Forecast 2009: Your investments

(Money Magazine) -- Believe it or not, the extreme market volatility of late 2008 - the Dow Jones industrial average swinging 1000 points in a single day, the Chicago Board Options Exchange market volatility index (VIX) hitting all-time highs - may be a harbinger of good things in 2009.

That's because a peak in volatility has historically occurred within one month of major bear market bottoms since 1960, notes Sam Stovall, chief investment strategist at Standard & Poor's Equity Research.

Another ray of hope: The stock market historically bottoms out about three months before a recession ends. As we noted earlier, most economists believe we're in a recession that will last through the end of March.

If that forecast pans out, you can expect the market to bottom around the end of 2008. Even if the recession drags on longer than the pros currently think it will, we're probably still looking at a stock market rebound at some point during the first half of 2009.

"Any way you look at it, we think prices will likely turn higher before the economy or corporate earnings do," says Stovall.

But the biggest bright spot for investors is that this year's steep market declines have made stocks look much more attractive relative to their earnings prospects.

The price/earnings ratio for companies in Standard & Poor's 500 index now stands at 16.5, down sharply from 23.6 when the bull market ended in October 2007 and well within the 6.8-to- 23.5 P/E range during previous major recessions, as tracked by Birinyi Associates.

"We have not seen the kind of value that we have today since the bottom of the market in 1987," says First Trust Advisors' Brian Wesbury. "Great companies with incredible amounts of cash on their books are selling at very cheap prices."

Of course, none of this is to say that you can expect the market's trajectory to be straight up from here. In particular, there's still a lot of concern that the government won't succeed in unfreezing the credit markets in the near future. Until that worry goes away, the market will still be volatile, say experts.

"Our 2009 year-end forecast for the S&P 500 is higher than where we are today, but it won't necessarily be a fun path to get there," says Fusion IQ's Barry Ritholtz. "The market could be bouncing along the bottom for a few months before you start to see it rallying."

• Global losses from the subprime meltdown

The total amount is not yet known. If it proves to be far steeper than the $1.4 trillion currently expected, investors won't feel confident that the credit crisis is abating - which could send stocks lower.

• Forget about timing the market

You have no way of knowing exactly when stocks will hit bottom. Volumes of research have proved that not even the pros can figure that out with any consistency. And if you're out of the market when the rebound kicks in, the damage to your future financial well-being could be severe.

Consider this: In the first 40 days of a new bull market, stocks typically regain a third of what they lost during the bear, according to Standard & Poor's. Miss that and you'll feel like you got trampled.

• Rebalance

Markets like this can throw your asset allocation off-kilter fast. If your portfolio at the beginning of 2008 consisted of 70% stocks and 30% bonds, it's now probably a lot closer to 60-40. To get back to your target, unload some bonds and buy stocks.

The trick is to get your emotions out of the picture by arranging to have your portfolio rebalanced automatically, whether by investing in a target-date fund or hiring a financial planner who can periodically rebalance for you.

• Wait

Now that Barack Obama has won the White House, consider selling any winning stocks. The President-elect has said he intends to raise the capital-gains tax rate from 15% to 20% for people earning more than $250,000, and he may get pressured to lower that income threshold. So if you're sitting on some stock that has risen in value since you bought it years ago, consider unloading at least some of it before the rate rises.

Don't get too defensive

Make sure that the stock portion of your portfolio hasn't become overly tilted toward "defensive" sectors such as consumer staples and health care. During shaky economic times, these stocks usually outperform.

But "everybody has flocked into the safety of the consumer staples, so they've gotten pricey," says Tom Forester, manager of the Forester Value Fund.

Meanwhile, stocks from more economically sensitive sectors like financials and consumer discretionary (goods and services that people want but don't need) have been beaten down so much that they're starting to look like bargains: Standard & Poor's projects that those will be the two best-performing sectors in the 500 index next year.

• Resist high-yield bonds

With 10-year Treasuries yielding just 3.7%, you may be tempted by a high-yield bond fund: The average one now yields more than 10%. But Thomas Atteberry, portfolio manager with First Pacific Advisors, warns that it's too risky to load up on them until the recession ends.

"Right now the percentage of these bonds defaulting on payments is only about 2.5%," says Atteberry. "But during past recessions, defaults have reached up to 12%." Stick with high quality for now.