying

Quiz time! You see a baby bunny hopping among wildflowers in a meadow. You:

A. Run to get your camera.

B. Wonder at the renewal of life in springtime.

C. Envy a creature that doesn't have to worry about rising inflation, a stagnant economy and a stinking 401(k) account that has gone nowhere for a decade.

If you answered C, you're pretty much in the mainstream of investor sentiment these days. Oddly enough, that's a good thing: On Wall Street, gloom is good, and may even be a good "buy" signal.

The stock market may be deeply analytical in nature, but it's also highly emotional. The past few months, its mood swings have been unusually pronounced.

For example, the Dow Jones industrial average has posted losses of more than 100 points in 57 trading days the past 12 months. The average loss: 208 points.

It's not hard to see why Wall Street is so miserable:

•The credit crisis. The Federal Reserve has pushed the key overnight fed funds rate to 2% from 5.25% in September, but lenders are still terrified of actually making loans. As a result, it's hard for existing businesses to expand, and almost impossible to finance new ventures.

•The housing meltdown. The Standard & Poor's/Case-Shiller 20-city home price index has fallen 12.7% the 12 months ended February. In that month alone, San Francisco-area home prices tumbled 5%.

•Inflation. Even though the consumer price index rose just 0.2% in April, huge jumps in the prices of food and energy remain a big worry, particularly among those who like to eat and drive.

•Earnings. First-quarter earnings for the S&P 500 fell 25.9% from the last three months of 2007, says Howard Silverblatt, S&P index analyst. Earnings for financial services firms dove off a cliff and rolled down a mine shaft, dragging down earnings estimates for the S&P 500 as a whole.

As you might expect, all this bad news has depressed investors. That may be a good thing.

Investor sentiment is a contrary indicator: Typically, the best time to buy is when the public is thoroughly disgusted with the stock market.

Here's an example: The American Association of Individual Investors polls its members each week, asking its members whether they are bullish or bearish. On March 13, 59% of those surveyed were bearish. Since then, the Dow has gained about 6%.

Professional investors, too, hit new levels of despair in March. According to Investor's Intelligence, a newsletter that tracks sentiment, 46% of investment advisers were bearish in its March 14 survey — high enough to be considered a contrary "buy" signal.

Sentiment is only a reliable signal at extremes: Most times, it's suicidal to stand against the herd on the Street. Although sentiment has been getting more bullish since March, current readings are far from the fervent optimism that would trigger a "sell" signal.

And, despite all the gloom on Wall Street, you can make a fairly bullish case for stocks. Low interest rates, after all, tend to make stocks more attractive, particularly when compared with bonds and money market funds. The average money fund now yields just 1.95%, according to iMoneyNet.com. The dividend yield on the S&P 500 is 2.04%.

And aside from banks, many companies have decent earnings, says S&P's Silverblatt. Take out the horrible financial services sector, and the remaining companies in the S&P 500 reported earnings gains of 8.8% in the first quarter, he says. That's not bad at all.

To be sure, consumers remain just as depressed as investors. The Reuters/University of Michigan's Survey of Consumer Confidence fell to levels last seen in 1982. But 1982 really was much worse than today: Unemployment averaged 9.7%, the average mortgage rate was 15.1%, and Maneater, by Hall & Oates, had been on the Top 40 charts for weeks.

In addition, the government is sending out $100 billion in cheer to consumers even as you read this, and it's likely to be spent sooner rather than later. Even if people use the stimulus money to pay off credit cards rather than buy iPods, that means they will have credit lines to use when times are better.

If you're going to tiptoe into the market, play it safe: These are still perilous times, and you don't want to bet on highly specialized, volatile funds. Start by looking for broadly diversified, large-company stock funds. Should the economy slump again, large-cap stocks should hold up better than small-company funds.

The chart shows five top-performing large-company funds that look for stocks of companies with growing earnings. But they don't buy stocks whose prices are high relative to earnings.

These funds also have low annual expenses, which means you get to keep more of what you earn. The more you pay to your fund manager, the less you can keep for yourself.

Finally, all have good performance, relative to the risk they take. That's important: Sure, you can earn a bundle in a red-hot sector fund, but you run a big risk of giving it all back — and more — in short order.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.