Where to Put Your Money Now We'd be wary of bonds and real estate right now. But stocks haven't looked so good since 1999
By Michael Sivy Additional Reporting By Erica Garcia

(MONEY Magazine) – Hearts are often broken by kind words left unspoken, but right now your financial plans are more likely to be derailed by investments left unmade. The strategic decisions you reach at this point in the recovery will determine your investing results not only for the coming 12 months but for the next five years or more. And despite today's very real causes for concern--inflation, oil prices, rising interest rates and even potential terrorism--the long-term fundamentals of the economy and the market are more positive for stocks than they have been since 1999. By contrast, prospects for fixed-income investments and real estate are the dimmest they've been in a decade.

Unlike professional money managers, who have to scramble every quarter trying to stay a few steps ahead of their peers, you can focus on long-term goals: paying for college, buying a home, achieving financial independence or saving for retirement. And for long-term investors, today's stock market offers lots of opportunities.

Some stocks--especially aggressive growth issues--have run up rapidly over the past year or so. Tech bellwether Cisco Systems, for instance, tripled from its 2002 low before dipping in recent months; it still trades at 27 times next year's projected earnings. But many blue chips are selling at below-average price/earnings ratios. In fact, the stocks in the S&P 500 trade at about 17 times earnings for the current year. That's only slightly above the market's historical average multiple--and below the P/Es of 18 or so that typically prevail when inflation is very low. Today's bargains could well be superior performers, not just over the long term but for the next 12 months as well. In short, at this point in the recovery, stocks look like the best game in town.

Having the right overall strategy, however, is just as important as choosing individual companies. So before getting to specific picks, I'll take a look at some of the current misconceptions about the economy and the stock market--and also assess today's key economic trends. After that, I'll outline the prospects for real estate and then touch on questions about risk, diversification and income investing. The following story, beginning on page 62, discusses simple financial moves that can pay off big.

The recovery is on track

The biggest misconception about the current bull market is that it is somehow abnormal and that the decline earlier this year was needed to correct excesses that had led to overvaluation. In fact, neither of those things is true.

The bear market ended in October 2002. After bumping along for a few months, the market began a major advance in March 2003. If you plot the rise in stock prices since then against the average of the 21 recoveries since 1900 (see the chart at left), you discover three things. First, this bull market tracks the historical average fairly closely. This is in sharp contrast to the bear market of 2000-02, which was far worse than the norm and also far more severe than the economic recession that accompanied it. The brutality of that slump seems to have left many shareholders skeptical of the ensuing bull market.

The second discovery is that the correction, which ran from February to May of this year, was also completely normal. A typical correction begins 16 months after the start of a bull market, lasts for four months and consists of a 16% drop in the Dow. The recent correction began 17 months into the recovery, lasted for four months and so far has consisted of a drop of less than 10%.

The third interesting fact is that this recent correction seems to have occurred not because shareholders thought stocks had shot up too fast, but rather because of growing concerns about the future. The chart on the left at the top of the facing page shows the MONEY/ABC News Consumer Comfort Index, which hit bottom in March 2003 and began rebounding just around the time the recovery began in earnest. As you can see, confidence rose strongly until January 2004, right before the correction started. Since then, the index has fallen back more than halfway to its 2003 lows.

The risks are overstated

There's more to investor confidence than psychology. So it's helpful to run quickly through today's key economic issues to see which trends are positive and which are not.

OIL PRICES The era of cheap oil is over, for the simple reason that the fields producing at the lowest cost are starting to run dry, especially in the Middle East. The recent price spike to a record $42 a barrel, however, is not necessarily a sign of worse to come. Oil will likely average $30 to $35 a barrel over the coming decade, according to industry analysts.

That's higher than the average price for the past 20 years, but it's still well below past peaks, after inflation is taken into account. In today's dollars, oil hit $82 a barrel in 1981 and a gallon of gasoline cost $3. The recent $42 a barrel spike occurred because of hiccups in supply at a time when demand was rising rapidly. But supply is on track to improve over the coming months. In fact, world oil reserves actually rose 10% last year.

INFLATION Price increases have been low for more than a decade, less than 3% for much of that time. Most economists recognize that inflation pressures have been building, partly because of oil prices, but many believe that inflation will ease during the next year or two. One reason: Productivity gains remain exceptionally strong. In the first quarter, productivity grew by 3.8%, holding increases in unit labor costs to only 0.8%.

In fact, Federal Reserve chairman Alan Greenspan told the Senate Banking Committee in mid-June that "inflationary pressures are not likely to be a serious concern in the period ahead." In other comments, he noted that at this point in the recovery, corporations will likely try to avoid passing higher costs through to consumers. Profitability is rising fast enough to cover expenses, and companies are more likely to be concerned with gaining market share than with maximizing current profits.

UNEMPLOYMENT It's true that employment was slow to pick up for months after the recovery began. Nonetheless, pessimism about the economy seems to have masked the extent to which job creation is improving. In May the U.S. economy added 248,000 jobs, more than most analysts expected. And since March, 947,000 jobs have been created. That trend seems likely to continue.

PROFIT GROWTH Put together all of today's key economic trends--a mild uptick in inflation, high productivity and new hiring--and you have all the earmarks of a recovery that has completed its initial rebound but still has several years to run. As a result, corporate profit projections are robust. As the chart above right shows, earnings for the S&P 500 reached a high in 2000, then declined. But profits should reach a new high this year and continue to post solid gains through 2006--and probably beyond.

Where real estate fits in

The outlook for the overall economy is positive, but before we look at specific strategies for stocks, it's worth considering how real estate fits into your total financial plan. Not surprisingly, property ends up being a significant percentage of total retirement assets for most Americans. In fact, most affluent people end up heavily overweighted in real estate; instead of accounting for 15% to 20% of their total net worth, home equity may account for more than a third.

Investment is only one of the reasons for buying a home, however. Property you're actually going to use yourself, including a vacation home, is meant for enjoyment. So when the outlook for home prices looks bright, it's perfectly fine to buy as much house as you can afford. Currently, however, the outlook for real estate isn't so positive. The chart below shows how annual increases in the median home price compare with inflation. After moving up roughly in line with inflation during the early 1990s, home prices recently have risen considerably faster than inflation. That has been possible only because a sharp drop in interest rates enabled buyers to carry bigger mortgages. Now that rates are rising, however, potential buyers will be unable to afford the most expensive properties.

It's hard to give specific advice about real estate, since each property is individual and values are heavily dependent on local market conditions, which can vary from town to town. But there are a few general rules:

-- Buy the home you want--after all, your primary return comes from living in it--but this is not the time to strain to buy more house than you need.

-- While real estate investment trusts (REITs) and other real estate securities can be valuable diversification tools, now is not the time to be adding such investments to your portfolio.

-- Recognize that the first sign of a slump in real estate is a drop in volume. Because sellers resist marking down prices, houses sit on the market longer. And if expensive houses for affluent buyers are the only properties that are moving, prices may appear to be ticking up even though the overall market is weakening.

-- If you don't already own a home, be cagey. At some point you'll get a chance to scoop up bargains in REITs and similar picks. You'll also enjoy an attractive entry point for buying a first home. Don't jump the gun--be patient and the opportunities will come to you.

The right mix for you

The stock universe can be divided into four categories by earnings growth rate. There's a group of clunkers--stocks whose profit growth prospects are so meager that they will disappoint in the long run no matter how cheap they are when you buy them. At the opposite extreme are the high-flying aggressive growth stocks that always seem to be overvalued and poised for a fall.

The more attractive choices are the two stock groups in the middle of the spectrum--average companies that are undervalued and moderately above-average growers that are priced at only a small premium over the market. Such stocks typically outperform aggressive growth issues over the long term because it's simply easier for a company to maintain a 13% growth rate year after year than to sustain 25% or more. And when a stock with a P/E above 25 misses an earnings target, the market can be quite unforgiving.

Diversification and risk

Conventional wisdom says that the chief risk to investors is volatility and that risk tolerance is largely determined by your age.

Neither of these truisms is entirely correct. Volatility is of secondary importance for long-term investors. If you're confident in your strategy and willing to hold for years, short-term price fluctuations really don't matter. The much bigger risk is falling short of your ultimate goals because you were out of the market during its biggest gains.

In addition, recognize that your portfolio mix needs to reflect the amount of money you have, as well as your age and appetite for risk. If you're just starting out, you probably won't have much money to invest. And your biggest asset--whether you realize it or not--is the future stream of income from your job. If you have only $10,000 in the bank but a couple of million dollars of salary ahead of you, you can afford to put all your cash in a growth stock fund and diversify as you get more money to invest.

At the opposite end of the age scale, if you're a retiree with $100,000 or $200,000 invested to supplement Social Security, you need to be fully diversified. But if you have $3 million, you can put it all in high-yield stocks. You'll earn $100,000 in favorably taxed dividends each year. Best of all, you don't have to worry about short-term price fluctuations since you'll never actually have to sell.

What if you need income?

The charts on page 58 show expected levels of interest rates, based on recent inflation trends. As you can see, current inflation would justify an increase of 1.5 percentage points for Treasury bill yields. Ten-year bond yields, already up a percentage point from their 2003 lows, could rise at least another half a point.

This is certainly bad news for fixed-income investments. But the glory days for bonds are long gone anyway. Bonds can deliver superior returns only when interest rates are in a major long-term downtrend, as they were from 1981 to 1998.

Stocks, on the other hand, should easily be able to weather a moderate increase in interest rates. Since 1955, there have been 14 distinct periods when Treasury bill yields rose significantly. In 11 of those cases, stocks enjoyed healthy gains, according to the Leuthold Group, an institutional investment advisory firm in Minneapolis. During those 11 periods, short-term interest rates typically climbed more than two percentage points, while the S&P 500 was still able to gain 37%, on average.

Your smartest strategy if you need current income is to favor high-yield stocks, preferred shares or some other alternative to long-term bonds, which could be hit hard by increases in interest rates.

Spotting today's bargains

Most investors should build their portfolios around stocks with moderately above-average growth and P/Es in the 16-to-24 range, as well as value stocks (some offering fat yields) with P/Es below 18. If you screen the worldwide universe of 11,000 or more publicly traded stocks for financially strong U.S. companies large enough to be major players in their industries, you get down to fewer than 500 stocks. Screen for those with above-average earnings projections and you're down to fewer than 200. Focus on only the leaders in that group and you're down to fewer than 100.

The stocks that currently rank best in such a screen fall into four broad sectors. Here's a quick look at the economic forces driving the sectors, along with two picks in each. All eight of these stocks have market capitalizations of more than $10 billion, solid balance sheets and P/Es below 17, based on projected 2005 earnings.

CLASSIC GROWTH Computers and pharmaceuticals remain America's two great growth industries, even though both have had a bumpy ride over the past five years. IBM is a compelling choice because it is the biggest and best-diversified company in the computer industry and is gaining share in the important server market.

Pharmaceuticals remain a key growth group because of the aging of baby boomers. Overall spending on health care is projected to rise. And spending on pharmaceuticals should increase as a percentage of total outlays because drugs are the cheapest way to treat many chronic ailments. Pfizer is the giant in the industry. Moreover, the diverse company is a research powerhouse that makes four of the world's 11 best-selling drugs.

FINANCIAL SERVICES Some stock analysts caution that rising interest rates will hurt financial stocks. But others disagree and note that rates are starting off from a very low level. In addition, the industry is very diverse. Some financial services, such as mortgage refinancing, may suffer from rising rates, but others will easily ride out the increases. Right now it makes the most sense to focus on companies engaged in brokerage and investment banking, which would get a boost from a strong stock market. Citigroup is the largest and best-diversified U.S. financial services company. Merrill Lynch is the leading full-service broker and is also a major underwriter and investment bank profiting from the upturn in initial public offerings and mergers and acquisitions.

CONSUMER SPENDING As rising mortgage rates curtail refinancings, consumers will lose one source of extra cash. But that should be more than offset by new hiring and rising pay as the economic recovery gathers steam. Fortune Brands is an extraordinary collection of consumer franchises, including Jim Beam bourbon, Titleist golf balls, Moen faucets and Swingline staplers.

Home Depot remains the leading retailer of do-it-yourself home improvement products and can turn in above-average growth numbers even if rising interest rates somewhat slow the housing market.

INFLATION HEDGES Inflation will likely rise as the recovery proceeds. The most attractive stock choices are companies that incorporate an inflation hedge--because they produce commodities, for instance--and that are also attractive as growth or value choices. (For more suggestions, see "Three Ways to Ride Inflation" on page 117.) In the growth category is Alcoa, the world's largest publicly traded aluminum producer. The company is one of the few big commodities businesses with a projected growth rate as high as 14%. An appealing value alternative is Anadarko Petroleum, a relatively pure play on energy prices. While many other oil and gas companies depend largely on fields in faraway places with strange-sounding names, most of Anadarko's oil and gas reserves are in North America.


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