Sell stocks? Hang on? An investor's dilemma

Michael Sivy, Money Magazine editor at large

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NEW YORK (Money) -- The economy is weakening, the stock market is slumping and there's plenty of bad news. It's easy to feel confused.

If you sell stocks that are way down, you could be getting out at the bottom and miss the rebound. On the other hand, you can feel foolish hanging on to a stock that just keeps dropping.

It may seem as though you would benefit from lightening up on stocks in a falling market and loading up when shares are rising.

But for most of us, the expenses to buy and sell are too high and we aren't in a position to catch trends early enough.

Plus, the costs of guessing wrong can be devastating. Miss big gains at the start of a bull market, and you'll never make up those lost profits.

Does that mean you should be a completely passive investor relying on a few index funds? Some academics would say yes, but I think action is warranted in certain circumstances.

The key is reacting to extremes in stock prices, not to the market's short-term direction. Growth stocks were clearly overpriced in the late 1990s. And it was perfectly reasonable back then to have sold some shares with price/earnings ratios above 30, say, and put the proceeds in a diversified mutual fund.

But even in an extreme market, you shouldn't dump everything in favor of cash. And if you're saving for retirement, you should be even more restrained with their 401(k)s and IRAs.

That's especially true in today's stock market, with stock values that are nowhere near extremes.

Growth stocks are a bit cheap, while low-P/E value stocks are a bit expensive, relative to their historical levels. And corporate giants are more likely to be bargains right now than are small companies with market capitalizations less than $3 billion.

The conclusion is that investors should be using the current market downturn to add to their holdings of blue chips, especially those projected to grow earnings at an average rate of more than 10 percent a year.

There's no need to rush, though. Your smartest move is to identify gaps in your portfolio mix and buy stocks to fill those gaps when the shares look like bargains.

Or if you're a mutual fund investor, just continue to contribute to an S&P 500 index fund.

The market as a whole may be at reasonable levels, but some specific stock groups are obviously quite depressed. Shares of some big drug companies have been down for a long time. And financial services have been suffering since the subprime mortgage crisis intensified in July.

Since then, big financials have fallen by around 20 percent, and some specific stocks are down much more.

At today's prices, a broadly diversified portfolio of financial stocks would probably be a bargain. But if history is any guide, the group may not hit bottom until the full extent of loan losses are known.

That won't happen until audited 2007 results are reported early next year. So the safest strategy is to wait until February or March to buy. You may also want to invest through an index fund or an exchange-traded fund (ETF). (Smart strategies for a scary market)

While most big banks will ride out their loan losses, a few face more serious disruption. Citigroup (Charts, Fortune 500), for instance, might have to sell stock to raise additional capital or might be broken up.

Such stocks may still be attractive for extremely patient investors, however. David Katz, president of Matrix Asset Advisors, thinks Citigroup is now significantly undervalued.

Katz also likes Pfizer (Charts, Fortune 500), the long-troubled pharmaceutical giant.

Depressed stocks are not always poised for a rebound, of course. There's a big difference between companies with solvable problems, even severe ones, and those whose basic business has been impaired.

In the current financial stock selloff, the mortgage lenders face the biggest challenges. They not only have large losses that will require writeoffs, they also have to worry about the future for mortgage lending.

A case in point is Washington Mutual (Charts, Fortune 500), which is on the Sivy 70 list. I haven't removed it from the list so far, but there's clearly a question of whether its earnings growth will revive even after all the current financial sector problems are over.

There's one final fact to keep in mind. The stock market really does perk up - although sometimes with a lag - after the Federal Reserve begins cutting interest rates.

A new study released in September by leading financial analysts found that between 1973 and 2005, stocks returned an annualized 17.4 percent when the Fed was lowering interest rates vs. only 5.3 percent when the Fed was raising rates.

After pushing up rates for three years, the Fed began cutting in August and September. Historically, lower rates can take nine months or longer to boost the economy.

So the market may not improve until mid-2008. But unless you need to get rid of especially troubled stocks, it doesn't make sense to do a whole lot of selling at this point. If anything, you should take advantage of any weakness over the next few months to scoop up bargains or improve the balance of your portfolio.