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Why this market will get unstuck
Mid-year update: Prices are low, inflation is modest, and profits are on the rise.
June 11, 2005: 9:28 AM EDT
By Stephen Gandel, MONEY Magazine
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NEW YORK (MONEY Magazine) - Like a muscle car mired in the mud, the stock market is spinning its wheels, and you're probably tired of how it's spinning yours.

Even after a pickup in May, the major stock averages are down as midyear approaches. That means it's been 18 months since you've seen consistent gains in your portfolio, leaving you to contemplate how much happier you'd be had you rolled your blue chips over into a nice little condo in Miami or San Diego.

Get over it. Any investor with a time horizon longer than next week is almost certainly better off in stocks today than in any number of hot housing markets.

The contrast could not be starker: Properties are selling at reckless prices even as the investment case for them crumbles. Stocks, meanwhile, are cheap and unloved just as profits and the economy are showing surprising strength. Three million more people have jobs than did at the start of 2004, consumers continue to whip out their wallets, and corporate earnings have risen 17 percent in the past year.

Sure, plenty of investors are worried about the potential for resurgent inflation, but bears are always worried about something. The point is that while stocks may not get moving again next week or even next quarter, the outlook is much better than you probably think.

All eyes on the Fed

The job of keeping inflation under control falls to the Federal Reserve, whose only real tool for that purpose is to raise interest rates.

It's not exactly a surgical instrument. Some analysts worry that the Fed won't raise rates fast enough, allowing inflation to take off, while others fear it'll raise them too much and choke off growth. History shows that the central bank tends toward the latter error.

"Usually the Fed keeps raising rates until something goes wrong in the economy or the market," says Richard Bernstein, chief U.S. strategist at Merrill Lynch. "Even Alan Greenspan has never gotten it right."

So far, though, there's no evidence that the chairman has been anything but spot-on. Economic growth is slowing as the recovery ages, but not by much. Job growth was strong in April, as were retail sales.

Meanwhile, oil prices, which peaked in early March at $57, have started to fall, leaving people with more money to spend. Throw in the likelihood that the cheaper dollar will generate greater demand from abroad, and you have good reason to anticipate strong U.S. corporate profits.

For the past year, in fact, Wall Street analysts have been finding that they have consistently underestimated the profits companies will earn.

Has the Fed gone too easy on inflation, then? If it had, you'd expect to see a jump in the yield of the 10-year Treasury bond, which is extremely sensitive to any hint of future inflation.

The reality: Even though the Fed has tripled short-term rates to 3 percent since June 2004, the 10-year yield has actually fallen. In other words, bond investors believe that inflation will remain low, that the Fed will soon stop raising rates -- and that stock market pessimists can stop worrying.

Until they do, though, there is opportunity. The price-to-earnings ratio of Standard & Poor's 500-stock index recently stood at 20, or nearly a third less than the 29 it has averaged over the past five years. One would have to go back three decades to find stocks so cheap compared with their recent prices.

So, what's your move?

Go light on bonds

While yields have held steady so far this year, they're not likely to fall from here. That means you can't expect any capital gains from a rise in bond prices (which climb when interest rates fall). If you have more than 40 percent of your portfolio in bonds and you are not within five years of retirement, that's probably too much. If you like bonds' cash flow or security, consider funds that hold debt with maturities under five years. They're safer, and you won't give up much return.

Drain your oil stocks

If you have held oil or other basic materials stocks for a while, you've done well. It's time to take profits and diversify. These industries tend to outperform at the start of a recovery, when growth is at its peak.

Drop REITs and utilities

Real estate investment trusts have had an amazing run in the recent property boom. But more and more economists, including Greenspan, are warning that real estate is looking bubbly. Utility stocks too have had a good run, as their comparatively high dividend yields stood out in a low-interest-rate economy. But as the stocks have risen, their yields have fallen. There are better income plays out there now.

Buy health care and tech

Bernstein of Merrill Lynch believes that the market is ready for a new set of favorites.

"The big story for the rest of the year will be the shift from cyclical stocks [such as energy]," he says, to health-care and consumer stocks.

No matter what the economy does, people will continue to spend on medications and on staples like food and toilet paper.

Liz Ann Sonders, chief investment strategist at Charles Schwab, says investors will take more notice of the rising earnings at technology companies as the rest of the economy grows more slowly. Like Bernstein, she favors health-care companies and consumer outfits as well. Either way, she prefers the safety of large-company stocks over smaller ones.

"You should be playing defense with most of your portfolio and buying tech stocks with the rest," says Sonders. And leave the condos to someone else.

Follow-up: Updating our picks

Among the stocks and funds we recommended in the first half of the year, these six merit another look.

BUY

Pharmaceutical HOLDRs (PPH (Research))
Price then: $68.51
Current price: $74.97

IBM (IBM (Research))
Price then: $92.10
Current price: $76

Technology Select Sector (XLK (Research))
Price then: $21.53
Current price: $20.11

Pharmaceutical HOLDRs, an exchange-traded fund that owns shares in 21 drug companies, is up 9 percent since our recommendation ("Best Investments," January). The sector has rebounded from the lows prompted by safety concerns over blockbuster pain relievers. And over the long term, spending on drugs is headed in one direction.

MONEY has recommended investing in large-capitalization technology stocks several times this year. So far the advice hasn't paid off. The Technology Select Sector exchange-traded fund is down 7 percent since we picked it ("Small Stake, Smart Moves," February), and profit problems have dealt a more severe blow to IBM ("Old Glamour Stocks," April), down 17 percent.

But don't give up. Earnings at stalwarts Cisco and Intel are improving, and that pattern will continue across more companies. Earnings at IBM should rebound as well. The company is restructuring and has raised its dividend. At a price-to-earnings ratio of 16 based on next year's earnings, IBM looks like a bargain.

SELL

Marathon Oil (MRO (Research))
Price then: $36.92
Current price: $47.90

AIG (AIG (Research))
Price then: $67.70
Current price: $53

Michael Sivy's pick of Marathon Oil ("Small Stake, Smart Moves," February) was a gusher. Shares of the Houston-based energy company are up 30 percent. But the well is running dry. Marathon's earnings growth is expected to slow next year. What's more, a recent acquisition hinges on the price of oil staying high, and petroleum prices are falling.

Things have only gotten worse for AIG since MONEY predicted the insurance giant would rebound ("When Stocks Get Smacked," March). Longtime CEO Maurice Greenberg resigned; replacement Martin Sullivan said AIG had overstated earnings since 2000; and New York State attorney general Eliot Spitzer has sued the company.

AIG's shares have long fetched a premium price due to the company's consistently strong income growth. The question now is how real that growth was. AIG stock is still valued 20 percent higher than its rivals. If AIG is trading for less than your purchase price and you'll take a gain in your portfolio somewhere else this year, selling is a good way to lower your tax bill.

HOLD

CGM Realty (CGMRX (Research))
Since our recommendation: +16 percent

CGM Realty ("Best Investments," January) rose 15 percent immediately after we picked it but has fizzled in 2005. The reason: Manager Kenneth Heebner sold home-building stocks, which have continued to rise. But getting out early can be a smart move. Home prices have risen more than incomes. That can't continue, and if prices stagnate or fall, builders will suffer. Heebner has bought companies that own malls and office buildings, sectors that will benefit in a period of economic growth.  Top of page

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