Get ready for the market recovery

When stock prices pick up, you'll want to be able to jump right in. Here's how.

By Leslie Kane
Senior Editor

Be prepared." You may have recited that motto as a Boy or Girl Scout, but it's just as apt for investors. Although the economy is still in a slump, most folks believe the recovery will come relatively soon. By making wise investments now, you can maximize your profits as the economy strengthens.

"The time to invest is before the recovery lifts prices, not after," says Frank Armstrong, president of Investor Solutions, an investment advisory firm in Miami. "The economy still has fundamental problems, but even if we have another terrorist attack that pummels stocks, such unpredictable events typically have only a short-term impact on the market."

Although time estimates for a resurgence are as vague as fortune cookie predictions, most investment gurus expect it sometime this year. In fact, some already see glimmers of improvement in the markets. "Traditional market indicators, such as growth and emerging market stock indexes, are on the rise," says Andrew Clark, a research analyst with Lipper, a mutual fund analysis company in Denver.

For instance, the Russell 1000 Growth Index, which returned –26.9 percent over the past 12 months,* now reports a one-month return of –1.8 percent. The Morgan Stanley Capital International Markets Free Index, which includes stocks from 26 of the world's emerging markets, followed its 12-month loss of 13.5 percent with a one-month gain of 3.3 percent.

Other signs that would signify an upturn are still negative. But if you're searching for investment bargains, that's actually good news, because it means you still have time to act. By the time positive omens become blatant, prices will have already climbed.

How will you know when the markets are poised to bounce back? Watch for these developments to occur consistently over several months, says Lipper analyst Clark:

• Fewer layoffs: When the spate of downsizing slows, it means companies are more comfortable with their profits, and consumers will start losing their fear that each day could bring a pink slip. They'll be more confident about spending, which will further boost the economy.

• Decline in inventories: When inventories bottom out, manufacturers ramp up new production and factories get busy.

• More building and construction: This indicates that companies are expanding. It also shows that consumers and businesses feel more confident about their financial health and are willing to make long-term financial commitments.

• Rising consumer optimism: When folks have a gut-level belief that America's ready to prosper again, they're set to buy and invest.

A rising market will buoy all investors. But to maximize your profits, you need to invest strategically. Whether you're reviewing your current holdings or evaluating new ones you'd like to add, here's what you need to keep in mind.

Think greater safety and diversity

"Your most important decision is your allocation of bonds and stocks," says Paul Merriman, an investment adviser with Merriman Capital Management in Seattle, WA. "Pretend you're totally invested in cash, and re-evaluate your asset allocation."

That's good advice even when you expect stock prices to rise. Investors who thought they were risk-tolerant and loaded up on stock when the bull was raging may want to be more cautious now.

Generally speaking, the more time you have to ride out and recover from market drops, the more risk you can afford to take. So, as a rule of thumb, if you won't need the money until 20 years from now, advisers typically suggest the following mixes, depending on your risk tolerance: For younger people, 80 percent stocks and 20 percent bonds or 90 percent stocks and 10 percent bonds; for the middle-aged and the young retirees, 70 percent stocks and 30 percent bonds or 60 percent stocks and 40 percent bonds; for much older retirees, 30 percent stocks and 70 percent bonds or 20 percent stocks and 80 percent bonds.

Pay attention to diversity. Choose funds from various asset classes: large-cap, mid-cap, and small-companies, and international funds. Select some growth funds and value funds. Growth funds emphasize companies with rapid earnings growth; value funds favor low-priced stocks of companies that are either temporarily out of favor or are struggling but have the potential to recover. Different asset classes don't move in complete correlation, so when one group nosedives, another may be stable or positive.

Also be careful not to invest too much in any one industry. "Although clients with diversified portfolios were dissatisfied when other investors made spectacular profits on technology stocks, those same clients are happy now," says Merriman. "Some of their portfolios are up 5 percent, while the tech-heavy investors have lost 25 percent or more."

If you yanked your money out of the market when it started diving and you're now heading back in, do it in stages. "Invest the fixed income portion immediately," says Merriman. "If you're afraid of the market's near-term direction, invest the equities portion over a six- to 12-month period. If you're ready to accept the market risk with your equity portion, invest it all now and quit second-guessing."

Buy short-term bonds or bond funds

Stick with funds whose average duration is around two years, says Frank Armstrong. As the economy recovers and interest rates head back up, portfolio managers with short-term holdings that are maturing will be able to buy bonds that pay higher interest.

Even more important, shorter maturities mean less price volatility. "If you buy long-term bonds now, you'll lock in their low rate of return," explains Frank Armstrong. "As interest rates go higher, those bonds will lose a lot of capital value. In fact, if you already own long-term bonds or bond funds, dump them."

Tap into spending patterns

Invest in companies with the products that consumers purchase most, particularly during a recovery. "Consumer cyclicals are good bets," says Clark. "They're tied to household consumption and investment, and traditionally have led the market out of slumps. Early in a recovery, favor companies that deal in consumer goods and drugs, foodstuffs, and finances, as well as food chains, retail stores, banks, utilities, and insurers.

"When recovery becomes further established, energy stocks, building and construction firms, paper, textiles, and consumer durables such as automobiles tend to outperform the market," says Clark.

Retailers wore long faces as earnings estimates dropped steadily throughout 2001, especially in the second half. But increasing production and consumer confidence should boost profits later this year.

Most diversified mutual funds contain some consumer cyclical companies, but if you want to focus a small portion of your assets in them to take better advantage of their potential for faster growth, consider the Fidelity Select Portfolios. The Fidelity Select Consumer Industries Portfolio focuses on companies that make and distribute consumer goods. Holdings include Coca-Cola, Avon, Kimberly-Clark, and Safeway. Another choice is Fidelity Select Retailing Portfolio, which invests in merchandise retailers such as Lowe's, BJ's Wholesale Club, Pacific Sunwear of California, and Williams-Sonoma.

One consumer area to skirt over the next year is health care, Clark says. "The sector's long-term outlook is bright, but the industry has had some recent earnings misses, so now is not the time to add to your holdings," he says.

Hedge your bets with energy funds

"Oil prices are inversely related to consumer goods profits," says Clark. "Crude oil prices affect the cost of heating oil, gasoline, and the final prices of many goods. So if you hold consumer cyclicals, add an energy or natural resources fund. That way, you'll be covered no matter what happens.

"Energy prices represent a large risk factor for the US economy," Clark adds. "If OPEC continues to get non-OPEC members to cooperate on production cuts, if the weather turns nastier, or if tensions worsen in the Middle East, an energy shock could arise and cut growth in the US economy."

Because gasoline prices have dropped since last fall, independent oil and gas producers' earnings and stock prices are in a trough, says Clark. So are many energy funds' returns. For example, although Icon Energy Fund, which invests in oil drilling and production as well as natural gas, returned 40.7 percent over three years, over 12 months it lost 9.9 percent. But energy funds' current slump could be a buying opportunity for investors.

Dip into real estate or REITs

"If you don't own real estate, put a good REIT fund in your portfolio," advises Clark. "REITs will do well as the economy recovers."

A REIT, which stands for real estate investment trust, is an investment company that specializes in real estate or mortgage investments. Mortgage REITs make loans to firms that develop and manage real estate; equity REITs own and lease property.

Last fall's declining interest rates allowed REITs to refinance their debt, which helped offset slow rental revenue. And although new construction declined during 2001, so did demand for real estate, lessening the likelihood that a market glut will depress real estate values and, with them, REIT prices. In January of this year, the real estate funds tracked by Morningstar returned an average of 0.2 percent, down from 8.2 percent over the three months ending Jan. 31.

Funds to prime you for a market recovery

*Unless otherwise noted, all index returns are through Jan. 31, 2002; all individual mutual fund returns are through Feb. 20, 2002.

Leslie Kane. Get ready for the market recovery. Medical Economics 2002;6:39.