Trouble ahead for stocks?
A January selloff plus slowing profit growth could add up to danger in 2005. Here's how to shore up your defenses.
By David Stires

(FORTUNE Magazine) – ONE OF THE FEW THINGS YOU CAN usually count on in the markets is that, like lions after a slumber, stocks rise at the start of the year. Spurred by resolutions, investors often kick off the new year by funding their retirement accounts. And among those folks lucky enough to work for companies that award year-end bonuses, many choose to go shopping for equities (rather than at the new-car lots). The flood of new money into the market tends to push share prices higher.

Not this year. Although the merger wave helped buoy stock prices in January's final days, all the major U.S. equity indexes finished the month in negative territory. Both the S&P 500 and the Dow dropped nearly 3%; the Nasdaq fell more than 5%. If history is any guide, that's a bad omen. Since 1938, the direction the S&P 500 takes in January has predicted its overall direction for the year fully 80% of the time.

Even so, few Wall Street strategists are throwing in the towel on 2005. Most believe the combination of low (if rising) interest rates, reasonable stock valuations, and climbing profits will fuel high-single-digit gains this year. Abby Joseph Cohen of Goldman Sachs, for example, predicts the S&P 500 will rise 9% this year. Smith Barney's Tobias Levkovich forecasts that it will gain 7%.

But the history books offer a number of important lessons that are particularly relevant to today's market. And together, they suggest that investors may want to proceed with caution this year.

One worrisome development that's received surprisingly little attention is that the Federal Reserve is raising interest rates just as profit growth is slowing. Typically it's the reverse: The Fed raises rates when profits are accelerating and low- ers them when they're slowing. This process creates a "buffer" system for investors, cushioning the blow of either higher rates or falling profits. But right now the buffer is out of whack.

Following the bursting of the tech bubble, Fed chairman Alan Greenspan was so worried about deflation and recession that he repeatedly slashed interest rates, bringing them all the way down to 1%, the lowest level in decades. Now Greenspan is in the middle of what's widely expected to be a lengthy series of rate hikes that will take the Fed funds rate up to 4% by the middle of next year, from 2.5% currently. Multiple rate increases tend to hurt stocks. Since 1970, whenever the Fed has called for three or more consecutive rate hikes, the S&P 500 has fallen an average of 6% over the 12 months after the initial hike. On Feb. 1, Greenspan announced the sixth rate increase since June 30, 2004. To make matters worse, profit growth is slowing dramatically. Analysts estimate that earnings will rise 8% this quarter, down sharply from the 26% surge in the first quarter of 2004. They forecast that profits will continue growing at this more modest pace for the foreseeable future (see chart above).

At least one longtime market observer is alarmed by the trend. Richard Bernstein, chief U.S. strategist at Merrill Lynch, says the combination of a rising Fed funds rate and slowing profit growth has occurred only three times during Greenspan's 18-year tenure. In each case stocks initially rose. But within a year or so they tumbled by at least 15% each time--in 1990, 1998, and 2001. Although Bernstein says the combination of rising rates and slowing profit growth was never the sole cause of the subsequent selloff, he maintains that it played a big role--particularly from 1999 to 2001. "History shows it hasn't been a good combination," he says.

Given his cautious outlook, Bernstein suggests that investors lighten up on U.S. equities. He recommends defensive sectors such as consumer staples and utilities. He's a fan of Ameren (AEE, $51), a St. Louis utility with a 5% dividend yield, and Dominion Resources (D, $69), a gas and electric utility in Virginia with a 4% yield. He also likes cereal maker General Mills (GIS, $53) because of its strong brand name and consistent dividend, now yielding 2.3%.

Admittedly, historical comparisons can be tricky. Bulls like Sam Stovall, chief investment strategist at Standard & Poor's, say the current situation is quite different from the three examples that Bernstein warns about. In those years, Stovall says, the Fed was trying to slow the economy; today it's merely looking to end the stimulation. "They're looking to take their foot off the gas, but they're not looking to put on the brake," he says. He thinks the current rate of economic growth is healthy enough to generate another year of stock gains; he predicts the S&P 500 will rise 9% in 2005.

Stovall recommends late-cycle cyclical stocks in the industrials and energy sectors. His picks include railroad giant Burlington Northern Santa Fe (BNI, $47), which is seeing particularly strong demand in its coal-freight business, and Devon Energy (DVN, $41), which has a big natural-gas business.

Other bulls agree with Stovall's argument. The assumption is that Greenspan is correct in not raising interest rates more quickly, because inflation is under control. Indeed, the consensus forecast among economists is for the U.S. consumer price index to continue growing at a moderate 2.5% annual clip.

But several top investors, including Pimco bond guru Bill Gross, believe the CPI dramatically understates inflation. Among other things, they argue that the government's "hedonic" adjustments--meant to account for quality improvements in an array of products, from computers to cars--tend to lowball inflation. And given rising commodity prices and the falling dollar, they expect inflationary pressures to pick up. That's bad news for stocks. History shows that P/E multiples tumble as inflation rises (see chart at right). And with the S&P 500 trading at 20 times the previous 12 months' earnings, or 25% higher than its average P/E of 15 since 1926, stocks could have a long way to fall.

Finally, bulls and bears agree on at least one red flag: The current bull market is getting old. Ned Davis Research marks the start of this bull market as Oct. 9, 2002, which means it had run for 847 days through Feb. 4, 2005. That's far longer than the 614 days the median cyclical bull has lasted since 1900. Moreover, this market is following the classic bull pattern, rising sharply in the first couple of years and then trailing off, suggesting that it will be closer to average length than to the long run of the 1990s. Meanwhile, down days this year have seen heavy volume while rallies have lacked strong demand, indicating that enthusiasm for equities is waning. And although many see the recent merger wave as a sign of a healthy economy (for more on the current M&A boom, see First), others point out that bull markets tend to peak with a flurry of deals.

There are general guidelines to picking stocks in a dicey market. For instance, investment pros generally recommend migrating into quality stocks--that is, cash-rich companies with consistent earnings growth and clean balance sheets. Having ample cash and low debt means firms are more likely to boost dividend payouts and less likely to need fresh capital to stay afloat, protecting them from rising interest rates.

Henry McVey, U.S. equities strategist at Morgan Stanley, recommends companies that are in the process of paying down debt, such as Tyco International (TYC, $34) and Dow Chemical (DOW, $51). Deleveraging provides an opportunity for margin expansion as debt gets repaid and interest expense comes down. He also likes companies with rising dividend payouts, such as Altria Group (MO, $64) and Yum! Brands (YUM $46). For those who prefer funds, there's the iShares Dow Jones Select Dividend Index (DVY, $60). The exchange-traded fund recently doubled the number of holdings in its portfolio to 100 of the top dividend-paying stocks and has a 3.2% yield. So even if stocks go nowhere, it puts cash in your hand. That's something you can count on.