The 'perfect storm'

by Don Kuehn

Not long ago, there was a movie about a crew on a New England fishing boat caught in a confluence of weather factors that swept them out to sea. The storm front, combined with a fast-moving hurricane had rarely been seen before and was impossible to predict. It was the "perfect storm."

Investors have been hit by their own version of the perfect storm. The bursting technology and telecom bubble, terrorist attacks on America and the recent wave of corporate accounting scandals that felled Enron, Global Crossing, WorldCom and a bunch of other companies have wrought havoc on the portfolios of virtually everyone who sought growth through equity investing.

Meeting production deadlines for a monthly column prevents me from being too timely in the subjects I try to bring to your attention. But the proportions of this market decline warrant some observations.

Between early 2000, when the stock markets reached their peaks, and mid-July of this year, the total value of the Wilshire 5000 Index--the broadest measure of the domestic stock market--fell 45 percent, or some $6.6 trillion.

The best-known market indicator, the Dow Industrials, dropped about 30 percent, the S&P 500 shed 40 percent and the tech-heavy Nasdaq plunged about 75 percent. Numbers aside, millions of Americans have had to rethink retirement, alter college choices, delay home improvements and cancel vacations. If this ain't a depression, it sure is depressing.

The economy has certainly seen bear markets before. But, for most of us, the growl was worse than the bite because the stocks that went down the most were ones that few individuals owned. With the democratization of the equity markets brought on by the widespread ownership of mutual funds during the "easy money" '90s, that's not the case this time. The stocks that have suffered the most in this bear cycle include some of those held by the greatest number of investors. We can all feel the pain.

Of the 20 stocks held in the greatest number of customer accounts at Merrill Lynch at the beginning of this year, 16 have fallen more than the average S&P 500 stock. Fourteen of the 20 were trading for less in July than they were after the terrorist attacks in September 2001. Interestingly, the declines have not led to mass liquidations. Merrill customers have not voted with their feet and run for the exits.

That may be part of the problem. The history of bear markets shows that a phenomenon known as "capitulation" is a necessary ingredient in any recovery. Capitulation occurs when investors completely lose faith in the markets and throw in the towel. Massive selling takes the markets down to levels where prices just become too irresistible, and eventually institutional investors and savvy individuals return with a buying vengeance.

It isn't easy to write a column that tries to encourage people to invest for a secure future when their investments have been slashed and their goals deferred. But the question that always has to be answered is where do you put your money today?

Fundamentally the American economy is in pretty good shape. Even though consumer confidence surveys have shown some recent slippage, inflation is under control, some sectors have experienced actual growth during the bear market, and unemployment remains relatively low despite massive layoffs in a few high-profile companies and industries. In short, there are ample reasons to consider adding to your portfolio at this time.

It may be too late to switch from stocks to bonds. Interest rates are unlikely to go lower and are more likely to rise from these relatively low levels over the next year and beyond. That means bond investments could lose value as prices drop and interest rates rise.

This certainly is not the first, and will not be the last, bear market. If you're sitting on a well-diversified portfolio of stocks or funds--even if they are worth less than you paid for them--remember that stocks historically have always come back. Over time, it's stocks that produce the best return on your investments.

Keep in mind that the stock prices of really good companies have been slashed over the past two years by as much as 50 percent to 90 percent. There are tremendous bargains out there if you are an investor in individual stocks. Look for sectors likely to be in demand whether the economy grows at a rapid pace or trudges along. There is no reason to take great risks on boutique stocks when blue chips are so inexpensive. Do your research and buy carefully.

If you are inclined toward mutual funds, you can find great prices on funds with sound management and track records that beat their peer group. This may be an ideal time to diversify your investments while prices are low.

Most experts agree that there are a few tips that apply to investing in the storm of volatile markets and accounting scandals we find ourselves in:

• Keep your balance. Find a comfortable ratio of stocks, bonds and cash equivalents that fits your needs and temperament and stick with it. Periodically (not more than twice a year) review your progress and rebalance if necessary to maintain ratios between asset classes.
• Don't throw in the towel; add to your portfolio. Continuing to make automatic contributions to an IRA, 403(b) or other savings plan won't guarantee profits, but the theory of dollar-cost averaging has proven itself over good markets and bad.
• Avoid knee-jerk reactions to current events. Everyone gets nervous when they watch account balances fade or when one scandalous story follows the last. Stay the course. Don't derail a well-thought out investment plan.
• Don't forget the tax consequences of selling. Even today's low prices may reflect a profit on stocks or funds that you have owned for a long time. You'll owe taxes on any capital gains realized in nonqualified accounts. "Nonqualified" means your personal, taxable accounts, not IRAs, 403(b) or 401(k) accounts that accumulate tax-advantaged.
• Set realistic expectations. Let me be the first to tell you this: The next recovery cycle will not be a replay of the 1990s market boom. Most analysts predict a mild, slow rebound. Hold enough cash to live on comfortably if the recovery is slow.

We all can hope that by the time you read this the markets will have experienced the "capitulation" that experts say is necessary to create a bottom to this bearish cycle and a major correction will have begun. If so, perhaps we will all see a rainbow at the end of what has certainly been a perfect storm of negative influences on the market.