Why the sky isn't falling
Wall Street's Chicken Littles have it all wrong -- and there's money to be made betting against them
NEW YORK (MONEY Magazine) - We're all doomed. One forecaster says the U.S. is on the edge of a recession that will crush the stock market. Another insists that inflation is about to flare up and destroy your purchasing power.
It's hard not to be rattled by such dire predictions, even if you're basically optimistic. So is there really something deeply wrong with our economy -- and are there things you need to do right away to protect your investments? Or should you be looking for ways to take advantage of all the current pessimism?
Some measure of caution is always sensible when you're managing long-term savings. After all, it's money you can't easily replace. Still, you don't want to mistake a bonk on the head from an acorn for a sign that the sky is falling. Remember Y2K? Dow 5000? Those predictions in the late 1980s and early 1990s that the Japanese would eat our lunch?
Overreacting to such possibilities isn't just silly, it can be self-defeating. If you don't remain properly invested in a mildly depressed market, for instance, you'll miss the fast profits that come when share prices first start to rebound. Here's a look at five of today's big worries, including clear-eyed assessments of the real levels of risk and some suggestions about how you might be able to profit from the Chicken Little syndrome.
"Oil prices are going to soar even higher!"
THE REALITY Yes, turmoil in the Middle East and hurricane damage to Gulf Coast wells and refineries have temporarily put a crimp in supply. Strong demand, including greater consumption in China, also has boosted energy costs.
But there's no long-term energy shortage. Canada's oil sands alone contain nearly as much petroleum as Saudi Arabia has. It just costs $20 a barrel or more to produce, six times the cost of the cheapest existing wells in the Middle East. Other sources of oil and gas are abundant as well, although at high prices. The bigger catch is that it takes as long as five years to find and bring new production online.
BOTTOM LINE Oil production can be slow to catch up with demand. So although it's likely that prices will be generally high during the next 20 years, they should stabilize at some point below today's steep $61 a barrel.
Owning big oil stocks like ExxonMobil (Research) or ConocoPhillips (Research) does make sense for the long term -- you get dividends, currently around 2 percent, as well as long-term inflation protection. But you don't need to rush to buy big oils if you don't already own them. You might even get a chance to scoop those stocks up at lower share prices if you wait for a pullback in oil prices to $45 a barrel some time in the next couple of years.
"A nasty new inflation spiral has begun!"
THE REALITY No question, inflation has picked up. The consumer price index rose at annualized rates of as much as 4.7 percent in 2005, compared with 1 to 3 percent for most of the previous three years. But recent peaks aren't sustainable. In fact, November's inflation number was down sharply -- the biggest monthly drop in 56 years -- because of an unexpected tumble in gasoline prices.
Over time, there will probably be an upward creep in consumer prices as long as the economy remains robust. But productivity gains and cheap imports are still stopping companies from hiking wages too much. Indeed, we may actually see a reduction in inflation, perhaps to less than 2.5 percent, if oil prices ease substantially in 2006.
BOTTOM LINE Even if we aren't on the brink of an inflation surge, any prudent long-term investing strategy will include inflation hedges. If you're setting up a new portfolio, you might want to search for stocks that would likely be able to keep up with inflation. Besides energy companies, that includes raw-materials producers and real estate investment trusts. Or you could rely on a fund like T. Rowe Price New Era (Research), which owns the shares of natural-resources companies.
And it's worth noting that the fund has even performed well in today's climate of low to moderate inflation, returning an average of 16.5 percent annually over the past five years. Again, however, many inflation hedges are expensive at the moment, and you may have a better buying opportunity if you wait and inflation slows this year or next.
"Interest rates will continue to rise!"
THE REALITY Federal Reserve Board chairman Alan Greenspan has now hiked short-term interest rates 13 times in a row, to 4.25 percent, the highest level in almost five years. Since the Fed began raising rates in June 2004, the big surprise has been that long-term interest rates have not followed along at all -- in fact, the yield on 10-year Treasuries has even fallen slightly.
Some analysts fear that this means the Fed will have to keep raising rates until bond yields catch up. An alternative view, however, is that the Fed rate hikes simply mean the economy is doing well -- and that the mysterious refusal of bond yields to surge only signifies that inflation is under control. Moreover, many Fed watchers think that Greenspan hopes to complete almost all of this round of short-term rate increases before he steps down on Jan. 31. That way, his successor, Ben Bernanke, can start his term as Fed chairman with a relatively clean slate.
BOTTOM LINE Most forecasters expect two rate hikes in 2006, taking short-term rates to 4.75 percent. If Greenspan has gauged the economy correctly, overall growth can continue at a healthy clip while long-term yields inch up. This scenario would be better for high-yield stocks than for bonds, which are hurt by any rise in interest rates.
It's also worth noting that major bank stocks often rally once a string of increases in short-term rates is completed. This effect bodes well for banking giants such as Bank of America (Research), Citigroup (Research) and J.P. Morgan Chase (Research), which yield at least 3.4 percent and trade at less than 12 times estimated earnings for 2006.
"A recession is just around the corner!"
THE REALITY Well, one thing is clear: There's no recession yet. Real gross domestic product has grown at an above-average annual rate of 3.3 percent or more for 10 quarters in a row. So why should the economy suddenly sour now?
Two possible reasons are worth thinking about. The first is that short-term interest rates are now nearly as high as long-term rates, which is normally a sign that the economy is slowing down. But it could also be the result of unusually low inflation pressure, thanks to growing productivity, cheap imports and sound Fed policy.
The second reason some analysts give for fearing a recession is that the consumer is stretched quite thin. Consumer debt per household is near record highs. So are bank-card delinquencies and minimum required payments as a percentage of disposable income. And now that mortgage rates are rising, it's harder for homeowners to refinance and use home equity to pay down debt.
But these trends threaten only a small percentage of consumers, hardly enough to drag down the overall economy. Much more important is the fact that unemployment has fallen to 5 percent, down from 6.3 percent in 2003. Many Chicken Littles don't get it: The best sign of a strong economy is strong employment numbers.
BOTTOM LINE Focus on your own finances. If you have more than $1,000 of credit-card debt, pay it down. The amount you save on interest will likely be far greater than what you can earn in the stock market. And the flexibility that comes with low indebtedness provides enormous intangible benefits.
"The bull market will be over before it's started!"
THE REALITY The current bull market has gone on about as long as the typical post-W.W. II expansion, but its stock price gains have been smaller than usual. To match, the S&P 500 would have to rise from 1270 to 1400, or at least 10 percent.
BOTTOM LINE During this bull run, earnings have risen far more than the norm, so a further 10 percent gain in share prices seems the least to expect. And big-cap growth stocks, even with some recent gains, remain undervalued by about 10 percent relative to the rest of the market.
In short, if you focus on blue chips with double-digit earnings growth and relatively low price/earnings ratios, you have a good shot at gaining up to 20 percent in 2006. Among stocks in the Sivy 70 that meet those criteria: 3M (Research), which just appointed a promising new CEO; Fortune Brands (Research), a collection of superb consumer businesses; overnight shipper FedEx (Research); defense contractor General Dynamics (Research); chipmaking giant Intel (Research); software kingpin Microsoft (Research); and discount retailer Wal-Mart (Research). It will take more than an acorn to knock down stocks like these.
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