Two Smart Moves for Tricky Times Is the economy improving? Are interest rates going to spike? How to adjust for the possibilities
(MONEY Magazine) – So is this still a bull market? Just when we were getting used to the idea that we could make double-digit gains again, things got shaky. The S&P 500-stock index has been sharply up and down so far this year, gaining just 2.5% by late April. Bond prices have recently tumbled. And all of this despite the fact that by many measures the economy is looking up. Retail sales are surging. Corporate profits are strong. CEOs say they're more confident than they've been in 20 years. And in March, U.S. employers created 308,000 new jobs.
So what's been holding investors back? Blame Iraq. Blame $2-a-gallon gas. Or blame fears that this recovery really isn't sustainable. (Pessimists argue, for example, that those jobs numbers were inflated by the resolution of the California grocery-store strike.) And remember, good news often makes Wall Street a little nervous. When the economy grows, the Federal Reserve will start to fret about inflation and may begin to hike interest rates. That's bad for bondholders and takes a toll on corporate earnings too.
None of this leads us to think that you should dramatically change your portfolio right now. If you had, say, 60% of your money in stocks and 40% in bonds a year ago, that still makes sense today. But a couple of tactical adjustments are in order:
-- Move some money out of small-cap stocks and into blue chips, especially steady growth companies.
-- Reduce the interest-rate risk in your bond portfolio.
On the following pages, we explain our thinking and show you how to execute these timely moves.
1. Buy blue chips
Blue-chip stocks are still sitting on the sidelines. Smaller, more speculative companies have outpaced large-caps for four straight years now. And over the past 12 months, the Russell 2000 index, which tracks small-cap stocks, has risen 51%. The big-cap S&P 500 rose 25%.
For the first time since 1984, in fact, blue chips are trading at a discount to small-caps, with an average price/earnings ratio of 18.2 vs. 18.6 for the little guys, according to the Leuthold Group. Since small-caps tend to have more volatile earnings, this role reversal seems unsustainable. If the economy begins to slide, large-caps are likely to lose less. And if the recovery is for real, we think that at these cheap prices, blue-chip shares are poised for impressive returns.
Here's why: Giant companies tend to perform well in the later stages of an economic recovery. T. Rowe Price Growth Stock manager Bob Smith notes that since the second World War, large-caps have averaged an 8% gain in the second year of a rebound; small-caps returned just 5%. In the early part of a recovery, tiny increases in economic activity can be enough to propel a small firm from losses into profitability, and investors flock to those impressive initial growth rates. But as a recovery matures, it's the big, diversified firms that keep pushing out steady growth quarter after quarter. Blue chips also tend to be less sensitive to rising rates. When short-term interest rates rise, large-caps have returned an annualized 10.3% vs. 7.7% for small-caps, according to Ned Davis Research.
Here are four blue-chip companies with above-average earnings growth and reasonable stock valuations. All boast powerful brand names and dominant market share. We've also singled out a strong large-cap fund.
General Electric (GE)
The conglomerate's earnings have been flat or down for the past few years, mainly because of weakness in its power and jet-engine businesses. With both segments starting to rebound thanks to a pickup in the economy and in air travel, GE is returning to growth mode. "Next year GE will see fairly impressive acceleration in earnings, and the stock is very reasonably priced," says Bob Turner, chief investment officer of Turner Investment Partners. Turner reckons that GE, trading at $32 a share and 17 times expected 2004 earnings, should climb past $40 in the next year.
Sure, Microsoft's heady growth days are past, and the company is still facing legal woes. But it's also a cash-generating machine, and it will benefit from increased tech spending as the economy improves. "Its Windows operating system is practically a monopoly, and its profitability is nearly assured," says Pat Dorsey, Morningstar's director of stock analysis. "This is one of those companies that's rare to get at a reasonable price, and if you can, do it." This premium company's P/E is 21, just above the market. Seems reasonable to us.
Veteran value manager Bill Nygren of the Oakmark fund says he's recently been finding a lot of opportunities in blue chips, but that the maker of Budweiser beer is a favorite. "This is a company that is probably going to grow its earnings at 10% a year regardless of the economic environment," he says. "People consume beer whether the economy is good or bad." It also has strong brand loyalty and is selling for just 17 times earnings. And it's a China play: With a stake in brewer Tsingtao, Anheuser is tapping into one of the fastest-growing beer markets in the world.
The entire pharmaceutical industry is under pressure from generics, patent expirations and worries about drug importation. But Pfizer, which is still digesting its acquisition of Pharmacia, has a solid pipeline. It owns 14 of the top 25 best-selling medications in the world, including Lipitor, Viagra and Celebrex--none of which lose patent protection until the end of the decade. "Pfizer is easily the best managed among the large-cap pharmaceutical companies, and its pipeline is much better managed than competitors'," says Bob Turner. Pfizer is trading at a below-market P/E and has little debt, plus loads of cash on its books.
ICAP Select Equity fund (ICSLX)
This large-cap value fund, which MONEY picked as one of the six best funds for 2004, stayed away from surging technology stocks last year but still racked up a 40% gain. So far this year, the fund is up 5%. Manager Rob Lyon has been increasing the fund's holdings in energy companies and blue-chip multinationals. Expenses are low: just 0.8% vs. 1.4% for the average large-cap value fund. "It's cheap and has very experienced management and a great track record," says Kunal Kapoor of Morningstar. --DONNA ROSATO WITH LISA GIBBS
2. Cut your rate risk
Let's face it, no one can read Alan Greenspan's mind. But interest rates are near historic lows, so they're going to rise sooner or later. And it's even more certain that the bond market will react--make that overreact--far in advance of any actual rate hikes. In mid-April the 10-year Treasury yield jumped to 4.4%, up sharply from a low of 3.7% the previous month, on news that the economy seems to be picking up. (Bonds' yields rise as their prices fall.)
None of this means you should radically overhaul your bond portfolio, assuming you are well diversified. But we'd certainly stay away from long-maturity bonds and invest any new money in bonds that will hold up best when rates rise. Here's how to ensure a smoother ride in the coming year.
Scoop up short maturities
The money you really need to keep safe ought to be in a money-market fund right now. The next safest place to be is a short-term bond fund, one with an average maturity of three years or less. The typical short-term government bond fund slipped just 0.5% during the four weeks ending April 16 vs. a loss of 1.6% for intermediate-term government bond funds. Vanguard, T. Rowe Price and Fidelity all offer good low-cost choices.
But you should still hold a hefty stake in intermediate bond funds. And keep reinvesting your dividends. Remember, there's a bright side to rising interest rates: As your dividends are plowed back into the fund, your money buys bonds paying higher yields. Over the long run, studies show, those higher yields give you a better return than you would have gotten had rates remained flat.
Treasuries are more rate-sensitive than comparable corporate bonds and munis, so it makes sense to lighten up on them. But don't drop them altogether. "Chances are, as the economy hits bumps, there will be periods when Treasuries rally," says Andrew Clark, senior research analyst at Lipper.
What about inflation-protected Treasuries, or TIPS? We remain fans of TIPS, but they are starting to look a little expensive. The 10-year TIPS recently yielded 1.9%, down from 3.5% two years ago. Of course, TIPS payouts rise with inflation, so the bonds still belong in a diversified portfolio.
Stake out stable value
"A stable-value fund is one of the best income deals you can get today," says Diane Pearson, an investment adviser with Legend Financial in Pittsburgh. Offered in most 401(k) plans, stable-value funds (also called capital-preservation or retirement-income funds) invest in bonds, cash and guaranteed investment contracts sold by insurance companies. Sounds dull, but the result is a combination of money-market safety with bondlike yields. The average stable-value fund yields 4.4%, according to Hueler Analytics. If your 401(k) plan lacks a stable-value fund, consider one of the handful of retail offerings, such as PBHG IRA Capital Preservation (800-433-0051). However, you will have to invest in these funds through an IRA account. --PENELOPE WANG