Depression is here again. So is there anything worth buying?

It looks as though the rally that has seen most global stockmarkets rebound by more than 20% since early March may already be fizzling out. After some euphoria over a few 'green shoots' signs that the rate of decline in the economy might have been slowing a little investors have been dragged back to reality by the realisation that the most serious problems facing the economy are going to be with us for a long time.

Billionaire financier George Soros hit the nail on the head when he said: "It's a bear market rally because we have not yet turned the economy around. This is not a financial crisis like all the other financial crises that we have experienced in our lifetime." He describes the recovery as looking like "an inverted square root sign. You hit bottom and then you automatically rebound some, but then you don't come out of it in a V-shaped recovery or anything like that. You settle down, step down."

Teun Draaisma at Morgan Stanley, who has a pretty good track record of calling turning points in this bear market, warned earlier this week that it was time to sell out of the rally. Draaisma has three "signposts" to indicate that the bear market is over and none are "flashing green". Corporate earnings have not yet troughed, the US housing market is yet to bottom out (he reckons this won't happen until mid-2010), and the mess that the world's banks are in hasn't yet been decisively dealt with.

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Perhaps more to the point, "after the biggest valuation overshoot ever, in 2000, we have not had a meaningful valuation undershoot", he says. In other words, stocks simply haven't got cheap enough yet. Draaisma also points out that, in the US between 1930 and 1932, there were five bear-market rallies of 20% or more, lasting an average of 35 days each. So it's hardly unusual to see short-term double-digit rebounds during a much longer period of decline. American investor Marc Faber, of the Gloom, Boom and Doom Report, who predicted this latest upswing, has warned that he expects a near-term correction of up to 10%.

This all makes perfect sense. The world is in the throes of a recession on a scale that most of us have never seen. Berkeley professor and Great Depression expert Barry Eichengreen said earlier this week that global industrial output had fallen even faster in the last nine months than in the early 1930s, with world trade also collapsing more rapidly. "It's a depression alright." So the idea that we could already be heading back into bull market territory seems all too easy.

What's making things particularly difficult for investors is the fact that the outlook is so unclear. Analysts are torn on whether we face deflation or inflation (we're talking here in terms of general prices falling or rising, rather than the stricter definition of changes in the money supply). On the one hand, asset prices have dived, unemployment is rising, and banks are very reluctant to lend all very deflationary. But on the other, central banks are taking progressively more extreme measures to attempt to pump money into the system, while the global supply of goods may have fallen even faster than demand, due to global supply chains being disrupted by the credit crunch.

It's possible that we're facing the worst of all worlds, at least in Britain. While asset prices houses in particular are definitely deflating, and will continue to do so, it's by no means certain that the price of consumer goods is set to fall. The most recent UK inflation data made this clear while the Retail Price Index (which includes mortgage interest payments) was flat year-on-year, the annual rate of inflation in the Consumer Price Index (which doesn't include most housing costs) actually rose, to 3.2%. That's stagflation, where the economy and wages aren't growing but the cost of living is still ticking higher.

So, what can investors do in a market like this? As we've said before, we'd avoid conventional gilts. With the government so heavily entrenched in the market, it's impossible for an investor to build up a sensible strategy. If we're headed for stagflation rather than deflation, then the fixed income offered by gilts won't be very attractive, particularly at current levels. It's still worth having exposure to corporate bonds, which are historically cheap and haven't really taken part in the recent equity rally although we'd do so through a fund, such as the M&G Corporate Bond fund (020-7626 4588) or Invesco Perpetual (0800-085 8677), both of which are light on exposure to banking.

As for the stockmarket, attempting to bounce in and out of the market to try to take advantage of swings in sentiment is a high-risk strategy, and one that simply isn't practical for most people. Instead, investors should do what they should always do try not to be distracted by the daily swings in the market, and instead focus on buying quality firms at good value prices. We look below at five attractive blue chips that are paying solid dividends so even if your capital shrinks or stays flat while the economic slump is worked out, you are still generating a decent income in the meantime. For those with a bigger appetite for risk, we look at what James Montier at Socit Gnrale describes as the world's cheapest assets below.

Five defensive blue chips to buy now

Saying that you should buy defensive blue chips is all very well, of course. But given the number of firms reducing or cancelling dividends to conserve cash, how do you spot a reliable dividend payer that is strong enough to stand another battering?

Our suggestions share some common traits. First off, they have experienced management teams this downturn is a particularly scary place for business novices. Next, all have well-established brands that should continue to attract customers from weaker rivals during the hard times. But by themselves, these two attributes are not always enough to stop profits sliding and dividends being cut when times get tough, as any number of car manufacturers can testify.

So a third ingredient is a counter-cyclical business model. That means firms that produce a product or service that most people use most of the time. Obvious examples include firms delivering power, drugs and, these days, mobile phones. However, interdealer broker ICAP also demonstrates (see below) that supplying a vital service, even when it's linking together battered financial market participants, can also make a firm fairly storm-proof.

Lastly, we also like firms that enjoy the protection of a big "economic moat", as US investor Warren Buffett puts it. That means none of our tips are likely to attract new competition fast. The reasons vary the barriers to entry in pharmaceuticals include high research costs and drug patents. In oil exploration, the barriers are prohibitively expensive rigs and access to licensing agreements. In IT services they include product development time and the ability to scale up their products for the biggest clients.

Test management's commitment

Of course, none of these qualities is of much consolation to an investor if a company ends up cancelling its dividend. So David Stevenson in Investors Chronicle has some suggestions on how you can pick out companies that are more likely to maintain their payouts, even during tougher times.

While a strong past dividend record is no guarantee in a jittery market, you can take some reassurance from a firm that has increased its dividend year on year for a decent period. Standard and Poor's favours 25 years, while Stevenson believes the recent past is more relevant he looks at the last eight. Next he looks for forecast dividend growth from the firm's analysts. They sometimes make mistakes, but projected strong growth adds some comfort. The third positive signal is a stated dividend policy something, once declared, that management should feel pressure to live up to. ICAP, for example, has committed to pay out 30% of earnings as a dividend.

Lastly, Stevenson likes firms that have committed to a dividend reinvestment plan (DRIP), whereby shareholders can elect to have a cash dividend immediately converted to shares in the firm. It shows commitment to a decent dividend policy.

Check the firm can afford to pay

But even an enthusiastic management team with an impressive track record for paying dividends is no use if a company can't afford to pay its bills. So it's important to check regularly that a firm can cover its latest dividend from cash flow at least once and ideally twice (this is known as 'cash cover').

But Stevenson suggests casting the safety net wider. Hidden bombs are one threat to watch out for in particular a monster pension deficit. As the average employee expects to live longer and pension fund asset values fall, the size of the future liability hanging over firms still operating final salary schemes is mounting. Things are so bad that some now see a firm such as Rolls-Royce as little more than a huge listed pension deficit with a relatively small engineering firm bolted on the side. So avoid companies with the biggest pension black holes.

Last, "but by no means least", says Stevenson, is the level of borrowing. High debt may not be a problem a company with big assets and steady cash flow, such as a regulated utility, can actually enhance returns using debt. But for less stable firms (and households for that matter) big debts can be catastrophic in a downturn. And the large interest payments that come with them are always a potential threat to dividends, as they have to be paid first.

Avoid potential bankrupts

One final check the Altman Z score. This is a useful way to reassure yourself that a (non-financial) blue chip is not on the critical list. This is a very real threat right now. Insolvency specialist Begbies Traynor reckons 35,000 British firms alone will go to the wall this year. Meanwhile, Moody's reports that 35 companies defaulted on their bonds in March, the "highest number in a single month since the Great Depression", said Bloomberg's John Glover.

Devised by Edward Altman in the 1960s, the Z score sums up the chances of a firm going bankrupt in one easy-to-grasp number. It is designed to test the financial strength of a company by combining five ratios that use key figures from a firm's balance sheet and profit-and-loss account. The ratios are as follows: operating profit to total assets; retained earnings to total assets; working capital to total assets; sales to total assets; and market capitalisation to total assets. If you are handy with a set of accounts you can plug the relevant numbers into a pre-prepared online calculator, such as the one at Creditguru.com/CalcAltZ.shtml, to find out the Z scores for yourself.

The lower the Z score (which is typically a single-digit number), the worse the outlook. Generally, a score below 1.8 is seen as a red flag. At worst it can point to potential bankruptcy. At best it reveals a tendency, noted by Morgan Stanley's Graham Secker, to "underperform the market, especially during recessionary periods".

What to tuck away

Stevenson's review throws up 16 "dividend heroes". But focusing specifically on those companies with relatively low debt (gearing) and a decent Altman Z score, there are four stocks that we would suggest look like particularly good bets just now. These are oil major BP (LSE:BP), yielding 7.5%; energy company Centrica (LSE:CNA), yielding 5.3%; pharmaceuticals giant GlaxoSmithKline (LSE:GSK), on 5.5%; and accountancy software firm Sage (LSE:SGE), yielding 4.3%. All four have Altman Z scores of at least 2.4 or higher and all are massive brands, operating in sectors with high barriers to entry. If these companies can't maintain their dividend payouts, it's hard to imagine who can.

Another company that might be worth looking at is financial intermediary ICAP (LSE:IAP), which yields 5%. The Altman Z score doesn't tells us anything useful about financial stocks, as Altman himself has conceded primarily because their balance sheets are prepared differently to firms such as BP or GlaxoSmithKline. But don't let the fact that it's in the financial sector put you off. ICAP enjoys a dominant position as the world's largest broker of deals many of which are huge between banks. The trading that it both facilitates and earns commission on is a vital part of the plumbing that keeps the City running. So it makes money whether the market is heading up or down. Indeed, the latest results saw revenues exceed $1.5bn for the first time, as John Glover notes on Bloomberg. With the shares down 47% on the year, now looks a good time to buy.

"Probably the cheapest assets in the world..."

Is the global share slide over? Or has the last month seen just another bear market rally? "I haven't a clue," says Socit Gnrale's James Montier. He reckons time's better spent "hunting for opportunities where 'maximum pessimism' is more obvious". And with the "economic implosion in Japan creating some extraordinary bargains, Japanese small caps are probably the cheapest assets in the world".

Japan's economic woes are clearly greater than any other major country. The economy shrank by 3.3% in the fourth quarter of 2008, its worst showing in almost 35 years, while February's exports plunged a record 49.4% on the same month last year. And the Organisation for Economic Co-operation and Development (OECD) sees Japan's GDP slumping by 6.6% this year, compared with a 4% fall in America and a 3.7% decline in Britain.

The stockmarket fallout has been horrendous. Despite a 25% rally over the last month, the Nikkei 225 index stands at less than half its mid-2007 level, and now trades below the value of its constituent companies' net asset value (NAV). The Graham and Dodd price/earnings ratio the current index level relative to the ten-year earnings' moving average shows Japan's stocks at their cheapest since pre-1980.

For Japanese small caps, the historical contrast is even more extreme. The HSBC Smaller Companies index is down by almost 60% from its peak just over three years ago. Even more than their larger colleagues, these small caps trade well below NAV. "This is confirmed by our bottom-up [individual company analysis] valuation work," says Montier. "What better time to accumulate stocks?"

This week's £67bn fiscal stimulus package should help the share rally. And Japanese smaller companies' funds look a natural fit for long-term value investors, though there's a risk that a rally in the pound against the yen would stunt sterling returns. The Baillie Gifford Shin Nippon investment trust (LSE:BGS) is over 50% invested in the industrial, trade and retail sectors and currently trades at a discount of around 22% to NAV meaning you're getting those cheap stocks even cheaper. The fund's top holding is EPS, which provides testing services for drug groups.