So Long, Bear Market
Is the bear market in stocks behind us? A lot of smart people think so.
Take Paul McCulley, managing director of Pimco, the giant bond house. He's expecting a prolonged recession followed by a weak recovery. But, he adds, "The time to buy is before the end of the recession."
McCulley is bullish on the dollar, beaten-up financial stocks, shares of large multinationals, municipal bonds, and investment-grade corporate bonds.
As fund aficionados know, Pimco and its chief, Bill Gross, are best known for their excellent record of forecasting the twists and turns of the bond market and the economy. The flagship Pimco Total Return fund has an outstanding long-term record. Over the past ten years, the class A shares (PTTAX) returned an annualized 6.4% through April 30, putting it in the top 4% of all intermediate-term taxable bond funds. Particularly impressive: The Pimco team correctly anticipated the subprime mortgage mess, which ensnared many other bond funds.
(The class A shares levy a front-end sales charge. You can buy the class D shares (PTTDX), which don't have as long a record as the A shares, without sales charges or transaction fees through many discount brokers.)
McCulley and Gross remain concerned that turmoil could again engulf the financial markets if housing prices continue to fall. But in recent a note to clients, Gross said: "For now all is quiet on our investment front and the war appears to be winding down." That marks almost a complete turnabout from an interview he did with Kiplinger's in February.
What prompted Pimco's change of heart were the events of March 17. That was the day Federal Reserve Chairman Ben Bernanke engineered the sale of Bear Stearns to JPMorgan Chase and effectively opened the Fed's discount loan window to investment banks. "The time to buy stocks is before the end of the recession when the central bank and the fiscal authorities have pulled out all the stops," McCulley says.
But he's bearish on Treasury bonds: "I least like the Treasury sector. It's a call option on Armageddon. That was a good bet for the last nine months, but I want to short Armageddon now. I want to go long the concept of the economy being a going concern."
McCulley is hardly the only new bull. Standard & Poor's strategist Sam Stovall, who just a month ago predicted that the market would drop another 10% from its March 17 trough (by which time it had fallen 19% from it October peak), now says "The worst is likely over." He adds, "We believe it unwise to ignore the favorable alignment of our economic, fundamental, technical and historical indicators."
Like Stovall, I had thought the market would fall further, but I'm not so sure anymore. Indeed, Standard & Poor's 500-stock index rose 10.3% from its March 17 close through the May 2 close.
Ron Muhlenkamp, who manages the first-rate Muhlenkamp Fund (MUHLX), is an independent thinker who agrees with Stovall and McCulley. "I think we've passed the point of maximum pain as far as the stock and bond markets are concerned," he says. "The Federal Reserve has made it clear that it'll do whatever is necessary to keep things from getting out of control."
No one is talking about a booming bull market -- much less a robust economic recovery. McCulley compares the current financial crisis and economic weakness to the savings and loan debacle of the late 1980s and early 1990s. More than 1,000 thrifts failed during that crisis, leading to regional real estate busts and the last consumer-led recession. The S&P 500 lost 19.9% between July 16, 1990, and October 11, 1990, but the economy remained weak into 1992.
This recession is likely to be similar. McCulley foresees an elongated U-shaped recession this time -- one that lasts longer than the typical V-shaped downturn. Because of the continuing housing decline and the reluctance of lenders to part with cash, the Fed's powers to stimulate the economy are weakened. "We will get a recovery, but it will be feeble," McCulley says.
But that doesn't mean investors should avoid stocks. Corporate balance sheets are flush, and many foreign countries are in much better than shape than the U.S.
What to buy? Stocks of large companies make the most sense in a time of economic weakness. They have the most strength to survive hard times. Plus, McCulley likes stocks with "an international flavor." U.S. companies that export heavily are major beneficiaries of a weak dollar. McCulley also favors higher-quality financial stocks.
First-rate large-company funds include recently re-opened Dodge & Cox Stock (DODGX), Selected American Shares (SLADX) and Vanguard Primecap Core (VPCCX) -- all Kiplinger 25 members. All boast superb records and low expense ratios. Selected is heavily weighted in high-quality financials.
McCulley says the dollar is near the end of its decline against the currencies of other developed nations. Foreign stock funds have been huge beneficiaries of that decline. But McCulley sees economic weakness in the United Kingdom, which should hurt the pound, and an overvalued euro. The European Central Bank has been single-minded in raising interest rates to combat inflation-the height of folly in McCulley's estimation.
Oil also seems to be nearing a peak. Increasingly, speculation is the main force driving the price up. "When you reach a point where something goes parabolic, as has the price of oil, you know you're getting close to the end of the game," McCulley says.
Munis have already rallied against Treasuries, "but they still represent good value." My favorite in that market is Vanguard Intermediate-Term Tax Exempt (VWITX).
In taxable bonds, Pimco is inching into lower-quality credits. Right now, McCulley is a big fan of corporate bonds rated single-A and better, as well as mortgage-backed securities issued by Fannie Mae and Freddie Mac. It's too early, though, to consider high-yielding "junk" bonds, he says.
Don't look for housing to hit bottom anytime soon. "It's a crash on the installment plan," he says. "Check back with me in a year."
Steven T. Goldberg (bio) is an investment adviser and freelance writer.