Iraq, oil, the economy. You can find plenty to worry about, but there's also a lot you can do to position yourself for better days
(MONEY Magazine) – Lots of investors are worried that the bull market is fading. If stocks were rising at the normal rate for a recovery nearing its second anniversary, the Dow would be 1,800 points higher, at 12,000 or so. Why the lousy performance? Fear. And there's plenty to worry about—from sky-high oil prices and the continuing risk of terrorism to the possibility that inflation and interest rates will soar while the economy falters. As a result, investors have been moving to the sidelines, waiting to see what happens next.
Playing for time, however, isn't a particularly sound, let alone foolproof, strategy. Most bull markets last longer than two or three years—and the big profits come from staying in for the long haul, not from trying to jump in or out at the right moment.
But given that danger appears to lurk around every corner, what are you supposed to do? It's crucial to figure out how to put your money to work without making yourself overly vulnerable to setbacks. The key to smart investing during uncertain times is to distinguish between conditions that will pass and those long-term trends that will determine where your portfolio ends up.
One useful way to separate the serious threats from the background noise is to imagine yourself a year from now. What will the problems of 2004 look like in retrospect? It's not difficult to make some plausible guesses. A lot of what seems scary today should dissipate over time.
THE ELECTION Looking backward from 2005, the anxiety surrounding the presidential race will be long gone. Obviously, it matters which candidate wins (for an assessment of their respective economic programs, see the story on page 122). But from the stock market's point of view, the differences probably won't be huge. Whatever positive effects result from President Bush's tax cuts and more business-friendly policies could be offset by the damage done by a continuing deficit. And if a Kerry administration tries to rein in that deficit, especially by raising taxes on capital gains and dividends, it may dampen growth and depress the stock market.
WAR AND TERRORISM You don't have to be Tolstoy to know that the repercussions of war are impossible to anticipate. But it seems likely that a year from now Iraq will have become more like Afghanistan—a country with a degree of stability despite on-going conflict. It also seems probable that, whichever candidate wins the Presidency, the United States will try to avoid getting involved in another war right away.
The dangers of terrorism, however, will continue unabated. The only positive news on that front is that the stock market will eventually adjust to reflect the ongoing risk, just as it did during the Cold War in the late 1950s and '60s. War-related shocks typically have a big initial effect. But unless the situation keeps getting worse, valuations adjust fully, risks are relegated to the background along with hurricanes and earthquakes, and investors go back to comparing companies' earnings with those of the previous year.
OIL PRICES Will the high price of oil have triggered a recession by next fall? That seems unlikely, though some economists today believe it's possible. Clearly the $40-plus price of oil is a big drag on the stock market right now. In fact, according to a recent Gallup poll, 62% of investors say that energy costs are hurting the investment climate "a lot."
Yes, cheap oil is being rapidly used up, and in the long run prices have to reflect that. But what's driving costs at the moment is the political shakiness of suppliers like Russia and Venezuela, and the market's fear that terrorism could disrupt production. There is now a "terrorism premium" of at least $10 a barrel.
But unless the threat of terrorism keeps getting worse, the premium will begin to diminish within a year. In addition, a continuation of expensive oil will bring more supply on stream and the price could fall substantially, as happened in the 1980s, when oil prices sank for eight years after a spike.
THE ECONOMY The scary scenario for the future is stagflation—a nasty mix of rising inflation and weak demand that we last encountered in the Carter years. You can concoct a plausible case for such a disaster: The jobs that were lost during the recession still haven't been fully replaced. Until a couple of months ago, there were signs of resurgent inflation. That, in turn, makes it more likely that Federal Reserve chairman Alan Greenspan will want to keep jacking up interest rates.
On balance, though, the current trends suggest not an economic nightmare but a moderate, long-lived recovery. Job losses may be severe in certain specific places and businesses. But unemployment overall is 5.5% and falling. Consumer prices actually declined in July, so inflation can't be coming back all that fast. Yes, interest rates probably need to rise as much as a full percentage point, but increases of that size are normal at this stage in a recovery. A year from now, it should be evident that the bull market is still chugging along.
What's much more important about interest rates is that the trend is reversing—and that rates will be rising not only a year from now but for much of the coming decade. Yields on 10-year Treasury bonds topped 15% in 1981 and then fell steadily until they dropped below 3.5% last year. During that time, investors got used to the idea that bonds could return as much as stocks. Those days are over.
Considering that the investing climate is difficult, but encouraging if you look beyond the current chaos, what strategies make sense for today's shareholders? I can see four that manage to lower your risk while leaving you positioned to profit, assuming the recovery picks up again.
• FOCUS ON BLUE-CHIP GIANTS WITH STRONG BALANCE SHEETS. Because of the likely turn in the interest-rate trend, it's a pretty good bet that the market is undervaluing companies with extremely low debt and a lot of cash on hand. When interest rates are rising, companies that don't have squeaky clean balance sheets face higher borrowing costs, while those that do can easily afford to expand or raise their dividends. That alone isn't a reason to buy a stock, but it's a huge plus in a company you otherwise like. And there's a variety of stocks to choose from in the low-debt camp, including Coca-Cola, ExxonMobil, Home Depot, Johnson & Johnson, Microsoft, Staples, 3M, Viacom and Walgreen. Of particular interest is Pfizer, the giant drugmaker whose shares have suffered as investors worry about an onslaught of generic competition for its blockbuster drugs. We develop the case for that stock in more detail on page 72.
• LOOK FOR INCOME ALTERNATIVES TO LONG-TERM BONDS. In uncertain times, it's even more important than usual to include income investments in a well-diversified portfolio. But if long-term bonds are fundamentally less attractive, what are investors supposed to do? Two things, actually. First, you might want to select less risky stocks. You can achieve the same risk/return balance with growth and income stocks that you previously achieved with a mix of aggressive growth stocks and bonds. Second, you can use high-yield stocks to replace some of the bonds in the income part of your portfolio. Dividend stocks are more attractive than they used to be thanks to last year's reduction in the tax on dividend income. For more on these stocks, see the story "Dividends Rule!" in the September issue of MONEY (also available to subscribers at money.com/sivy). If you prefer to embrace this strategy using mutual funds, take a look at "Mutual Reassurance" on page 71.
• TAKE PROFITS IN THE MOST VOLATILE OIL STOCKS. Since oil prices are expected to rise over the long term, it makes sense to maintain a core position in oil stocks such as ChevronTexaco, ConocoPhillips and ExxonMobil. If you have more than 7% or so of your portfolio in oil, however, lighten up. Start with the most volatile energy stocks to reduce your exposure in the event that the oil bubble bursts. At the top of the sell list are oil service companies, such as Schlumberger, which tend to track the short-term oil price trend.
• LOOK FOR COMPANIES THAT DOMINATE NICHE MARKETS. Some mid-size companies with exceptionally good specialized businesses can grow faster than the overall economy. The key is finding an underlying growth trend that will likely continue no matter what the state of the business cycle. Examples include Teva Pharmaceuticals, the leading producer of generic drugs, and Spanish-language broadcaster Univision, which is benefiting from the rapidly increasing Hispanic population (for our take on that company, see page 68). Other attractive areas include defense electronics, financial services and specialized hardware and software. When you get right down to it, nothing beats a rich niche.