Dealing with the Market's Great Unknowns


By Gene Marcial Iraq is casting a dark shadow over the stock market. And for as long as the protracted debate continues over whether the U.S. should launch an attack against Saddam Hussein, the uncertainty that has been spooking stocks will go on. The issue has nearly preempted many other important concerns such as the Bush Administration's strategy (such as it is) for dealing with the problems plaguing the economy, which has only exacerbated the gloomy sentiment among investors (see BW, 9/2/02, "The Smart Fiscal Policy That's Needed Now").

Little wonder that the stock market is depressed. And it isn't surprising that investors are confused, given the many unanswered questions that confound them. All of this results in extreme uncertainty -- an element that unhinges the market and erodes investor confidence.

The recent volatility makes it seem as if investors have lost their minds. But it's more a matter of the herd mentality not being able to decide "whether to throw in the towel in disgust and dump stocks altogether -- and bring about that much-waited capitulation -- or whether to jump back in to catch the economy's next up-leg," observes Edwin Everett, strategist at David L. Babson & Co., a Cambridge (Mass.) investment firm that manages some $75 billion in assets.

"PERENNIAL UNPREDICTABLES." "Thus, we saw manic up-and-down trading this summer, with the market moving 4% to 6% on its wildest days," he notes. These mood swings, says Everett, are what make stock prices so unpredictable. "The short-term outlook is always uncertain and reliably unpredictable," argues Everett, because of such volatile moves.

The immediate future simply isn't knowable, he says, and it's not worth investors' time trying to predict it. One of the "perennial unpredictables," says Everett, is trying to divine what stock prices will do next week or next month.

Another perennial unpredictable: Where will the course of international developments lead? "The issue of the moment is, when will we invade Iraq?" says Everett -- though it doesn't seem to be a question anymore, judging by the tone of public discussion, he adds.

GLOBAL EFFECTS. Yet considering how such a conflict would disrupt the world energy markets and the U.S. economy, Wall Street "seems oddly complacent about a U.S. engagement in a hot war," notes Everett. He recalls that the S&P 500-stock index dropped 20% when Saddam invaded Kuwait in 1990. (It recovered when the U.S. counterattacked.) And reverberations from September 11 brought down the S&P 500 by more than 25% through July's lows. Globalization, he says, has made the impact of market-jarring crises more quickly and more widely felt around the world.

So how does an investor play today's market given so many short-term uncertainties and unpredictables?

Over the long-term, "the stock market is fairly predictable," asserts Everett. He notes that equity prices trend upward as stocks follow the "inexorable (though not straight-line) path of corporate earnings." He acknowledges that what's in dispute now is just what "profits" are and how they should be properly calculated, following the accounting abuses that have been discovered recently. Still, Everett thinks per-share earnings are "the basic engine of stock performance, individually, and for markets collectively."

STRONG SECTORS. Everett co-manages Babson's Private Clients Group, whose $1.3 billion in assets are invested in a core portfolio of what he says are 30 to 40 "quality-growth" stocks. "We focus on companies in attractive industries, and which have proven over the long haul that they can sustain high operating margins, clean balance sheets, good cash flow, and are led by strong management."

Sectors that he believes have such long-term dynamics include health care, financials, and the industrials. In health care, Everett is bullish on Pfizer (PFE), which stands out, he says, among the pharmaceuticals because of its long-term growth record.

In financials, Everett thinks American International Group (AIG) has demonstrated its long-term proficiency in finding new ways to increase its business and its earnings. And among industrials, General Electric (GE) towers over its rivals despite the complexity of its businesses and accounting systems, says Everett. Over the years, he says, GE has delivered good, sustainable growth in revenues and earnings. He thinks the giant's new management will continue such a record.

DISCIPLINE IS KEY. What Everett looks for in a company is what almost every other investor also looks for. But the difference is in the discipline his group enforces in sticking to the long-term winners: the "quality growth" stocks.

Given the limits to what information they can know, Everett says prudent and successful investors should diversify their portfolios to limit the impact of the market's "perennial unpredictables," and they should "use time and compounding to minimize the financial disruptions of near-term market vagaries." Of course, getting through the short-term turmoil -- and out from under the shadow of Iraq -- remains the immediate challenge. Marcial is BusinessWeek's Inside Wall Street columnist


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