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INVESTING: Quarterly Review & Outlook

Weighing the Opportunities

Whatever the Economy's Next Phase, There Are Ways to Play It


Goodbye to the bear, and hello to . . . what, exactly?

The second-quarter turnaround on Wall Street raised hopes that the worst stock market decline in at least 13 years has run its course.

But even if the bear rests in peace, what will follow it is far from clear. Another roaring bull market? A long period of weak returns? Or, after a short-term advance, a new bear phase?

Hanging an investment strategy for the next few years on a single scenario would be the neat, clean thing to do. It also could turn out to be extremely dangerous, financial advisors warn: If things don't play out as you've bet, your portfolio results could range from mediocre to disastrous.

With the crash in technology stocks, many people learned the hard way over the last year about skewing their investment portfolio too heavily toward one sector or one scenario.

But a risk now is that gunshy investors will opt to be overly conservative, underestimating the potential for many types of stocks to do well in this decade, even if previous leaders continue to struggle.

The second-quarter rally was a case in point: Though broad-based, it was led by small and mid-size stocks, while the big-stock leaders of the late-1990s performed about half as well, on average.

The blue-chip Standard & Poor's 500 index gained 5.9% in the quarter ended Friday, rebounding from a two-year low set April 4.

The mid-cap S&P 400 index, by contrast, surged 13.2% in the period.

Strong gains in mutual funds that target small and mid-size stocks helped lift the average domestic stock fund's quarterly total return to 8.5%, according to fund tracker Morningstar Inc. Even so, the average fund still was down 5.8% for the first half--a reminder that the bear market's losses could take quite a while to recoup.

The stock market's comeback seems to be owed in large part to the Federal Reserve's deep cuts in short-term interest rates in the first half: six strong doses of medicine for the wobbly economy.

Though the market all but ignored the Fed in the first quarter, by the end of the second quarter investors were far more confident that the economy will in fact avoid a full-fledged recession.

Now the issue is the shape of any economic rebound--whether it resembles a "V," meaning strong growth soon resumes; a "U," meaning business activity just plods along for a while, gradually turning higher; or an "L," meaning stagnation lingers for a long period.

The rebound's shape could determine what happens with corporate profits, on which stock prices are based in the long run.

The most popular view on Wall Street today is for a U-shaped recovery. High corporate and consumer debt loads, plus overexpansion in the tech sector in recent years, could restrain spending for a sustained period, many economists argue. At the same time, the Fed's aggressive credit-easing will support a gradual recovery, they say.

"I expect slow growth and a sluggish turnaround," said Jay Mueller, economist at Strong Capital Management in Milwaukee. "Things should be back on track by the latter half of next year. But by 'back on track' I don't mean we're likely to see five years in a row averaging 28% returns in the stock market as we did in the late 1990s."

He expects equity returns over the next five years to look much more like the historical norm--averaging closer to 10%.

But in a U pattern, "It would be much harder to pick winners and losers" in the market, Mueller said. "Some sectors will do well. But the sweet spots will be hard to predict."

They already have been: The rally of the last three months has been led by an eclectic bunch, including software stocks, entertainment issues and steel shares.

If Mueller is wrong and the economy rebounds far faster than expected, it's conceivable that stock prices could be much stronger across the board in the second half of this year and in 2002.

On the other hand, if the surprise is that the U.S. economy is entering a long stretch of stagnation, stocks overall could be lousy investments. Instead, conservative bonds could become the best place to invest.

The uncertainty, financial advisors say, argues more than ever for portfolio diversification--a concept many investors began to appreciate a year ago.

Said Russel Kinnel, Morningstar's chief mutual fund analyst: "Even if you're right about calling the economy, translating that into actual investments is never easy."

As an example, he noted that "the conventional wisdom is that in a recession 'cyclical' stocks get killed." Yet in the current economic slowdown, many cyclical industrial companies have fared much better than in the past--thanks in part to investments they made in cost-saving technology in recent years.

And Russ Koesterich, analyst at Instinet Research in New York, notes that individual stock sectors tend to recover at their own pace.

"People talk about Vs and Us and Ls as if it's one big picture, but it's not," he said.

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