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Optimistic about the stock market

Here's why long-term investors should see the current bear market as a positive opportunity.

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By Michael Sivy, Money Magazine editor-at-large

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E-mail Money Magazine editor-at-large Michael Sivy at msivy@moneymail.com.

NEW YORK (Money Magazine) -- Tuesday's bad economic news, and the sharp selloff that resulted, are the latest signs that the stock-market decline is still going on.

But in the midst of all this turmoil, it's very important for investors to keep the bad news in perspective.

In fact, if you have a time horizon of five years or more, this is actually a time of opportunity - and the long-term outlook is quite positive.

The immediate problems are real enough. Banks and other financial companies are continuing to write down bad loans.

The mortgage crisis is continuing. And Federal Reserve Chairman Ben Bernanke has acknowledged that even with government relief efforts, foreclosures on homes are likely to continue for a while. Those problems are hurting some other industries.

The Fed will be forced to keep cutting interest rates to limit damage to the economy, as it is expected to do at its March 18 meeting. But those low rates will increase the chances of serious inflation.

Most economists think the U.S. is now in a recession. The consensus forecast is for the economy to contract for the first half of the year.

Sounds awful, doesn't it? And in fact, if you are a professional stock trader, judged on your monthly or quarterly profits, this would indeed be a time to be worried about job security.

Take a long-term approach

But the issues for long-term investors are quite different. You'll certainly want to make sure that your portfolio doesn't suffer big short-term losses, even if they're only temporary.

But what matters most is where your portfolio ends up five or 10 years from now - and what your compound rate of return has been over that period.

The first objective - limiting short-term volatility - is easy enough. Just follow the usual advice: Include conservative investments in your mix, especially some that pay regular income. And diversify as broadly as possible.

While you may want to bottom-fish a little bit, be cautious about loading up on financial stocks, however depressed they appear. They still could announce surprising bad news.

Achieving the second objective - earning an above-average compound rate of return over five or 10 years - is a more complicated question. And that's where I think optimism is warranted.

Remember that stock prices reflect all the bad news that is already known. And because investors act in anticipation of future developments, prices tend to rise or fall as much as six months in advance of the economy.

Prices of blue chips today are down 15% to 20% from their October highs. And many financial stocks, of course, are down far more. That means share prices visibly reflect the bad news that has come out already and the likelihood of slow growth or economic decline until the second half.

Economy is resilient

But from a long-term perspective, the only thing that matters now is whether the slump will be much, much worse than expected or last far longer than midyear. Here's why I see a favorable answer to that question:

Normal bear markets are based on a downswing in the business cycle. An economy that has been accumulating imbalances and excesses for several years turns down so that the problems can be flushed out over a period of six months or longer.

But except for the mortgage crisis, the economy hasn't been all that far out of balance. Although the economy is slowing now, for four years it hasn't had a negative quarter. It also hasn't grown at an unsustainable rate for more than a quarter or two.

And although inflation picked up in January, hitting 4.3%, the core rate is only 2.5%. If you look at annual averages, inflation looked worse in 2005 than it did last year.

And since 2001, unemployment has been higher than it is today more than half the time.

These numbers will doubtless get somewhat worse over the next few months. But what's key is that the economy hasn't been way out of line and in need of a trip to rehab.

Instead, current troubles are the result of a specific financial shock - namely, the collapse of a network of bad loans.

Some forecasters see this as the start of a domino effect leading to catastrophe. New York University professor Nouriel Roubini sees rising odds of a worst-case scenario based on a big further drop in home prices, leading to another round of major losses on subprime mortgages.

If those losses spread, credit card lenders, commercial property, Wall Street firms, industrial companies and the stock market would all be taken down.

That's possible, but none of the evidence I've seen suggests that the total of likely losses will be large enough, compared with the equity in the banking system, to create such a disaster-movie outcome.

Far more likely is that a couple of major banks fail or are forcibly merged, while others take sizable losses and have to dilute their stock to raise more capital. That's bad for the shareholders of those specific banks, but it doesn't take down everyone else.

The bottom line is that the U.S. banking system can take its lumps and survive. And the Fed can buffer the shock, as long as interest rates are kept low and the Fed pumps enough money into the economy to maintain liquidity at the banks until everything gets sorted out.

With yields below 2% on Treasury securities that have maturities from 90 days to three years, today's 3% fed funds rate is too high. The Fed needs to cut by at least another half percentage point.

Next year, the Fed may have to reverse course and raise interest rates to prevent inflation from getting worse. But by then, the economy should already be in recovery.

Blue chips worth buying

Indeed, many blue chips are weathering the crisis fairly well. One of the reasons is that many leading U.S. companies get a significant percentage of their profits from overseas. Some big tech companies, for instance, get more than 60% of their business outside of North America.

The point is that most of the world - and a large part of the U.S. economy - is still in reasonably good shape. There are some very specific problems that can be contained, as long as the Fed handles them properly.

In addition, current share prices reflect the problems we already know about. Ideally, the banks would have identified all their losses for the year-end 2007 earnings report. But there will probably be some further writeoffs in the first quarter and maybe even the second.

Admittedly, this is only moderately good news. Stocks could still be dead money for a quarter of two. But if you're an investor saving for retirement - or if you have a five-to-10 year time horizon for other reasons, your best buying opportunities may come in the next six months.

Certainly, there are reasons to stay defensive. But it is also noteworthy that stocks such as Burlington Northern (BNI, Fortune 500), Disney (DIS, Fortune 500), DuPont (DD, Fortune 500), Hewlett-Packard (HPQ, Fortune 500), IBM (IBM, Fortune 500), Johnson & Johnson (JNJ, Fortune 500), Microsoft (MSFT, Fortune 500) and 3M (MMM, Fortune 500) all trade at less than 15 times estimated earnings for the current year.

Some of these stocks could fall further in the next few months if their earnings disappoint. But from the perspective of someone with a 10-year time horizon, current prices look rather cheap.

After all, most forecasters remained upbeat when the major indexes were at a top. Why wouldn't you expect that they would be too bearish just as stocks are hitting bottom? And how wrong can you go in the long run, if you buy a diverse selection of blue chips at 15 P/Es or less? To top of page

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