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THE GURUS SPEAKFour experts reflect on the market turmoil and share their counselHow are the pros playing this turbulent market? To get some answers, Contributing Economics Editor Christopher Farrell talked with Fiduciary Trust Co. International President Anne Tatlock, Sit Mutual Funds President Mary Stern, and two leading academic market watchers, Jeremy J. Siegel, finance professor at the Wharton School, and William N. Goetzmann, professor of finance at the Yale School of Management.
SNIFF OUT SMALL CAPS Still, like many other money mavens, Stern, 50, remains cautiously optimistic. She thinks the global crisis is far from over, but believes investors don't face financial Armageddon, either. Inflation is dormant, and that's good for financial assets, she says. But while many investors are enamored of large-capitalization stocks, because they're easier to buy and sell when times are tough, Stern prefers smaller companies that have fallen far out of favor. The Dow Jones industrial average is up 7% this year through Oct. 23, but still down 9% from its July peak. Yet the Russell 2000, a commonly used benchmark for small caps, is down 15% so far this year and is off 25% from its April peak. Stern's own fund, Sit Small Cap Growth, is down almost 22% since April. Stern thinks that small companies are not so exposed to the international economy, and thus should grow faster than their bigger cousins. For example, the consensus among Wall Street analysts is that earnings on the Standard & Poor's 500-stock index will expand by around 3% next year. Earnings on the Russell 2000 small-cap companies, meanwhile, are expected to grow 15% to 20%. Valuation levels are also more attractive. Price-earnings ratios on mid-cap stocks are about equal to the Standard & Poor 500's p-e of 27. But mid-caps should grow two or three times as fast as the market in general. Small-cap stocks can be bought at a modest discount to the market's p-e and have estimated growth rates three to four times the overall market. So by all rights, Stern maintains, this would be a great time to snap up such apparent bargains. Stern is bullish on health technology, software, and computer and financial-services companies in the small- and mid-cap sectors; among small caps, she is high on commercial service companies, as well. Stern also favors tax-exempt bonds (page 132). For anyone in the 28% tax bracket or higher, they offer a good risk-adjusted, aftertax return compared with U.S. Treasury securities. A person in the 28% tax bracket would have to find a taxable yield of 7% or better to beat a 5% tax-exempt intermediate bond. By contrast, most Treasury securities are yielding 5% or less these days. In reflecting on the turmoil of recent months, Stern finds a lot of the investment lessons mundane--but critical for anyone participating in the markets. Diversification, asset allocation, and reasonable return expectations are the mantras. ''We had been lulled into a belief that we could just throw money into the market--and be wealthier than before,'' she says. No more.
YOU CAN'T BEAT STOCKS So after the Dow's 9% retreat from its July peak, is Siegel cautious? You bet. Noting that slowing corporate-profit growth and high price-earnings ratios don't mix, ''I don't think the current stock market decline is over,'' he warns. Indeed, he thinks investors now need to lower their expectations on equity returns, arguing that the 15% to 20% annual gains of the great bull market were a once-in-a-lifetime performance. But is Siegel giving up on stocks? No way. ''For the long run, relative to bonds at 5%, I still think there is no contest,'' he says. Siegel sees annual stock returNs getting back to the historical rate of 7%, after adjusting for inflation, for years to come. While that's far below the double-digit rates of recent years, it still represents a tidy real return. He even thinks long-term returns could do slightly better than the historic average, say, 8%. One reason Siegel remains a bull is the remarkable productivity gains from the technological revolution. Technology will remain a potent force in the economy, he says. ''The dynamics of the computer revolution are very much intact. And I do think we are in a communications revolution. This is something that can generate a lot of profits.'' Another factor is the global economy. A driving force in the bull market of recent years was the vision, fueled by the collapse of communism, that the developing world's consumers would become big buyers of soda, razor blades, disposable diapers, cars, computers, and other goods. The global financial crisis has put that vision on hold--but not indefinitely, Siegel believes. EmerGing economies will recover, and that will provide opportunities for dynamic American companies to record good earnings growth. Siegel's advice for investors is not to try to time economic or earnings recoveries, however. ''It's hard for the best investors to bail out before the top. It's even harder to get back in at bottom when a deep gloom grips the market,'' he says. For those reasons, he argues, investors are better off regularly purchasing stocks via 401(k) or other retirement savings plans. That way, they can buy good companies at cheaper prices when the market turns down. And by all means, stick with well-diversified mutual funds or broad portfolios of high-quality equities. Three-quarters of any portfolio should be in Standard & Poor's 500 stocks, he says. What are Siegel's favorite market sectors? In addition to high tech, which includes some of the world's most dynamic companies, he favors pharmaceuticals. He thinks consumer-products makers with strong brand names will continue to do well in world markets. Siegel is also starting to draw a bead on real estate investment trusts, which he terms the ''emerging asset class of the next century.'' REITs have suffered huge declines recently after a dramatic growth surge, and Siegel is wary of plunging in right now. But he notes that real estate offers an opportunity for genuine diversification because this sector doesn't march in lockstep with stocks and bonds. That's an intriguing tip from a prof who long has lectured on diversification as the key to successful investing.
THE U.S. IS A GOOD BET Still, Tatlock is concerned. Behind the turmoil in the marketplace, she sees a massive unwinding of highly leveraged investments worldwide. The impact is showing up in poor market conditions and impaired liquidity. Yield spreads between government debt and corporate loans are yawning. Some investors worry that companies won't have access to the capital they counted on for growth in 1999. Many fear that the near-collapse of Long-Term Capital Management--the hedge fund that tried to boost returns by leveraging up its assets as high as 100 to 1--is only the tip of the iceberg. ''No one really knows the amount of leverage in the global economy right now,'' she says. Despite her global concerns, Tatlock, 58, thinks the U.S. stock market has stabilized. The market now has a floor established by Alan Greenspan, who can further cut rates if the economy or the international situation requires it. But the Fed chairman doesn't have to worry about the market going way up either, because corporate earnings won't be all that strong. She says companies have made an effort to bring down analysts' earnings expectations, which should make for fewer nasty surprises to pummel stock prices. Tatlock also notes that individual investors are getting back into stocks. Tatlock sees heartening patterns in the comparison between today's correction and the market after the 1987 crash. This year, the average stock-price decline from peak to trough has been 43%, about the same as the 44% plunge in 1987. And 37% of U.S. stocks are down more than half this year, vs. 36% in '87. This doesn't mean U.S. stocks are a screaming buy--just that the market is not as overvalued as before and a lot of risk has now been factored into prices. Europe is another story, she says. Negative earnings surprises are far more likely there because European analysts' estimates are far too high. So what should the average mutual-fund or 401(k) investor do? For people with an investment horizon of 10 years or more, Tatlock believes the evidence points toward stocks' outperforming bonds--just as they have done, on average, for decades. But anyone with a shorter-term focus should give attention to bonds, even though Treasuries have already made a huge upward move in recent months. ''Interest rates are still trending down,'' she says. Tatlock also expects the wide spread between Treasuries and corporate debt to narrow after hedge funds and other distressed investors unwind their positions. But steer clear of junk bonds, she counsels. If even the most creditworthy corporations may suffer as the economy weakens, think what that could mean for issuers of high-yield debt. So keep your bond portfolio well-diversified--and wait for the economy to recover.
STICK WITH THE BIG MARKETS What Goetzmann sees makes him wary of the world's emerging stock markets, even though some have fallen to ridiculously cheap levels. More than gut feelings are behind this position: He is an authority on global stock market trends. For example, a paper he recently co-authored with Philippe Jorion, ''A Century of Global Stock Markets,'' constructed inflation-adjusted indexes, excluding dividends, for equity markets in 39 countries, including Germany, Japan, Portugal, and Peru. The paper (available on the Web at viking.som. yale.edu) showed the U.S. is the exception among markets too often wracked by financial crises, political upheavals, expropriations, and wars. Indeed, the U.S. recorded by far the highest uninterrupted inflation-adjusted rate of return, 4.73% a year, between 1921 and 1996. In sharp contrast, the median real appreciation rate for the other countries was only 1.5% annually. Goetzmann says the data shed light on whether investing internationally pays. Many pros believe that adding international stocks or funds to your domestic equity holdings will reduce your portfolio's overall volatility over time. Goetzmann concedes that point but maintains it's oversold. His and Jorion's data show there is no sure way to hedge against a really big crisis. That was the case during the oil crises of the 1970s and 1980s, as well as the Persian Gulf war in the early '90s and the global financial upheaval of 1998. Goetzmann says emerging economies' bourses are the ones to watch for signs of broader global trouble. While they thrive when the global economy is on an upswing, they're the first to get hit by slumps. That is why he invests his own money in a core group of countries, including the U.S., Britain, and Japan, where investors have well-established legal rights. By contrast, ''I would be concerned about East Asia, or anywhere [else] governments are trying to balance the desires of global investors and the needs of citizens.'' Like many finance professors, Goetzmann views market shocks as beneficial because they can teach people about their willingness to absorb risk. The trouble is, as markets become more interlinked, there is no safe haven. Yes, you should invest in equities for the long term. But even if you think you are well-diversified, you'll face some scary global market crashes along the way.
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Updated Oct. 29, 1998 by bwwebmaster
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