Riding a Stormy Stock Market

More selling could hit US stocks if interest rates keep rising; but you can reduce the risk of losses without exiting equities

Beware the bull!

Bullfighters call him a revoltoso, a rapidly charging beast, quick to turn.

After rumbling for a six-year-charge, the bull stock market may be digging in for a reversal. Already, the bull market has fled in the face of rising interest rates and other economic obstacles, losing 8 percent in just a few trading days in recent weeks.

During the first quarter, owners of equity mutual funds lost almost 2 percent, a new experience for many investors. It compares poorly with double-digit full-year returns of 1995 and 1996.

But it looks positively benign compared with the beating taken by mutual funds that invest in fast-growing small companies.

These "small cap" growth funds lost 11.26 percent for the quarter.

If experience of recent years repeats itself, this turn of events could be a pause and a buying opportunity.

But it may also signal the end of one of the longest bull markets in US history. For many investors, that suggests a different sort of opportunity, one to shift strategies and become more defensive.

Some of the numbers from past quarter, for example, make the argument for diversification among your holdings.

While domestic stock funds lost ground, funds that invest in foreign stocks held on. As a group, they rose almost 2 percent.

Emerging market funds rose 8.19 percent. And Latin American funds sizzled ahead 13.25 percent.

You may want to keep those numbers in mind because, for the American market, many economists now predict more rate hikes from the Federal Reserve. Some analysts see that ushering in a full-fledged bear market, often defined as a stock market drop of 20 percent.

Although it would be rash for a long-term investor to rush headlong from the market, it's not too late to trim exposure to stocks, advisers say.

"Investors should pull back a bit from equities and look for conservative fund managers with good track records," says Christy Coon, president of Lake Shore Capital Management Inc. in Chicago.

Doubts about corporate profits

It's not just interest rates that are raising doubts on Wall Street.

Any weakness in earnings growth could provoke the bull to turn around.

"I sense an increasingly ominous turn brewing on the corporate earnings front," says Stephen Roach, chief economist at Morgan Stanley & Co. in New York.

First, the dollar has jumped this year by about 9 percent against the Japanese yen and 10 percent against the German mark, dealing a glancing blow to the profitability of American companies.

Also, increasing numbers of workers in coming months could demand higher wages as the unemployment rate hovers at unusually low levels. If that increases concern about inflation, the noise from any rate hikes could drown what appears to be accelerating economic growth.

Not every analyst is sounding the alarm.

"The earnings, generally speaking, are quite good in most sectors," says Bob Meyers, a partner at Lake Forest Capital Management Co. in Lake Forest, Ill.

He predicts earnings will remain sound, and the current turmoil in the market will finish as no more than a correction.

"What is happening today is correcting a situation where the market has been too good for too long," Mr. Meyers says.

Ms. Coon agrees. "The market was overvalued, and there is some profit taking and rearranging of assets. We were due for a full correction," she says.

Defensive options

Still, some analysts say a slight pullback from stocks might be prudent today, if only to rebalance your portfolio. Rocketing stock prices may have misaligned your preferred allocation of assets among stocks, bonds, and cash.

Investment advisers point today to a broad landscape of investment havens, from the serene to the dormant.

One of the most tranquil - and popular - sanctuaries today is a money market fund. (See money funds, Page B3.) A bolder alternative are funds that invest in equities overseas. (See foreign funds, Page B2.)

Bond funds, especially those that buy short- or intermediate-term issues (10 years or less), offer higher yields than cash, but with the risk of losing value.

Bond prices move opposite from interest rates. Higher-yielding new bonds make older bonds less attractive.

Avoid bond funds?

Many advisers suggest avoiding bond funds for now. If your goal is the income generated by bonds, they suggest buying individual bonds and holding them to maturity. That way you know exactly what return you'll get.

"It's a very difficult time to take a bet on fixed income, unless you're going very, very short and you are betting that the rate activity on the short end is over," says Tracy Gordon, spokeswoman for Charles Schwab Corp.

"My recommendation for most people is to buy individual bonds at this point, or two-year Treasuries - they are a pretty good buy," says Sheldon Jacobs, editor of the No-Load Fund Investor, a newsletter based in Irvington-on-Hudson, N.Y.

Some economists are more bullish on bonds, predicting interest rates will fall by year end.

Equity-income blends

Investors who wish to remain in equities can take shelter in growth-and-income funds. These own the stocks of big, stable companies that pay dividends.

In recent weeks, many investors moved assets from aggressive growth funds to these sturdier offerings. Balanced funds, investing in both stocks and bonds, and real estate funds also can give an equity portfolio both ballast and hefty yields. (Five-year top performers in each of these categories are listed above.)

Real estate funds typically focus on real estate investment trusts (REITs), which own and manage shopping malls, apartments, and other property. Like natural-resource funds, these are seen as a hedge against inflation.

"REITs have good dividends," Mr. Jacobs says. "And they have a low correlation to the market, meaning they generally go their own way or decline far less than other types of stocks."

"I don't think REITs are necessarily a safe haven," says Meyers. "They pay more of a yield, and that could prop them up, but when we have this kind of market just about everything goes down."

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