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Bottom's Up

Every October, as predictable as the seasons, the market takes a precipitous turn for the worse. But if you know it's coming, why not profit from the rebound?

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Nobody wants to call a bottom in the market. If stocks keep going down, you look like a moron. If they go up, the buyers take the credit. So why bother?

Because it's October, that's why, and I have seen the market bottom in October so many times that I can't help myself. I don't think this October will be any different.

Why do we keep getting bottoms in this fateful month? What is it about October that produced massive home runs if you purchased stocks at the end of this month in each of the past three years? Frankly, it makes all the sense in the world for both psychological and calendar-related reasons. Everybody is scared of October. It's when we had both our 1929 and our 1987 crashes. And we had three crashettes in October just during the past decade. It has a notoriety that even non-market-savvy magazines and newspapers always talk about in evergreen pieces that appear yearly (almost always with pictures of Kodiaks attached).

It's only natural, then, that people hold back from purchasing stocks in the month of October. And professionals buy puts, or options that allow them to be stopped out of a stock if it goes too low. Negativity gets built up to an extreme. It turns a garden-variety downpour, as we had in the beginning of the month, into the monsoon that hit during the third week of this October: a 438-point decline in the Dow Jones averages during the very first moments of trading.

The anxiety becomes entirely self-fulfilling. And, of course, self-cleansing. The first reason the market bottoms in October is that the sellers finish their selling. Those weak holders who can't stand the pain get blown out, leaving only stalwarts and long-term buy-and-holders who don't sweat the stock-owning program.

Second, the fiscal years for mutual funds tend to end on the last day of October. Many of these funds are now making their distributions to shareholders. Mutual funds typically like to be tax-sensitive, meaning that they don't want to present you with a giant capital gain as part of the fiscal-year-end festivities. This year in particular, they don't want to because even if they took profits in January, February, and March, many of the funds are down for the year. That means that people who own these funds must declare those paper profits and pay taxes on them, even though they actually made no money. The only way to offset the paper gains is to sell the fund and take actual losses.

The unholy combination of losers getting booted and winners being taken off the table has become an annual October ritual. Come November, both are mercifully completed.

The unholy combination of losers getting booted and winners being taken off the table has become an annual October ritual. Come November, both chores are mercifully completed.

People know that these taxable distributions of profits are coming, too. The investing public has gotten smarter and smarter in recent years, and it knows to wait to contribute more funds to mutuals until after they have made the distributions. That way, they sidestep any instant tax consequences that would occur. You can therefore expect a flood of new money flowing into funds after the distributions are made, producing a third reason for a bottom.

Fourth, we have now seen the summer's earnings for many companies, as most get reported in the first weeks of October. Often, summer produces a slowdown. This year was no different. Analysts then knock down their earnings estimates for the year because of the annual disappointment stemming from a slack July, August, and September. Once the cuts are made and the expectations are readjusted down, we stock traders are again free to bet that companies will report better-than-expected earnings, especially because those expectations are now sharply reduced! That's rally tinder. It always works.

Fifth, most of the dangerous bubbles in the market have now been deflated, particularly with the stomping of the fiberoptic boom stocks just last week. That was a constructive development, not cause for alarm, since so many money managers were hiding in these kinds of overvalued stocks -- which is exactly what made the market seem so crazy to the average investor.

Finally, November begins the make-or-break time for many mutual-fund managers. The year hangs in the balance. Collectively, these cautious souls know that unless they generate some performance in the last two months of the year, they may be without jobs come January, or without dollars to invest, because no one from their firms will promote their funds to customers. That means taking every penny you have on the sidelines and throwing it furiously at the market, as nobody ever made a lot of performance sitting in cash.

This final propensity to play to save the day has become so ingrained that at Cramer Berkowitz we try to predict which stocks are most likely to be driven up by those trying to show that they had a hot hand in the end. We look for stocks like Merck and Philip Morris and UnitedHealthcare and Millennium Pharmaceutical to put on quite a show at year's end. Who cares that these stocks are expensive relative to where they were earlier in the year? They are the ideal hiding places for lemmings worried that someone might think they missed a big move in some obvious momentum growth stocks. It is a shameless annual bout of self-preservation, and it has worked well ever since hypergrowth investing came into fashion a decade ago.

The more rigorous among you might be puzzled by my thesis. What about those nasty fundamentals the declining euro, the high oil prices, the weakening semiconductor outlook, the uncertain political environment, the anemic Christmas consumer? To which I say, give me a break -- mutual-fund managers never let the fundamentals get in the way of a performance.

This November will be no different. Given the year's across-the-board terrible performance, you can bet that fund managers will be pulling out all the stops and buying like crazy. And you can bet I'll be there, too, taking stocks furiously, right alongside them.

TheStreet.com
Check out TheStreet.com's "10 Questions" this week. Jeff Van Harte, portfolio manager of the Transamerica Premier Equity fund, is on the hot seat. Available free at www.thestreet.com.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had a long position in Philip Morris. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites comments at jjcletters@thestreet.com


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