STOCK WATCH


Hang in There Investors

Jeffrey R. Kosnett

News of Lehman Brothers' bankruptcy sent the market into a tailspin, but here are three reasons not to give up on U.S. stocks.



To the surprise of few, markets reacted poorly to the failure of Lehman Brothers and the emergence of serious doubts about the future of American International Group. The sudden sale of Merrill Lynch to Bank of America is sad because it ends the independence of the world's best-known brokerage, but investors should be relieved that neither the Federal Reserve nor the Treasury now needs to ride to the rescue of a company that's much, much closer to the public eye than Lehman or Bear Stearns.

Despite the stock market's shellacking on September 15 -- the Dow Jones industrials plunged 504 points, or 4.4% -- the good news is that some combination of the government and investors is tackling, one by one, the financial companies with the biggest problems.

Last week, for example, the government took control of mortgage giants Fannie Mae and Freddie Mac. Because an improvement in housing sales, if not a big turn in home prices, is one of the keys to a better economy and investment climate, it's a plus that the government moved decisively to support liquidity in the mortgage marketplace.

By contrast, Lehman Brothers' filing for Chapter XI reorganization is, I would argue, less cataclysmic than Frannie's demise would have been. Sure, the bankruptcy filing will wipe out shareholders, hit bondholders hard and cause thousands of people to lose their jobs. But the same stuff happens all the time to all kinds of companies, in industries as varied as autos, biotech and retailing, with far less fanfare.

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Lehman was large, but its demise doesn't leave a void in the real economy. There are plenty of other money managers, bond underwriters, trading desks, and investment researchers. Its solvent subsidiaries, including the Neuberger & Berman money-management unit, will find new homes.

Besides, there are plenty of other financial stories to consider beyond Lehman's demise. For starters, there's the $70 billion commitment by big banks and investment firms to serve as a general source of emergency credit to the financial markets. Then there's the seemingly sudden reversal in the decline of the dollar and the continuing fall in the price of oil. These developments aren't as noisy as headlines that contain such words as "meltdown" and "depression" but need to be considered before you make a rash decision about your investments:

Sinking oil prices. For most of this year, rising oil prices were seen as the primary culprit behind the stock market's lousy performance. You might have missed this: Oil prices headed lower, not higher, in the aftermath of Hurricane Ike, just as they did after Hurricane Gustav before it. Crude closed at $95.71 per barrel on September 15, down from a July high of $147.

The lower oil goes, the better it will be for a bunch of industries that previously cut their profit outlooks because of the cost of energy. If the trend continues, earnings over the next couple of quarters may not be as dismal as the consensus now seems to expect.

Troubles in emerging markets. Investors are, rightly, focusing much attention on the U.S., but former faves like Brazil, China, India and Russia have their own problems. And this could lead to investors pulling money out of emerging markets and reinvesting it in the U.S.

Despite huge declines so far in 2008, Chinese and Indian stocks remain at far higher risk than U.S. shares. A lot of the hot money from U.S. and European mutual funds could soon turn cold as investors scrutinize losses of 30% or more in many emerging markets. Many developing nations benefited from soaring commodity prices and are now suffering from falling prices for oil, iron and other stuff. Plus, Russia's invasion of Georgia is a reminder that many of these countries shouldn't be confused with western democracies.

Stocks versus bonds. U.S. Treasury bonds, benefiting from a flight to safety, scored a huge rally on September 15. But the move, along with the rout in stocks, served to widen the gap in values between stocks and Uncle Sam's debt. Ten-year Treasuries now yield 3.5%. That's less than the rate of inflation, even allowing that the inflation numbers are likely to sink along with falling prices for oil and other commodities.

With Standard & Poor's 500-stock index now trading at 12.5 times projected 2009 earnings, stocks don't seem anywhere near as risky as long-term bonds (even allowing for the likelihood that earnings estimates will come down). The S&P 500's dividend yield of 2.4% is at risk because more dividend cuts are possible, but utilities and property-owning real estate investment trusts, to name two sectors known for reliable income, currently yield 4% and 5%, respectively.

Trying to time the markets, as we all know, is futile. It's possible, maybe even likely, that the stock market will continue to take big hits as more skeletons are found in the financial-services sectors. But the lower stocks go, the closer we get to a bottom. Combine that with extremely high levels of pessimism and the absence of compelling alternatives, and that bottom may not be far off.



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