If you’re feeling sick about your portfolio’s performance this year, you’re not alone. The US stock market is truly in unprecedented territory.

As I noted on our financial blog At These Levels yesterday, the worst annual showing for the S&P 500 since 1927 is a 47.1 percent decline in 1931, right in the heart of The Great Depression. So far this year, the S&P 500 is down just under 49 percent; the index is on pace for its worst year ever, a staggering statistic in my view.

Not surprisingly, the gloom is palpable. At the beginning of 2008, there were still plenty of pundits predicting the US would skirt recession this year or only experience a mild slowdown. Now, most are convinced the nation is in for a deep recession that will be far more painful and longstanding than the contraction in 2001 or the early 1990s.

Investors are running for the hills and the safety of short-term US government bonds, as you can see in the chart below.

Source: Bloomberg

This chart shows the yield on a three-month US Treasury bill over the past several years. As with all bonds, yield moves inversely with price--that is, when the price rises, the yield falls.

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The current yield on a three-month bill is 0.0101 percent, the lowest yield ever recorded. Investors have been piling into risk-free short-term US government debt since the summer of 2007 when the credit crunch first began to infect global markets. This is the clearest sign of extreme risk aversion and market panic I can imagine. There’s just not much room left on the downside for 3-month yields.

The global currency markets also reflect the deleveraging process that’s currently underway globally. Consider the chart of the Japanese yen against the US dollar below.

Source: Bloomberg

The standard quotation in the yen/dollar currency market is how many yen it takes to purchase one US dollar; when this line is falling, the yen is gaining in value against the dollar.

The yen/dollar and yen/euro exchange rates are the easiest way to assess the intensity of selling by institutional investors, such as hedge funds, on a day-to-day basis. Institutional investors borrow money in yen because prevailing interest rates have been ultra-low for many years. Those investors then convert their yen into other currencies and purchase riskier assets such as stocks.

When traders borrow in yen and then sell those yen to buy other currencies, it depresses the value of the yen relative to the dollar and euro. Therefore, when the yen falls in value, it suggests that investors are leveraging; they’re borrowing more money in yen with which to increase their positions.

When the yen rises sharply in value it suggests these same traders are reversing their positions. In other words, they’re selling off their portfolios and converting the cash back to yen to repay their loans. When the yen rises in value, hedge funds and other institutional traders are deleveraging.

The trend in the chart is clear. The yen has been rising in value sharply since midsummer and recently hit a new decade high against the US dollar. A rally in the dollar against the yen--such as the one we saw from February through June of this year--would signal an end to deleveraging and the potential for upside in stocks. But there’s little sign of a meaningful turn in the yen at this time.

It should come as little surprise that institutional deleveraging coupled with terrible economic data and extreme risk aversion has resulted in a collapse in the S&P 500 under its 2002 lows. But don’t forget that the most downbeat market environments often offer investors the best long-term opportunities. As Warren Buffet recently advised in a New York Times op-ed, “Be greedy when others are fearful and fearful when others are greedy.”

With the stock market down over 50 percent from its highs last year, many stocks are already pricing in a severe economic retrenchment, trading at 10 and 20-year valuation lows. Few expect much in the way of corporate earnings growth in the coming year.

Moreover, all of that money sitting in short-term US government debt represents a massive pool of buying power. When investors do begin to regain their confidence and appetite for risk, they’re unlikely to settle for a 0.01 percent return for long.

It’s tough to time a bottom exactly; however, the current sense of extreme bearishness and risk aversion is a classic signal that a bottoming process is underway. Given distressed valuations across many sectors, the coming bottom will quite simply offer the buying opportunity of a lifetime.

One sector that is offering some outstanding opportunity amid the turmoil is healthcare. There are 10 official economic sectors within the S&P 500, as listed in the following chart.

Source: Bloomberg

This chart depicts the standard deviation of analysts’ consensus earnings estimates for 2009. Standard deviation is a statistical measure of variability, and the higher the standard deviation of earnings estimates, the more uncertain analysts are about earnings prospects for the group. In other words, standard deviation in this case is a measure of earnings growth predictability.

The sector that ranks highest on this measure is energy with a standard deviation over 90 percent. This suggests that analysts widely disagree about the prospects for energy stocks next year. Most likely, this reflects the wide variation in estimates for oil and natural gas prices among different analysts.

The bottom two sectors on this measure are Consumer Staples and Healthcare. The former group includes companies in the food, beverage and household products industries. Demand for basic staple goods has little correlation to economic conditions; even during severe recessions, consumers continue to buy food and soap. Therefore, staples tend to offer slow-but-steady growth prospects in good times and bad. This steadiness accounts for analysts’ high confidence in earnings projections.

Healthcare stocks also benefit from the same recession-resistant growth characteristics; demand for healthcare services is unlikely to fall even during a relatively prolonged recession. Moreover, biotech and pharmaceutical firms with a promising pipeline of new drugs or treatments can post impressive growth regardless of economic conditions.

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In an uncertain economic and market environment, investors crave certainty. Both healthcare and staples stocks have pulled back lately as investors shun all stocks in favor of cash and short-term bonds. But, both sectors have vastly outperformed the S&P 500 this year and as risk appetite does return, investors will focus first on predictable earnings growth.

The healthcare group ranks second to staples on earnings predictability and second-to-none in terms of earnings growth potential. In 2009, the S&P 500 Healthcare sector is expected to see growth just under 10 percent compared to less than 8 percent for the staples.

Bottom line: The healthcare and staples sectors are two of my favorites amid the current market turmoil.

For value, consider the energy patch. As noted above, the energy sector has the most uncertain growth profile of any economic sector in the S&P 500. But amid all that uncertainty lies opportunity.

As I noted in last week’s Pay Me Weekly, the natural gas market appears attractive right now. While few pundits have bothered to notice, natural gas prices have been handily outperforming crude since early September.

Source: Bloomberg

This chart shows the current price of natural gas divided by the price of oil. When the line rises it suggests that gas prices are rallying relative to oil; the line has risen sharply since late August. In fact, while oil has logged new lows in November, natural gas prices have not.

A few factors underpin this relative strength. The first is that natural gas demand is less sensitive to economic growth than oil demand. This is particularly true this year as the National Weather Service is projecting the US will experience the coldest winter in recent memory, driving an up-tick in demand for gas heating.

On the supply side, gas producers have been hit by a one-two punch this year: the credit crunch has made it tough for small producers to continue drilling, while low gas prices have rendered more than half of America’s gas producers unprofitable.

Source: Baker Hughes, Bloomberg

This chart show the US active rig count, a measure of the total number of rigs actively drilling for oil and gas in the US. As you can see, the rig count has already begun to fall as producers are cutting back on drilling activity and idling rigs. In fact, the rig count fell by 41 rigs in a single week in early November. That’s the sharpest one-week drop in the rig count since 1993.

US gas wells have a high decline rate; production can drop by more than half in a well’s first year in production. That means that producers must keep drilling aggressively to offset declines in production from existing wells. I suspect we’ll see the US rig count drop by more than 400 rigs by next summer. That will result in stagnant or falling US gas production near-term. 

Bottom line: Rising demand and falling supply spells a recovery in natural gas prices. Energy stocks leveraged to the North American gas market will perform well in coming months.