As stocks lose steam, it's time to be cautious

Your Money

April 17, 2005|By Tom Petruno

Investors are forever encouraged to focus on the long term. Wall Street is particularly fond of repeating that advice when the short term doesn't look so hot.

The U.S. stock market has run out of steam this year, which most investors know or will when they review their quarterly portfolio statements.

The 2.5 percent drop in the blue-chip Standard & Poor's 500 index since Jan. 1 isn't much, but it adds to the feeling that financial markets and the economy are in transition.

There's no way to sugarcoat the reality that investors are losing some long-term trends that have propped up stocks, bonds and housing values in recent years.

Ultra-low interest rates, which lasted from early 2002 through mid-2004, are history as the Federal Reserve tightens credit.

The sharp rebound in corporate profits, with S&P 500 company earnings rising more than 15 percent for six quarters through the end of last year, is waning. Profit growth in the first quarter, which ended March 31, is expected to be about 8 percent, based on analyst estimates compiled by data tracker Thomson First Call.

And who can forget the good old days of oil at $20 to $30 a barrel, the norm from 2000 through last spring? The talk of Wall Street is that $100 oil is possible in the next few years.

The World Bank, financier to developing nations, warned last week that global economic growth was poised to slow in the next few years from the brisk rebound of 2003-2004.

And with decelerating growth, issues that were papered over in headier times - the risks inherent in the gigantic U.S. trade deficit, for example - are likely to take on greater urgency, World Bank economists said.

The World Bank is predicting slower growth, though, not negative growth (i.e., recession). If the bank's forecast is in the ballpark, the global economy still would be expanding at an annual real rate of 3 percent or so through 2007. That would be better than the 2.7 percent average annual growth rate of 1991 through 2000.

But a key difference between the past decade and this one is that global growth is being powered much more by the developing world.

Those economies grew at a 3.2 percent annual rate from 1991 through 2000, not much faster than the 2.6 percent growth rate of developed countries in that period.

This year, developing-world economies are expected to expand at a 5.7 percent rate, more than double the 2.4 percent rate forecast for the developed world, the World Bank said.

Most U.S. investors have better things to do than keep track of numbers such as those, but Americans understand that investment opportunities are blossoming overseas. Egged on by the falling dollar and its favorable effect on foreign stocks and bonds, U.S. investors pumped record sums into foreign securities last year.

None of this is lost on Wall Street. With the U.S. economy more dependent than ever on foreign financing of our trade and budget deficits, many Americans are sending their personal capital abroad.

Within our borders there is widespread frustration with investment choices.

Short-term interest rates are up from their generational lows, but no one is getting rich off 2.2 percent yields on money market mutual funds.

Bond yields also have risen, but it feels too early to many market veterans to lock in long-term yields, with the Fed still lifting short-term rates and with inflation fears fanned by the surge in oil prices.

The residential real estate market might or might not be a bubble, depending on where you live. But should people be doing what they're increasingly doing, borrowing via risky adjustable-rate mortgages so that they can buy the biggest homes their real estate agent can find for them?

As for the U.S. stock market, shares might not be overly expensive, but neither are they cheap by the reckoning of Wall Street professionals. The average blue-chip stock is priced at about 17 times this year's estimated earnings per share.

The problem is that investors' margin for error has been reduced as the supportive trends of the past few years weaken or disappear.

If the economy and U.S. financial markets are in a transition phase, the question becomes whether it's a transition to a slower but more sustainable economic growth rate that allows interest rates to stay tame and stock prices to move gradually higher, or a sharper-than-anticipated economic slowdown that pulls the rug out from under share prices.

Or it could be a transition to another economic boom that drives inflation and interest rates higher, with mixed consequences for stocks.

A lot of good things might yet happen for U.S. financial markets in this decade.

But Bernie Schaeffer, a veteran market player who heads Schaeffer's Investment Research in Cincinnati, suggests that many investors need to do a better job in this transition phase of assessing the risks they might face if the optimistic forecasts don't pan out.

He worries that the relatively low volatility in the stock market over the past year has lulled investors into believing that a major decline is highly unlikely.

Schaeffer fears the opposite, a market pullback that could be "rapid and scary."

The lesson of the 2000-2002 bear stock market was that many people whose portfolios were overly exposed to risk found out that once their nest eggs were severely damaged, the road to recovery was a long one. That's the way the math works.

A prudent investor today should be asking the questions that many didn't ask at the market peak in 2000: If things go bad, how bad could it be for me? How much money could I lose and how much can I stand to lose?

Tom Petruno is a staff writer for the Los Angeles Times, a Tribune Publishing newspaper.

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