Markets

What's Next for Stocks and Bonds

As tension mounts between the certainty of rising interest rates and surging corporate profits, bet on the likelihood that stocks will rise in the second half of 2004.

By Jeffrey R. Kosnett, Senior Editor

From Kiplinger's Personal Finance magazine, July 2004

Iraq. Terrorism. The budget deficit. The upcoming presidential election. Add these to the many uncertainties that always dot the investment landscape, and it's no wonder that investors are queasy. But the market today is really about a tug of war: the conflict between rising interest rates (bad for stocks) and surging corporate profits (good for stocks).

No doubt interest rates are heading up. Reacting to a strengthening economy, the Federal Reserve Board has signaled that this summer it will begin to lift the key short-term rate that it controls. Investors, who set long-term rates in the bond market, have already spoken: Yields on the benchmark ten-year Treasury note have climbed from 3.1% in June 2003 to 4.8% in mid May.

Countering the potential damage of higher rates is a robust earnings picture. First-quarter earnings were spectacular. Among those companies that had reported numbers as of mid May, 76% exceeded analysts' profit forecasts, according to Zacks Investment Research. Zacks estimates that first-quarter profits were up 30% from a year ago. And the outlook for the rest of 2004 is promising. Big wheels such as Microsoft and 3M say earnings for the rest of the year will be better than originally expected.

Which force, higher rates or higher earnings, wins out? In our view, the pretty profit picture prevails as long as the rise in rates is modest and gradual. True, there are killjoys who will ambush stocks every time the Fed threatens to boost rates or bond yields climb. Rate-related stock sell-offs "are a knee-jerk thing," says Dean Croushore, a professor at the University of Richmond and a former economist at the Federal Reserve Bank of Philadelphia. "It's not so much the little increases that hurt stocks but the fact that sellers know there will be more and more" of them, he says. But rates are so low that it's hard to imagine that a rise of a couple of percentage points will choke off economic growth or prompt investors to dump stocks in favor of bonds or money-market funds.

Stronger second half

Stock-price plunges prompted by rate fears can be scary, but we believe the market will finish 2004 in positive territory. By year-end, look for a well-diversified portfolio of U.S. stocks to be worth 5% or so more than when you read this. You'll earn more from stocks than you will from Treasury, municipal or junk bonds, money-market funds, or certificates of deposit. Expect the Dow Jones industrial average, a little under 10,000 in mid May, to reach 10,500 in the second half of 2004. Investors with a time horizon of at least ten years should have 80% of their assets in stocks. Those with longer horizons or great tolerance for risk should have more in stocks.

One reason for our sanguine outlook is that many investors seem optimistic. "I told my wife the other day that when the stock market goes down, my stocks go up, and when the market goes up, my stocks go up, too," says Don Allison, 57, a farm-machinery dealer in Arley, Ala. Alan Swain, 59, a telecommunications executive in Omaha, is taking a more defensive posture. He's invested in stocks that pay fat dividends. But Swain also owns more aggressive stocks, including eBay and Nokia. By the time "the Fed raises rates," says Swain, "much of the shock will already be accounted for" in stock prices, which swooned this spring as longer-term rates rose.

Some Wall Street professionals predict that a small jump in rates could actually help stocks in the short run. Bear Stearns, for example, forecasts a "get it while you can" surge of borrowing, and a burst of corporate capital investment and consumer spending, during the rest of 2004. That would benefit industrial companies, including makers of cars, construction equipment and big-ticket technology products. Shares of diversified industrial leaders such as General Electric (GE), Dow Chemical (DOW) and 3M (MMM) should thrive the rest of the year.

All of this assumes that stock prices, as a whole, aren't in la-la land. In general, they are reasonably priced, although there are pockets of excessive exuberance -- for example, in the biotech sector, among Internet-related stocks and even among shares of small banks. But the overall market, as measured by Standard & Poor's 500-stock index, sells for about 17 times estimated 2004 earnings. That is above the historical average but well below the market's P/E of 29 in March 2000, just as the bubble was about to burst. Higher interest rates might put pressure on P/Es (and hence share prices), but not the way they did in the '70s and early '80s, when rampant inflation pushed P/Es into single digits.

Bigger is better

Stocks of small companies have had a great run since late 1999; many of them even made money during the 2000-02 bear market. Don't count on the pattern continuing through 2004. Now is the time to peck some of your small-company holdings on the cheek and say goodbye.

It's not that big business is overpowering its smaller rivals. The problem is stock-market dynamics. Small-company stocks usually lead and lag the market in five-year cycles. The cycles begin when small-company shares appear ridiculously cheap in relation to big-company stocks. The current cycle began in 1999, when the average P/E for small-company stocks was about half that of large-company stocks. Today, the average P/E of small-company stocks roughly equals the P/E of the large-company-oriented S&P 500 index. If anything, it's the lagging behemoths, such as Microsoft (MSFT), GE and Johnson & Johnson (JNJ), that now seem inexpensive.

If you have, say, 25% of your portfolio in small-company funds, reduce your allotment to 15%. If you own small-company stocks that carry inflated P/Es or sell at record highs relative to sales or book value (assets minus liabilities), think about selling.

Growth potential

Unlike the situation in late 2002 and early 2003, when some stocks, particularly in technology, were selling for less than the value of their companies' cash holdings, there are few sectors today with dramatic turnaround potential. "Nothing's really cheap," says Mark Jordahl, chief investment officer for U.S. Bancorp Asset Management.

Because of the powerful earnings trend, Jordahl thinks stocks will beat bonds over the rest of 2004. He suggests that investors trim their stakes in tech stocks and shift the proceeds into blue-chip health-care companies, as well as into "consumer cyclicals" -- companies whose fortunes depend on consumer spending. The rationale for the consumer stocks is that as Americans feel more secure about their jobs and investments, they'll spend more freely on luxuries. Consider, for example, sneaker maker Nike (NKE) and Carnival (CCL), a cruise-ship operator. Neither is a steal, but neither are the stocks trading at absurdly high levels.

Bargain hunters may need to settle for dented merchandise. Leuthold Group analyst Eric Bjorgen says he can't pinpoint entire industries that he would characterize as "unloved and undervalued." He says a few familiar stocks do fit the U&U profile, including car-parts supplier Dana (DCN), automaker General Motors (GM), insurer Hartford Financial (HIG) and bank giant JP Morgan Chase (JPM). The stocks are all well above their bear-market lows but still could advance smartly, says Bjorgen, if the companies are able to boost sales or overcome image problems or, in the case of JP Morgan Chase, dispel doubts among investors about its merger with Bank One.

Overseas advantage

Foreign stocks slightly trailed the U.S. market in the early part of 2004. Overseas bourses will probably run even with the U.S. market for the rest of the year or perhaps outpace it by a few percentage points. That's a reflection of accelerating economic growth throughout the world, and it suggests that investors should stick with their commitment to foreign stocks and even consider increasing their allocation to foreign markets.

After 11 years of economic stagnation and a bear market to match, Japan is back. Japanese stocks climbed 2% in the first five and a half months of 2004, three percentage points ahead of the U.S. stock market. Growth of 3% in 2003 (including a 6% spurt in the fourth quarter) marked the economy's best performance since the early 1990s. Several surveys of global-fund managers rank Japan's stock market as one of the world's most attractive, if not the most attractive, for the remainder of this year and next. One caution: Attempts by China to slow its own torrid growth could act as a drag on Japan's recovery.

If you can stomach a bit of extra risk, consider adding a Japan-only fund to your investments. One good choice is the iShares MSCI Japan Index Fund (EWJ). This exchange-traded fund (which means you buy and sell it as you would a stock, through a broker) mimics a Morgan Stanley index geared to large Japanese companies (its three biggest holdings are Toyota, Canon and Mitsubishi Tokyo Financial Group). Among traditional, no-load mutual funds, the best choices are Fidelity Japan (FJPNX), which focuses on larger Japanese companies, and Matthews Japan (MJFOX), which owns stocks of large and small businesses.

The weak dollar of the past two years has hurt European companies by making their goods more expensive for U.S. customers. But now that the dollar has stabilized and appears to be turning around, investors are counting on better earnings from European industrial companies. "If U.S. stocks rally, Europe will rally even more," says Rudolph Riad-Younes, co-manager of Julius Baer International Equity (BJBIX), a diversified overseas fund with almost half its assets in European stocks. Europe isn't growing as fast as the U.S. and Asia are, but Riad-Younes figures that the additional spending generated by new members of the European Union will boost the entire continent.

Investors seeking a pure play on Europe should consider iShares S&P Europe 350 (IEV), an ETF with broad representation among large European companies. Solid choices among regular, no-load funds are ICAP Euro Select Equity (ICEUX), T. Rowe Price European Stock (PRESX) and Fidelity Europe (FIEUX).

Politics and stocks

As you look ahead to the big vote, you should know that market performance varies little between Republican and Democratic administrations. Bjorgen, who has studied this matter back to the founding of the United States, says that if you exclude performance during the administration of Republican Herbert Hoover (who presided over the first years of the Great Depression), the market does better when the GOP is in charge. If you include the Hoover administration, however, stocks perform slightly better when Democrats run the show.

At any rate, it's easy to manipulate the data for partisan purposes. Democrats can credit Bill Clinton's tax increases and the balanced budget that followed for the stock-market boom of the 1990s, and Republicans can ascribe the bull market of the 1980s to Ronald Reagan and his tax cuts. However, the main reasons for both rallies rested outside of what was occurring in Washington: dramatically lower interest rates, tepid inflation, strong corporate profits and a technology revolution -- namely, personal computers in the '80s and the Internet in the '90s. The other common denominator during both periods was divided government: For most of the '80s and '90s, one party controlled the White House and the other party controlled at least one house of Congress. Many experts see that as a blessing because there's less likelihood that Congress will enact laws that can derail the economy.

You'll hear a lot of poll results between now and the first Tuesday in November. Don't make sudden or dramatic investment moves based on what you think may happen on election day. Professional investors are paying much more attention to the state of the economy and corporate profits than they are to politics or, for that matter, to Iraq. For good reason. No one knows how the election or the war will turn out. But we are confident that profits will grow smartly over the rest of 2004.

--Reporter: Joan Goldwasser

What's Next for Bonds

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