As the subprime mess deepens, the economy is sure to weaken, although it should avoid entering into a recession, says the co-manager of Loomis Sayles Bond. That will likely mean more troubles for stocks and all but the safest kinds of bonds. By Steven Goldberg, Contributing Columnist August 21, 2007 Just how likely is further trouble in the stock market? Since the recent share-price declines can be traced directly to problems in the bond market, that's probably a good place to look for clues about the future performance of stocks. What the credit markets are saying: Bond prices are coming down, but they haven't reached what looks like the bottom yet. That likely means more bad news to come. Look at the numbers. High-risk "junk bonds," on average, are yielding about 4.2 percentage points more than super safe Treasury bonds. That's significantly more than in early June, when junk bonds yielded just 2.4 percentage points more than Treasuries -- the narrowest "spread" in at least a decade. But spreads averaged 5.4 percentage points during the past decade and have been as high as 10.6 percentage points. (Much of the recent increase in spreads is due to falling prices for lower-quality bonds, which has boosted their yields.) In short, common sense is beginning to return to the bond market, but we're not there yet. "Clearly spreads were too tight across most of the bond market," says Elaine Stokes, co-manager of Loomis Sayles Bond fund (symbol LSBRX). "Bonds are in the process of falling to reasonable prices. Some parts of the market are getting there." Investment-grade corporate bonds are trading close to their historical averages. Advertisement Not quite a recession Why should bond prices matter to stocks? For all kinds of reasons. After all, the unwillingness of many market participants to buy bonds, commercial paper and other types of IOUs -- a situation known as a credit crunch -- caused the stock market's swoon. Credit is the lifeblood of many businesses. Until the credit crunch eases, many will have trouble borrowing money. Particularly imperiled are private equity firms, which borrow to take companies private, and hedge funds, which use borrowed money to amplify investments in risky bonds and other securities. These activities directly affect stocks. The subprime mess, says Stokes, has just begun to affect the economy. More than one-fifth of all mortgages made during the past three years were subprime. As the rates on these mortgages start to reset, more and more people will default, "and there will be a ripple effect through the economy." Consquently, Loomis Sayles Bond is holding a much-higher proportion of high-grade bonds than it usually owns. Nevertheless, Stokes thinks the economy will avoid a recession. "The economy is still very strong," she says. The Federal Reserve must lower the federal funds rates a couple of times to safely get past the soft patch in the economy, she adds. The Fed's August 17 move to cut the discount rate, the rate it charges banks that want to borrow from it, was important in providing liquidity, but, says Stokes, "It's also the Fed saying we're going to be there." Now they need to deliver. Junk bonds should continue to fall in price until the economy stops slowing or spreads widen further, she says. While she won't offer a prediction on stocks, junk bonds and stocks frequently move in tandem. A weakening economy, which can lead to lower corporate profits, is hardly a recipe for higher stock prices. Advertisement Where to put your money For your stock investments, emphasize quality. I wouldn't put more than 10% of your stock money in small caps. Large, stable companies and funds that invest in them are still your best bet. My favorite funds remain Marsico Growth (symbol MGRIX) and Vanguard Primecap Core (VPCCX). Champlain Small Company (CIPSX) is my favorite small-cap fund. Don't ignore foreign stocks. Stokes and her co-managers think the dollar will continue to give ground, and they see stronger growth abroad than in the U.S. Loomis Sayles Bond has one-third of its assets in foreign currencies. Dodge & Cox International (DODFX) remains my favorite overseas stock fund. For your bond money, Loomis Sayles Bond is one of the best-though it's a risky fund. It has lost about 2% in the past month, but it has returned an annualized 13% over the past five years through August 17, putting in the top 10% among all taxable bond funds. You'll also do well in a high-quality municipal bond fund such as Vanguard Intermediate Term Tax Exempt VWITX). That will allow you to cope with some of spine-tingling volatility that is almost certain to continue in the stock market. Steven T. Goldberg (bio) is an investment adviser and freelance writer.