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JAMES FLANIGAN

Investment Climate Calls for Caution

August 01, 1986

Interest rates on money-market funds and certificates of deposit are back down to what banks used to pay on passbooks 10 years ago, and the stock market looks like it has reached a state of nervous exhaustion. What do you do?

Mix your metaphors: Get liquid and keep your powder dry. That is, put your money in the ready cash position and be prepared for anything. After all, when even Paul A. Volcker seems uncertain about what's ahead for the economy, who are you to be a hero?

The widely revered Federal Reserve Board chairman told Congress the other day that while he did not think there would be a recession, the economy could fall into one if our foreign trade didn't pick up.

Clearly, it's a time to hang loose with your investments. That means turning to money funds, which currently pay around 6%, giving you the illusion that you've slipped back in time. The fact is, however, money funds today are paying about as high an interest rate as they ever have, adjusted for inflation, which is the perspective you should have when investing money.

Zero Inflation

Inflation in the first six months of this year, as measured by the consumer price index, was zero. So you're getting the full 6% interest today. That's worth as much as the historic high average rate of 16.8%, which, according to the Donoghue Money Fund Report, was paid in 1981, a year when inflation was 10.4%. A year ago, by contrast, while you could have received 7.5% on money funds, inflation was 3.8%, so you were really earning 3.7%.

Inflation, deflation says you; 9% beats 6%, and there are plenty of investments paying the higher rate. Of course there are, and with each there is some variety of higher risk.

One Los Angeles broker, beseeched by his clients to find them something paying more than a Treasury bill (currently 5.86%), buys electric utility stocks that pay a dividend of 8.5%. A sensible choice--with a good utility the dividend is secure and there is the possibility of capital appreciation. But, equally, there is the possibility of depreciation; Treasury bills don't risk principal, common stocks do.

Rate hunger can make you stupid. Mutual fund sponsors such as T. Rowe Price Associates of Baltimore and Investors Diversified Services of Minneapolis report many of their customers switching from money-market funds to high-yield bond funds, which are still paying close to 10%.

Investing in 'Junk Bonds'

The customers' timing could not be worse. High-yield funds invest in corporate bonds rated BBB or below--so-called junk bonds. Such bonds pay high interest because the rating agencies perceive a relatively high risk of default, stemming from a risk of insolvency in the companies issuing them. Junk bonds used to scare investors, but in recent years a theory gained credence that taken in the aggregate, junk bonds' high interest overcompensated for the risk of default.

The theory may not have been disproved totally last week when LTV Corp., a prominent high-interest borrower, filed for bankruptcy protection. But prices of other junk bonds fell on the news, and so did the asset values of high-yield funds. With a slowing economy making it harder for debt-heavy companies to meet their interest obligations, junk bond funds are obviously something for small investors to avoid.

Rather than chasing a few points of interest, they would do better to think like the big fellows.

"I'd be building a cash mountain, waiting for the bull market to fall out of bed," says Sir Gordon White, who has built Hanson Industries, the U.S. arm of the British conglomerate Hanson Trust, up to $4.5 billion in revenue in the last 10 years by buying and selling companies. White currently is husbanding cash against the day stock prices fall below asset values again.

True enough, you can't buy and sell whole companies. But if you're sitting with cash and the markets fall, you can buy your share of assets cheap, from stocks and bonds of good companies to bargains in real estate.

On the other hand, if the vastly increased supply of money that the Federal Reserve is pumping into the economy now to keep it afloat results, by some mischance, in renewed inflation, you will have your money in a short-term or variable instrument and won't find yourself locked in at a low interest rate.

The outlook for the economy might be alarming, if it were definable. As it is, it is only uncertain. "Discretion is the better part of valor" sums it up.

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