Forget the market; just pick stocks

Is the bear market over? You could make a strong case that it will be if the Standard & Poor's 500 Index ($INX) climbs over 935, the January high. That would break a string of lower highs that characterizes a bear market.

Or is this the stock market just setting up investors for another correction or even another bear market low? The stock market isn't exactly racing to a new high, and indicators say it's overextended and ready for a correction. It's not a good sign that on May 7 the market sold off on the good news that the stress tests wouldn't require banks to raise huge amounts of new capital. It sure looked like a bout of profit-taking.

So what do you do? You sure don't want to miss the rally -- if it's real -- and you sure don't want to buy in at a high if it's not.

My advice: Stop trying to figure out the direction of the stock market, and worry more about the value of individual stocks. Unless you're a pure index investor, you'll be buying individual stocks rather than the market as a whole anyway. So turn instead to the good old-fashioned exercise of calculating target prices. Thinking about this as a market of stocks, rather than about the stock market, will focus you on what's really important: the trade-off between risk and reward.

Let me set up the stock market problem facing investors now and then show you how target prices can help solve it for individual stocks.

Since its low at 677 on March 9, the S&P 500 has climbed closer to the magic 935 number. The index closed at 929 on May 8. That's a 37% gain from the March 9 low and just 6 points shy of where it was Jan. 6.

Why would that be important? Because bear markets don't sketch out a steady pattern of lower and lower prices. They're punctuated by major rallies, such as the one that began at the Nov. 20 low of 752 and then failed at 935 in January. But in a bear market each rally does fail and then -- and this is the defining characteristic of a bear market -- stocks fall to a low that's even lower than the one before.

Spotting the elusive bull

A rally that broke through the January high at 935 would disrupt that pattern and give investors confidence that the next time the stock market retreated, it would end that correction above the March 9 low. That combination of a higher high and a higher low would mean that the bear market had indeed ended and that stocks had moved into another bull market.

Bull markets don't move steadily in one direction any more than bear markets do. That's one of the reasons the current period is so hard to read. We could break over 935, a strong signal that the bear might be over, and still get what's called a retracement of about 33%. In fact, a correction of that magnitude would be typical of the kind of retreat that markets show after a 37% run-up in about 40 trading days.

Pay attention, though, to the word retracement. I'm not talking about a move to 950 on the S&P and then a decline of 33%. That would take us back to 636 on the index, well under the March low of 667. The bear market would still be in control.

A 33% retracement, on the other hand, would mean the index had given back 33% of the gains it had made during the rally. A move to 950 followed by a retracement of 33% would take the index back 93 points, to 857 (93 would represent 33% of the 283-point gain from March's low). That would still leave the market well above the March 9 low. A more severe retracement of 62%, also a common reaction to a big, fast move upward, would still take the market down just 175 points, to about 775, still well above the March low.

In these two cases, we're talking about a 10% or an 18% decline from 950 on the S&P.

If that decline ended there, the bear would be dead, and we could look forward to another bull. But, of course, the retracement could well not stop there and instead turn into another crushing bear market loss. How can you know for sure? Ask me to look back in 2010 or so.

Why it's easier to focus on stocks

Compare the confusion in that scenario with the relative -- and it's only relative, I concede -- clarity you get from calculating a target price on an individual stock.

General Cable (BGC, news, msgs), a stock I've had on my watch list for months (the list is in the left margin of this page), has had an even more spectacular run than the S&P 500. From its low March 6 to the close May 7, the shares have roared ahead 160%. That makes the 37% gain on the S&P 500 seem paltry.

But what now? Is it time to buy this stock that is so clearly outperforming the market? Time to take profits? To wait for the retracement? To write this off as a ship that's already sailed?

Certainly, this maker of electrical cables has a bright long-term future. General Cable is one of the 50 stocks in my book "The Jubak Picks." Here's what I wrote in 2008: "After years of underinvestment, it's time to start spending on the electrical grid in the United States. U.S. electric companies are projected to spend $14 billion a year over the next 10 years to make up for years of underinvestment. That's actually small change compared to what China, Russia and the rest of the developing world will spend in the next decade to build out their grids."

Earnings recovery

The problem for General Cable's stock, of course, is that the global economic crisis postponed much of this spending. The company's revenue peaked at $1.74 billion in the second quarter of 2008 and then fell to $1.63 billion in the third quarter, $1.29 billion in the fourth quarter and $1.04 billion in the first quarter of 2009.

Earnings followed the same pattern in 2008, with a peak at $1.37 a share in the second quarter and a trough at 34 cents a share in the fourth quarter.

But in this year's first quarter, the company managed earnings of 92 cents a share as the company's cost cuts kicked in. General Cable reduced the cost of sales in the quarter by $250 million.

And to cap its earnings announcement, the company projected second-quarter 2009 earnings of 70 to 90 cents versus a Wall Street consensus that called for earnings of 69 cents. The revenue story wasn't nearly as breathtaking: The company told analysts it expected revenue for the second quarter of $1.20 billion to $1.25 billion, with the Wall Street consensus figure at $1.21 billion.

You can understand why this stock has climbed off its lows. (General Cable actually set a low for this bear market on Nov. 21, 2008, at $7.62 a share.) Things are no longer getting worse at warp speed. Earnings and revenue that had been in free fall aren't plunging toward destruction.

How to calculate a target price

But that's not the same as saying that this stock, which repeatedly traded at $70 and $80 a share in 2008, will trade there again soon. Analysts have raised their earnings estimates for 2009 and 2010 after the company's recent performance, but even these new projections are well below actual earnings for 2008. The Street consensus says investors can expect General Cable to earn between $2.96 a share and $3.29 a share in 2010. Both numbers are well below the $4.36 a share earned in 2008.

One way to calculate a target price -- and by far the easiest for individual investors -- is to take some forecast of future earnings and multiply it by some reasonable estimate for the future price-earnings ratio.

So, for example, analysts at Sterne Agee project 2009 earnings of $3 a share and multiply that by a price-earnings ratio of 13 to get a target price for General Cable at the end of 2009 of $39 a share.

You're probably familiar with how analysts project future earnings, but where does that P/E of 13 come from? History in this case. Sterne Agee notes that historically General Cable's industry sector has traded at a 10% discount to the P/E of the stocks in the Standard & Poor's 500. If you think a post-recovery price-earnings ratio for the S&P 500 will be something like 14 to 15, then this assumption makes sense.

Give yourself a reality check

Reasonable analysts can disagree on a target price. So, for example, Credit Suisse set a target price of just $34 a share May 5. That's a big increase from its earlier target of $22 share, however. Zacks Investment Research set a target price of $39.20 on May 6. The most optimistic target for 2009 I've been able to find is from Stifel at $48.50. The brokerage company increased its target price from $44 on May 4.

I wouldn't suggest that you blindly accept any of these. (Although thanks to companies such as StarMine, these days you can find out which analyst that follows a stock is most accurate. StarMine's accuracy scores are available through many online brokerage companies. In the case of General Cable, the scores tell you that no one is terribly accurate; ratings range from a high of 67 out of 100 to just 10 of 100.)

But they can be good places to start if you aren't experienced in coming up with your own earnings and P/E projections, and they provide a good reality check even for those of us who are. In the case of General Cable, for example, the low P/E from Sterne Agee is a good reminder that even looking ahead we're buying into a damaged economy with tighter and more expensive money than in 2007. P/E ratios will probably be toward the lower end of the historical scale.

And the stumbling earnings recovery at the company predicted by the more pessimistic analysts is a good reminder that as the global economy recovers and customers resurrect spending plans, General Cable's revenue will indeed go up but that the company's cost of raw materials, largely copper, will also rise from currently depressed levels. That will cut into earnings.

Assess the risk-reward picture

Once you have a target -- one that you've calculated yourself, modified or simply borrowed -- then you need to put it to work. Let's say that after looking at all the numbers, you come out a bit more optimistic that Sterne Agee but not as optimistic as Stifel and set a target price of $40 a share.

Now, work backward from that number to a buy-or-sell decision. The stock at the close May 7 traded at $35.53 a share. If the stock reached your 12-month target of $40, you'd be looking at a gain of $4.47 a share, or about 12.6%. That gain isn't guaranteed, of course, but it's your best estimate of how much you'll make if things work out as you expect.

Is it enough? Depends on how much risk there is of things going wrong that you didn't expect. Right now that target price has a modest but steady economic recovery as a major assumption. That's not at all certain. The target price also assumes that commodity prices won't explode, that interest rates won't crimp customers' investment plans and that we won't see another turn in the credit crunch dry up funding for large infrastructure projects.

Make your buy decision

And, then, of course, there's the risk that the bear isn't over or that we're looking at a major retracement in stock prices after the recent big rally.

(You should also do the same examination of your assumptions on the upside. What could go right that you haven't built in to your target price?)

To me, looking at the most likely gain -- 12.6% -- and the likelihood that my assumptions tilt toward the overly optimistic, the reward isn't there in this stock for taking the risk. I'd pass on this stock at this price. Of course, if I believe in my target price, I'd be willing to revisit this decision:

• If the stock price fell to something below $32 a share, which would give me a potential gain of 25%, which is more in tune with my sense of risk today.

• Or if my estimate of the risk in the stock market and economy went down because I could see the future more clearly.

That's a lot of work for a single stock decision, I grant you, but this is the kind of market that requires lots of work. It's not a time to simply close your eyes and hope that the trend will bail you out if you blow off your homework.

Editor's note: After 12 years of writing two columns a week for MSN Money and beating the market soundly with his Jubak's Picks portfolio, Jim Jubak is taking a well-deserved break. His column is going on hiatus while Jim prepares himself for the next bull market. Over the years, Jim has developed a devoted readership numbering in the millions. An independent report by Nielsen NetRatings found that he was far and away the most widely read investing columnist -- No. 1 on the Web. I'm sure you'll join me in wishing Jim well. If you have any thoughts that you would like me to pass along to him, you can send them here. As always, I welcome your comments on this or any other aspect of MSN Money. -- Richard Jenkins, editor-in-chief, MSN Money