5 things that could signal danger for stocks

Investing

December 29, 1997|By Bill Atkinson

LIKE MOST of the people who rely on him for advice, Richard E. Cripps, the chief market strategist at Legg Mason Inc., is heavily invested in stocks.

Eight-five percent of his personal portfolio is in stocks such as BJ's Wholesale Club; Associated Group Inc., a wireless telephone developer; and General Motors Corp. The rest is tucked away in a money market fund.

"I would be foolish not to" be in stocks, Cripps said. "I view stocks as the best way for individuals to achieve their financial goals."

But stocks involve risk. And Cripps, who views himself as "conservative risk taker," has come up with five "warning shots" that would trigger him and his employer, Legg Mason, the Baltimore-based brokerage and financial adviser, to reduce their risk in the stock market.

Cripps said if two of the five warning shots occur, he would immediately double his personal cash holdings.

Here are the signals for which Cripps is watching:

A 15 percent rise in the stock market over the next six months.

Why would that be bad? If it happens, Federal Reserve Chairman Alan Greenspan will take action, Cripps said. He jolted the market in February when he said investors' expectations about stocks were "irrational."

"We have the liquidity to drive this market up 15 percent in a heartbeat," Cripps said. "If we did that, it would be considered something very dangerous. I think the Fed would come in and act."

A 15 percent increase from Friday's close of 7,679 would put the Dow Jones industrial average at a record 8,800 points; a 15 percent increase from the Dow's August record high of 8,259 would put it at nearly 9,500.

"You would have the market at a valuation level that it had never been at before," Cripps said. "It would cause an imbalance in the way people save money and the way companies do business."

Weakening corporate sales. It is one of Cripps' biggest concerns.

Sales growth could fall to 2 percent to 3 percent in the fourth quarter, from about 7 percent, because of intense competition from troubled Asian economies, which are slashing prices on the products they export.

Companies are boosting profits, not by selling more cars, computers or food, but by cutting costs.

"Shareholders are interested in profit growth, not sales growth," he said. "The issue that starts to concern us is that at some point you reduce costs so much that you put yourself in the position that you are not able to grow sales.

"The inevitable starts to happen. Your operating costs start to rise, and if you don't have the infrastructure [employees] to ramp up sales, your profit margin will decline.

"If you have rising operating costs and slowing sales growth, you could have a jolt to earnings. That is the fear that I have. That is the fear that the market has really been reacting to."

Cripps worries that companies are overly concerned with stock performance.

"They run it to make their stock price go up; they are not running it to increase sales," he said.

A slowdown in the profitability of banks, which are an important economic barometer.

A surge in bad loans might suggest that borrowers, whether they are consumers or corporations, are struggling and that the economy is weakening.

Problems at savings and loans surged in 1987 and ushered in the October stock market crash. Bank failures shot up three years later, and stocks again tumbled.

"We have had two market declines of 20 percent or greater in the last 15 years. Each of those corrections had been preceded by noteworthy weakness in financial or banking stocks," Cripps said.

Cripps said he will start to worry if bank stocks lag behind the S&P 500 in performance four consecutive months. Banks have trailed the index in November and December, he said.

Fewer acquirers using stock instead of cash to make acquisitions.

Seventy percent of all acquisitions this year have been done with one company exchanging its shares for the other, Cripps said.

Since stock prices have remained high, the shareholders of the company being bought have been anxious to do the deal.

"This keeps encouraging the companies to make more and more transactions," Cripps said.

But if shareholders grow angry because their holdings are diluted, and profits of the acquirer suffer after the acquisition, fewer deals will be done. Cripps said this will become evident if the stock prices of acquiring companies fall by at least 10 percent.

As a result, fewer deals would be done and the stock explosion in many companies that are viewed as takeover targets could end and drive down the market.

"At some point, the market is going to say, 'No, this game isn't going to work anymore,' " Cripps said. "That is going to be a negative for the whole market."

A surge in initial public offerings and secondary offerings, and a slowdown in the amount of money flowing into mutual funds.

If IPOs and secondary offerings continue to rise and there is a slowdown in money flowing into mutual funds, that is a sign that demand for stocks may be weakening.

"It will be a negative for the market," Cripps said.

Cripps has been thinking about these warning shots for the past month. He came up with them because this stock market cycle is too difficult to predict, and he wanted guidelines to explain when and why exposure to stocks should be reduced.

He's convinced that some of these warning shots will occur and that Legg's customers will benefit from the warning.

Investors are "going to respond to evidence that makes sense," he said.

Pub Date: 12/29/97

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