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What's Ahead for the Markets

The parade of bad news the past few weeks has been unrelenting. It's time to size up the world economy -- and what it all means for stocks, bonds and real estate.

Here at the height of summer, with no hurricanes gathering over the oceans, I know you'd rather be golfing or boating or relaxing rather than pondering Iraq and Israel and Lebanon and the pain of a sinking stock market. But the parade of bad news the past few weeks has been so unrelenting that it's time for an honest assessment of the economy and where it's going and what that implies for your investments.

First, hear this: There's no recession in the offing, at least not this year, even with surging oil prices. The government will announce its preliminary second-quarter economic growth results in two weeks. Growth is certain to slow markedly from the first quarter's 5.6% rate, but it should still come in around 3%. That is decent. True, it's the direction of the trend, not only the number, that gets the worriers worked up. If key segments of the economy, such as home purchasing or retail sales, look weaker than expected, you'll read some downbeat headlines.

But even if the growth rate is 2.5%, that's a long way from a recession. Key U.S. companies, such as Caterpillar, 3M and General Electric, are doing well, selling gobs of materials and equipment to buyers all over the world and reporting good profits. Their stock prices have been stagnant, but not the businesses. U.S. export growth is surprisingly strong-exports of goods are up 11% (adjusted for inflation) from a year ago. The trade deficit, if you don't count oil, has been roughly flat for two years.

Besides, slower growth has its blessings. It's likely to be just what it takes for the Federal Reserve Board to stop raising short-term interest rates sooner instead of later. A rate pause won't spark a serious stock market rally by itself, but stocks will have trouble advancing until the Fed's intentions are clear. A slower economy will also help consumers breathe easier. You'll see fewer adjustments to adjustable-rate mortgages, credit cards, and other debt obligations.


And if you were offered a choice, you would want to pull for interest rates, rather than gasoline prices, to fall. Say you drive 1,500 miles a month and get 25 miles to the gallon. A 30-cent increase at the pump costs you $18. But if you owe $300,000 on an adjustable-rate mortgage and the rate resets from 5% to 6%, the extra monthly pain is $180-ten times as much.

Standard Poor's chief economist David Wyss, who sees the economy slowing in the second half of 2006 but not backsliding, scoffs about using the stock market as a broad economic indicator. "I'm not one of those economists who thinks the market tells us where the economy is headed," he said last week. He has some calming words: "You know, if the economy grows 2.5%, that's not a bad number compared with the developed world. You'll still have your job, and while your wealth won't increase as fast as you'd like, you and most of us will still be doing well."

Wyss predicts that the Fed will increase rates perhaps one more time, in August, and even that boost is not a sure thing. At any rate, the peak is near. Then, seven months typically elapse between when the Fed quits tightening and when it first cuts rates, heralding a cycle of easier credit. During those seven months, stocks and bonds can bounce around a lot, but the economy normally holds steady. Then, if a new rate-cutting pattern is really at hand, it's time to rethink your investments. Some thoughts:

Bonds will be back. One of the obviously smart moves this year has been to keep maturities on your fixed-income investments as short as possible. Savings accounts at online banks and money-market mutual funds are yielding at or near 5%, about the same as a ten-year Treasury note. With the exception of longer-term municipal bonds, which most people own for income and for whom price fluctuations aren't especially important, there's been little reason to extend maturities.


But that will change. According to Lord, Abbett Co., once the Fed stops raising rates, longer-term bonds (as measured by the Lehman Brothers bond index) rally like crazy. Lord, Abbett cites five 24-month periods starting with the month of the final Fed increase. During those periods, the Lehman index earned annualized returns of 9%, 11%, 12%, 21% and 23% -- not too bad when you consider that you can earn this in high-quality bonds or bond funds, without taking on the risk of investing in junk.

Stocks just have to do better. The stock market is inefficient and sometimes downright silly. (My favorite example: Shares of 3M lost $5 billion in market value, or about 7%, on July 7 because 3M said sales of one product in one of its divisions -- and only its third-largest division -- were slower than the company expected for one quarter.) On July 14, General Electric told of how its businesses are generally growing nicely, but Wall Street gave it, along with just about every other stock, a thumbs down. The market is "grumpy," one portfolio manager told me not long ago. I'd have to agree. If it wasn't, it wouldn't take the news of bombs in Beirut so hard. Aren't there always tensions in that part of the world? And what does Hezbollah have to do with, say, world orders for John Deere tractors? Precious little. But the stock market loves to chew on news events and political theories. And traders act like a herd.

It could be early, of course, given the current terrible tone and the possibility that oil prices are truly uncontrollable, which depresses investors and can negate good news from a wide range of companies. But eventually, you'll want to own stocks like 3M, GE, Bank of America and Johnson Johnson, plus funds that invest in those kinds of large, blue-chip growth companies. By September, it'll be a wise move to start gently feeding some of that cash that's earning 5% into bonds, bond funds, stocks or stock funds.

Real estate. Shocking as it seems, real estate investment trusts are still up 14% for the year. Despite my caution about using stocks to judge the economy, this result is an economic indicator -- and a positive one. It means that office buildings are filling up and raising rents and that other kinds of REITs, such as those that own apartments and warehouses, are also in good shape. New construction will expand and be absorbed. If there were a recession on the horizon, these stocks would probably be falling. REIT stocks are expensive, so they aren't the swell buys they were a couple of years ago, but if you hold 'em, keep 'em.


Turning to residential property, there is little correlation between commercial real estate and the value of houses. So, just because commercial property is performing well doesn't mean that you should expect to come out ahead investing in or speculating in rental homes or condominiums. You should definitely wait before investing in condominiums and suburban houses, which are plagued by huge oversupply.

I think everyone should own some real estate for diversification purposes. But if you own your home and a few REITs or a real estate mutual fund, that's plenty for now. The next housing boom is several years off.