In Bear-Market Territory

The bears are on the prowl on Wall Street. After some wild swings, the Dow Jones industrial averaged closed at 12,099 on January 18, down 60 points, or 0.5%. Standard & Poor's 500-stock index dropped 0.6%, to 1325.

The market has already shed a sickening 10% in just three weeks this year and is off 16% from the high set last October 9, meaning that the indexes are close to bear-market territory (generally defined as a drop of 20%). In fact, the small-company Russell 2000 index is already in bear territory, having dropped 20.4% from its peak.

The stock market is anticipating a recession. You might say that it's come to this conclusion late and abruptly. The bond market, often a more accurate economic indicator, has been signaling recession since yields began declining rapidly last summer.

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Certainly the evidence of an economic slowdown is piling up by the day. We're not going to forecast the fact of a recession (defined by some as at least two consecutive quarters of negative economic growth), its duration or severity. But here are some factors to consider as you invest and adjust your stock portfolios during this slump.

If you assume that recession is here or on the way, let's take a look at the dismal history. Tobias Levkovich, strategist at Citibank, calculates that the average stock market decline during all recessions since the 1950s is 26%, or 10 percentage points greater than this market's decline to date.

The average period of index peak to trough during or around a recession is 228 days, with an enormous range of 40 days to more than 400 days. We're about 100 days off the index peak now.

Here's some good news. Since World War II, the frequency and severity of recessions has been declining. For instance, the most recent recession of 2001 was remarkably short and shallow by historical standards.

There are various theories for this trend. One is the triumph of monetarism -- the regulation of economic activity through the control over the supply of and demand for money -- and better monetary policy at the Federal Reserve.

Another is the dramatic improvement in information technology and related advances in logistics and supply-chain management. Recessions in the industrial era were often triggered or prolonged by the build-up of inventories in factories, warehouses and stores. That just doesn't happen any more in today's just-in-time economy.

But here's the bad news. This economic slowdown was triggered by the puncturing of the real estate bubble and the unwinding of financial excesses that were marked by speculation and massive leverage. We're still in the early stages of this great unwinding. Housing prices have more to fall, and the next quarter or two will surely bring a continuing stream of bank write-offs announcements.

Because banks, investment banks and other financial institutions are the lifeblood of an economy, it's hard to imagine a robust recovery or return of a bull market until the banking system is nursed back to health. In fact, an extended period of subdued growth until financials regain their health may be a larger risk than an economic downturn that may or may not meet the technical definition of recession.

Financial stocks will quite likely lead the next bull market. We don't know when that will occur, but in the meantime here are some things to consider when you parse your portfolio.

When you examine the stocks in your portfolio, subject them to a mental stress test. For example, if we do have a recession or a prolonged period of slow growth, will the company survive and, better yet, keep growing?

Ideally, you want companies with bullet-proof balance sheets -- lots of cash and little debt -- and an ability to fund investment through internal sources rather than needing to issue stock or borrow money.

Better yet, can the company continue to pay and increase dividends through a recession? Does it have complete dependence on U.S. consumers, who will need to hunker down and rebuild their own balance sheets during an economic slump?

Strong multinational companies, such as Altria (symbol MO), Johnson & Johnson (JNJ), Microsoft (MSFT) and Pepsi (PEP), meet the criteria of companies that will flourish and have, not surprisingly, held up well in this market.

Because fear is the great enemy of most investors in volatile times such as these, we thought it might be instructive to ask an emotionless computer for its opinion. So we asked Jeff Mortimer, chief investment officer of Charles Schwab Investment Management, what his purely quantitative bottom-up stock-picking models are telling him. The 19 variables he considers include earnings surprises, free cash generation and momentum.

Mortimer says the computer advises that, even after the sharp retreat in prices of financial stocks, banks such as Citibank (C) are still not attractive.

The industry clusters his computer likes the most are in health care-insurers Cigna (CI) and Aetna (AET), for instance -- and in technology shares, including IBM (IBM). Consumer-staple stocks such as Altria, Coca-Cola (KO) and General Mills (GIS) also stack up well.