By Amey Stone Investors who initially profited from hitching a ride on all the promise of the New Economy can't be blamed for feeling like they've been dumped on the side of the road lately. The Nasdaq's precipitous drop in March, 2000, has been followed by failed rally after failed rally. After losing a record 40% in 2000, the technology-laden index is down an additional 18% so far this year. The benchmark Standard & Poor's 500-stock index fell 10% in 2000 and was off 9% more through the first week in August, 2001.
If your response to the carnage was to retreat from investing, now is a good time to start thinking about coming back out of your shell. That's not necessarily because stocks are going to rebound any time soon.
Even though plenty of investment professionals continue to forecast a market upturn (see BW Online, 8/7/901, "A New Bull Market Is Well on Its Way"), one thing the stock slide has shown is how impossible it is for even the savviest Wall Street veteran to predict the market's direction. The bottom line is that second-quarter earnings season failed to provide any clear signs that the recession in corporate profits is behind us.
So why start thinking ahead now? Because the market has been fairly stable for enough time for investors to reconsider their overall strategies in a new light. This may not be the best time to bet on a rising tech stock. But it's a perfectly appropriate to take all those lessons learned the hard way during the New Economy's bust -- and put them to some good use.
Lesson No. 1: Diversify. This means not only making sure the bulk of your investments are in more than two stocks, but also that you own some other asset classes -- like cash and bonds. At midyear, Standard & Poors recommended that equities make up 70% of the average portfolio, with bonds accounting for 25% and cash 5%. S&P also thinks its 500-stock index will climb 12% and the Nasdaq 22% in the second half of the year. If your outlook is less rosy, you might want to be more conservative.
Newsletter Dow Theory Forecasts recommends that investors keep about 30% of the funds they would normally have in stocks in cash for the time being. "We're being a little bit conservative here, but we think there is some risk that we'll retest the lows of March and April, so we want to keep some in reserve until we get some confirmation that we've seen the lows," says editor Rich Moroney.
Lesson No. 2: Bonds aren't all bad. Sure, interest rates have fallen, making the yields on investment-grade bonds pretty ho-hum. But then again, a 5% return on a 10-year Treasury isn't that bad if stocks keep falling. And you can do better if you take a bit more risk and buy corporate bonds.
"Fixed income looks pretty good," says Jay Mueller, economist at Strong Capital Management. He thinks stocks may return about 10% for the next several years. That makes the 7% earned on corporate bonds pretty attractive, especially when you consider how much less risky they are than stocks. Margaret Patel, who manages the Pioneer High Yield (TAHYX) fund, believes the economy is stabilizing, which makes junk bonds worth considering. Her fund, which avoided the morass of telecom junk bonds, is up 12% this year.
Lesson No. 3: Cash isn't half bad, either. The 3% you can earn in a money-market fund isn't too appetizing. But it makes sense, as Moroney suggests, to keep more money in cash than you normally would so you can be ready to buy when signs are clearer that the economic rebound is at hand.
"Leave some of your powder dry," suggests Peter Cohan, author of E-Stocks. He thinks Check Point Software (CHKP) and eBay (EBAY) are great stocks to own because they have managed to increase earnings during the economic slowdown. Because he's pessimistic about the economy, though, he's not buying now. "This is a time to find good companies and good sectors, and then wait to see how the current scenario plays out," he says. "Then you'll have cash on hand when you find the right time to pounce."
Lesson No. 4: Valuation matters. This lesson became more than apparent when high-growth, high-priced stocks -- most often tech names -- plummeted in 2000. Many are still falling, as investors continue to reevaluate their growth prospects. This year alone, Wall Street darling EMC (EMC) is down 70%, Cisco Systems (CSCO) is down 50%, Sun Microsystems (SUNW) is off 39%, and Oracle (ORCL) is down 40%.
Despite the declines, lots of stocks are still pretty high-priced when you consider their near-term earnings prospects. If the economy picks up steam and earnings reaccelerate, today's prices may one day seem cheap. If the U.S. settles into a long period of very slow growth, stock prices will have further to fall. "It seems to me a lot of investors have already built in a rebound," says Paul Shread, senior analyst at Internet.com. "Now it needs to show up."
Moroney recommends that investors look for companies that can increase earnings but aren't too expensive on a price-to-earnings basis. "The company has to be reasonably valued, but it also has to have a fundamental driver where it has the ability to exceed what Wall Street expects," he says. Merck (MRK) and Southwest Airlines (LUV) are two stocks he favors now on that basis.
Lesson No. 5: Short-term trading is fun, but dangerous. Kept to a small part of your portfolio, trading is harmless enough and can be an exciting hobby for investors who have a taste for it. But don't expect to make much money.
"I don't think anybody makes money by short-term trading, except for a handful of professionals at large firms," says Patel. "It is fun to do, but it is very easy to get caught up in irrational strategies, and that is unhealthy." Enough said.
Lesson No. 6: Do your own homework. The last year and a half has made it clear that no one can predict the market's direction. It has also exposed many of the biases of Wall Street research. Even though stock analysts have been taken to task for hyping unprofitable companies, Shread says he is disheartened to see that many continue to pound the table for expensive and risky stocks.
On the bright side: Thanks to the Internet, investors have many powerful tools for doing their own research, notes Cohan. "I really believe that with all the information out there, if investors just put in a little bit of time and come up with an intelligent framework to process the information, they can choose stocks themselves," he says. For long-term investors who don't want to pick their own stocks, he recommends going with an index fund.
Despite the many opinions you'll run across, no one really knows what the next few months will bring for the economy. However, small investors (unlike professional money managers who must at least try to beat the market) don't need to feel pressure to be the first back into stocks and can afford to wait and see what develops. This is a good time to plan a strategy so you'll be ready to get back in when the economy and the stock market inevitably recovers. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.
Questions or comments? Join in the discussion at our Ask Amey Stone interactive forum