May we suggest a middle course? After five years of equity euphoria and a year-and-a-half of melancholy, it's time for stock investors to get used to normality. What's that? It means stocks will outperform other assets over the long run--just not at the double-your-money rates of the late 1990s. It means no one sector is going to dominate the way technology did in the last cycle.
That's the view of America's No. 1 equities expert, University of Pennsylvania finance professor Jeremy Siegel. "The [inflation-adjusted] returns on the market looking forward may not be as favorable as the long-run historical average," Siegel notes, but stocks will still return "considerably more than the 3.5% you'd get from an inflation-indexed bond." The key to capturing those returns: Approach the stock market as a bull but without expecting the wild growth that used to power your portfolio.
The next six months will be a great opportunity to try your legs as a sensible bull. BusinessWeek sees stocks ending the year up slightly, reversing the 8% drop of the first half. That may not strike you as bullish, but heck, it sure beats the negative returns we've been getting used to. The market's fuel: The Federal Reserve's record-setting five interest-rate cuts, with a sixth likely on June 27. Those, plus this year's $45 billion downpayment on an 11-year, $1.35 trillion tax cut, should restart the economy by fall.
Conventional wisdom holds that rallies come in the summer. In fact, summer heat is seldom good for stocks. Over the past 50 years, an investor who put $10,000 in the market in early May and sold out at the end of September each year would have netted just $3,000 profit for the entire period, while investing from Oct. 1 to early May each year would have netted a $595,000 gain, according to Ned Davis Research in Venice, Fla.
But don't let the market's summer blahs get you down. "You're letting the train leave the station without you if you don't have the courage to act now on stocks," says Michael Hengehold, president of Hengehold Capital Management in Cincinnati. By September, the Fed's rate cuts should lift stocks. The only time five consecutive cuts in the Fed's discount rate ever failed to boost the market was during the Great Depression, according to Ned Davis Research. "To bet against higher stock prices over the next 12 months is like betting for a Japan-style crisis ahead--and that's highly improbable," says James Stack, president of InvesTech Research in Whitefish, Mont.
Tax-cut checks and lower tax withholding should also give the economy a boost. Energy prices may have peaked, and the dollar remains strong. The result: Profits will bottom out in the second quarter, most analysts say, then show improvement in the fall. By yearend, companies should start showing real gains compared with last winter's down profits. "Earnings should be up year-on-year by the fourth quarter, thanks to stronger economic growth and easier comparisons," says Edward Kerschner, chief global strategist at UBS Warburg. Kerschner thinks energy, utilities, aerospace, and health care will enjoy the best earnings momentum for the rest of the year.
Notably absent from that list is the darling of the late '90s bull market. Don't place any bets on technology for the rest of this year. While some companies in software and storage show promise, the sector as a whole is still haunted by overcapacity and inventory problems that will hold down earnings. The consensus analyst forecast for tech earnings, according to earnings researcher First Call in Boston, calls for declines of 44% in the third quarter and 19% in the fourth, vs. the same periods last year. "It's highly unlikely that tech earnings will stage any meaningful recovery before the first quarter of 2002 at the earliest," says Charles Hill, First Call's director of research. Throw in tech's continuing high valuations, and it's easy to conclude that the tech correction isn't over yet.
That outlook highlights a key point: Even in an improving market, you'll have to pick your investments carefully. Look not just for the sectors best suited for a recovering economy but for individual stocks poised for gains. Take energy: While drivers and homeowners fume over high costs this summer, the drillers, miners, and generators reaping those hikes won't share equally. And cyclical stocks, such as consumer staples, have already gotten much of their bounce, so you'll have to look carefully for distressed shares that are positioned to seize new opportunities.
Our bullish forecast isn't a gimme any more than those 18-inch putts that were missed at the U.S. Open last weekend. There are lots of things that could go wrong. Even investors who have benefited most from the market's slowdown--value-oriented mutual-fund managers--fear that stocks are still pricey. The average S&P 500 stock is selling at 23 times this year's earnings--far higher than the average price-earning ratio of 15 over the past 70 years. "These valuations won't prevent a bull market or profit opportunities, but they will put a limit on upside potential," says InvesTech's Stack.
The market is expecting second-quarter profits to remain downright doggy: 65% of companies preannouncing have warned that earnings won't meet estimates. And even if earnings pick up in the fall, "investors are going to have to adjust to a world of slower growth," says Thomas Pence, Indianapolis-based manager for Strong Investments' Enterprise and Endeavor funds.
Money managers say it's time for rationally nonexuberant investors to return to the basics: an asset allocation that blends cash, bonds, and a variety of stocks to balance risk and reward. Many affluent investors have already done that, according to U.S. Trust Co.'s annual survey of the wealthiest 1% of Americans. As a result, even though they've suffered a 13% loss, on average, 57% don't plan big changes in their portfolios--and 22% are using the market decline to buy more stocks.
For investors addicted to the thrill of late-'90s markets, the changes are wrenching. In 1998, David Warren of Nashville quit his job at the Transit Authority to stay home and day-trade stocks--mostly tech shares. "I did all Internet stuff--I mirrored the Motley Fool portfolio and got heavily into momentum trading using technical analysis," says Warren, now 52. Then came the Nasdaq crash, which cost Warren and his wife, Carolyn, more than 50% of their stock portfolio. What's left of the Warrens' assets is now in a diversified portfolio of fairly conservative mutual funds. "I'd rather have stability and lower returns than the peaks and valleys we were seeing," Carolyn says.
Diversification will take discipline. Bond investors need to be more selective after a year of strong gains, and foreign stocks are still languishing. If global investing leaves you cold, you can get diversity by dividing your stocks by industry. Stephen Barnes, vice-president of Barnes Investment Advisory in Phoenix, notes that swings in TMT stocks--tech, media, and telecom--provide balance to the rest of the market.
Investing for the remainder of 2001 won't be a joyride. The best forecast calls for only small gains in stocks--and the risks of missing even those remain high. But every upturn has to start somewhere. For today's newly chastened investors, this could be where the next bull market begins. By Mike McNamee and Marcia Vickers