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Stocks & Bonds

Smart Moves in Today's Market

Risks remain. But thanks to strong earnings and low interest rates, stocks should finish the year in the black.

Editor's note: This story has been updated since its original publication.

The economy is perking up. Consumers are opening their wallets. Durable-goods orders are increasing, a sign that businesspeople are becoming more confident about the future. After dramatically reducing their capital spending, companies are once again investing in software, technology and equipment. Exports are rising. Even housing prices may have stabilized.

As recent turmoil in Europe over the possible default of Greece and perhaps other European nations has demonstrated, however, significant risks remain, and markets around the world are inextricably intertwined. Standard & Poor's 500-stock index sank 8% in May, and fell another 5% in June, as worries grew over a possible double-dip recession in the U.S.

At home, corporate earnings are dramatically recovering from the depths of the recession. From globetrotters, such as 3M and IBM, to domestically oriented operators, such as Chipotle Mexican Grill and railroad Union Pacific, companies are reporting a surge in profits this year. Analysts are hurriedly ratcheting up their forecasts. By 2011, they say, earnings for companies in the S&P 500 will return to the record levels set in the pre-crash year of 2006. My, that was fast.


If you sense a disconnection between a still-fragile economy on the one hand and burgeoning earnings and buoyant stock prices on the other, you are correct. Given the depth of the recession, which probably ended in the summer of 2009, the recovery is anemic by historical standards. (For more on the state of the economy, see our Economic Health Tracker.)

David Bianco, chief U.S. stock strategist for Bank of America Merrill Lynch, offers a logical explanation for this apparent anomaly: The complexion of the S&P 500 is increasingly deviating from that of the domestic economy. The home economy is driven by consumption, but the index is dominated by companies connected to business spending, energy, materials and sales overseas -- all of which respond to global economic growth. Bianco foresees the percentage of profits generated from abroad rising from 40% now to 50% or more within five years.

So where does this leave investors? With the S&P 500 still up about 60% from its March 2009 low, it's fair to ask whether the bull has any more room to run. That will probably depend on how the upheaval in Europe plays out. Assuming that the massive rescue plan shores up the slumping euro and helps Greece and other fiscally troubled European nations, such as Spain and Portugal, avert defaults, the U.S. stock market will continue to advance. Because of rock-bottom interest rates, strengthening earnings and abundant cash on the sidelines, we think the S&P 500, which was down 7% in 2010 through June 30, could finish the year with a return around 10%.

Long-term concerns

But many experts are pessimistic about the stock market's longer-term prospects. They fret about the implications of higher taxes, more regulation, lower long-term economic growth, stubbornly high unemployment and, perhaps most of all, the appalling condition of our public finances and the lamentable state of politics in our nation's capital. Alan Gayle, director of asset allocation for RidgeWorth Investments, calls himself a "nervous bull." Ed Maran, co-manager of Thornburg Value Fund, worries about the prospects of higher inflation and interest rates stemming from the deep fiscal hole we're digging.


And the recovery is still not complete. Four years after the bubble burst, housing is still an ugly sight. Some 3.5 million homes sit vacant -- twice the normal number. Sales of distressed homes, which weigh on housing prices, represent 35% of total house sales. Tom Zimmerman, a specialist in asset-backed securities at UBS, projects five million more defaults and two million more delinquencies over the next four years (currently, 10% of mortgages are seriously delinquent).

Even with the rebound in stocks and prices for some other financial assets, Americans are struggling to boost savings (the savings rate was still an anemic 3% in the first quarter of 2010) while cutting debt. This is no easy task in an environment of high unemployment and weak income growth. Merrill Lynch economist Ethan Harris thinks these and other factors will translate into subdued consumer spending for five years.

Banks are hardly pictures of health. Last year, the U.S. recorded its steepest decline in bank lending since World War II (despite the surge in government lending), and credit continued to contract in the first quarter of 2010. Some large banks are back on their feet, but the balance sheets of many local and regional banks are still grim. As a result, many banks remain unwilling to extend credit to small and midsize businesses.

With so much that could go wrong, as always ponder the risks before taking the plunge into stocks (see What Could Slay the Bull).


And now, with eyes wide open, let's look at some investment strategies for this market. One approach for picking stocks over the next year is to focus on shifts in the economy and earnings. The past year's market celebrated survival: Shares of small companies and low-quality firms soared after the world didn't come to an end. Investing in companies with sustainable revenue and earnings growth may be the next theme. Overall, profit growth will decelerate in the second half of this year, and earnings growth in 2011 will be modest compared with 2010, a big turnaround year.

One good place to start the search is with U.S. multinational corporations, particularly those with strong positions in fast-growing developing economies. Larry Adam, chief investment strategist for Deutsche Bank Private Wealth Management, says that the current recovery marks the first in which emerging nations are the locomotive that is pulling the world out of recession. Over the next five years, Deutsche Bank projects, emerging markets will account for 50% to 75% of global economic growth.

Merrill Lynch's Bianco sees opportunities in "global cyclicals" -- sectors such as technology, industrials, energy and materials that get a boost from rapid overseas growth. Bianco has a particular soft spot for U.S. companies that are replicating their business models abroad. He says that even big, mature companies can accelerate growth by raising low-cost capital at home and investing it overseas in high-growth developing countries.

Opportunities in blue chips

Mark Phelps, chief executive of asset manager W.P. Stewart, looks for U.S. companies with mature domestic businesses that are generating abundant cash flows, which can be redeployed in faster-growing markets, such as China. For instance, KFC and Pizza Hut, both part of Yum Brands (symbol YUM), are stale concepts at home but are booming in China, where Yum books 38% of its profits. Phelps, who likes both Yum and Pepsico (PEP), says that wages and retail sales in China are expanding by 15% a year.


Similarly, Jordan Opportunity Fund's Jerry Jordan has gravitated to high-quality U.S. blue chips that have the stamina to boost earnings for many years. For instance, he likes Coca-Cola (KO), another company with unexciting growth prospects in the U.S. but bubbling opportunities abroad, where it already generates three-fourths of its profits. Jordan has also warmed to media companies, such as News Corp. (NWSA), Walt Disney (DIS) and Viacom (VIA). He thinks they all have excellent opportunities for long-term growth around the globe, in part because of the proliferation of new venues for their content, such as Apple's iPad.

From a longer-term perspective, let's not overlook demand for commodities arising from the global economic recovery. Fred Sturm, the veteran manager of Ivy Global Natural Resources Fund, says that capital investment in large-scale mining and energy projects collapsed during the recession. That means new supplies of energy and minerals will be constrained while demand rebounds. For instance, car sales in China, up more than 50% this year, have surged ahead of U.S. sales. "Never before has the Chinese auto market needed this much fuel or iron ore to make cars," says Sturm. The Toronto-based manager sees prices of many critical commodities, such as oil and iron ore, rising 50% to 100% over the next five years, a period during which the world's population will grow by 350 million. As a result, Sturm favors natural-resources stocks, such as Occidental Petroleum (OXY), mining giant Rio Tinto (RTP) and Potash Corp. of Saskatchewan (POT).

If you prefer to invest through funds, Fidelity Contrafund (FCNTX) and Vanguard Dividend Growth (VDIGX) have large allocations to multinational corporations. If you feel more like sitting on the fence, consider some funds, such as FPA Crescent (FPACX) and Hussman Strategic Growth (HSGFX), that have the ability to own stocks as well as sell them short to profit from falling share prices.