Don't get hurt in hard landing

Investors should prepare portfolio for bear market in case Fed overshoots

Your Money

July 16, 2006|By JAMES P. MILLER | JAMES P. MILLER,CHICAGO TRIBUNE

The problem is, it's almost impossible to know when enough turns into too much.

Investors should keep that difficulty in mind, some experts are warning, as the Federal Reserve strives to simultaneously foster economic growth and contain inflation.

Because the Fed is by all accounts in the final phase of its cycle of raising interest rates, it may be time to consider a portfolio to guard against the Fed overshooting and causing a so-called hard landing, or recession.

"We believe the Fed is making its usual error: tightening too long and too far," David Wyss and Beth Ann Bovino of Standard & Poor's Corp. suggested in a recent report.

If their view proves correct - and many experts argue the Fed has indeed raised interest rates too high several times in the past - then the U.S. economy, which is widely regarded as facing a second-half growth slowdown, might instead plateau or even lurch downward for a time.

Historically, in the end-stage of a tightening cycle "the Fed has tended to overshoot" and raise rates too high, to the detriment of the economy and the stock market, observed Ed Clissold, senior global analyst at Ned Davis Research Inc.

Ned Davis isn't forecasting an overshoot, although the Venice, Fla.-based research and advisory firm recently recommended investors adopt a more defensive posture by overweighting cash and underweighting stocks and bonds.

Clissold noted that during the past several decades, stock markets have declined by a median of 4.9 percent in the six months after the Fed implements the final increase in a series of rate increases.

In part, Fed policymakers often go too far because officials must rely on backward-looking data as they set future policy. But the risk may be higher than usual in the current circumstances, Clissold said, because Fed Chairman Ben S. Bernanke has only been on the job for a matter of months.

To build up their credibility as tough inflation fighters, Clissold said, new Fed chairmen often tend to "tighten more than is necessary from an economic standpoint."

Merrill Lynch economist David Rosenberg recently noted the same phenomenon of a market downturn after the last Fed increase, but he has offered a slightly different take:

"The market goes down when the Fed goes on hold because of the reasons why the Fed goes on hold - a softening economic landscape coupled with emerging late-cycle credit strains."

When markets grow fearful of economic or geopolitical turmoil, investors typically stage a "flight to safety."

In general, that involves a shift away from cyclical equities, comprising companies in interest-rate or economically sensitive sectors. If the Fed badly overshoots, the outcome would most likely be either an outright recession or a steep bear market.

Under such circumstances, investors usually avoid the often-volatile stocks of high-technology companies, and steer clear of financial stocks - banks see more loans go bad, for example, and brokerage houses complete fewer stock trades on behalf of their customers.

The stocks of homebuilders tend to decline when the economy weakens, and so do producers of construction-related products such as cement and flooring, as well as traditionally housing-sensitive companies such as makers of carpeting and large appliances.

Companies involved with producing industrial commodities, such as aluminum and steel, are classic cyclical stocks that tend to take a beating during a bad economy. Makers of consumer discretionary products - things people like but don't necessarily need - generally fare badly when economic times are tough. Many experts recommend avoiding the shares of higher-end retailers during a downturn, in favor of more down-market players.

When investors hunker down, they tend to favor steadier, more "boring" stocks, such as makers of food and other consumer staples. Health care stocks also are considered recession-resistant, along with tobacco companies and utilities. Large-cap companies generally weather bad times better than small caps do. In addition, Treasury bills and cash (usually in the form of money-market accounts) represent a traditional safe harbor.

The question for investors is whether the economy is in fact on the verge of experiencing the wrenching effects of a Fed overshoot, or whether policymakers can engineer a soft landing. And that's not an easy call these days.

To keep the economy on a smooth growth path, the Fed must often juggle two conflicting aims. If interest rates are too low, the excess fiscal stimulation can cause the economy to overheat, igniting inflation. But in the current climate of rising inflation, if policymakers set rates too high, the economy can stall or even slide into recession.

The Fed has increased rates by a quarter of a percentage point 17 times during the past two years, most recently on June 29. Unfortunately for Bernanke, there's no simple way of knowing when it's time to stop tapping on the economy's brakes.

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