The economy and the stock market -- focusing on the '86 outlook

IT can sometimes be difficult, when trying to make an investment decision, not to be influenced by current events -- to climb aboard the latest speculative bandwagon in hopes of some quick profits. But more often than not, that bandwagon turns out to be playing a siren's song. So this issue attempts to part the veil on 1986 to give readers an opportunity to ponder next year's economic and investment climate -- and, theoretically, to prevent them from being lured to the shoals of short-term speculation. Economic outlook

Several recent surveys show that the majority of economists expect continued low to moderate growth. In 1986, the gross national product is forecast to rise 2 to 3 percent. But by year's end, the economy could slump into a recession. A recent survey survey of the National Association of Business Economists showed that 52 percent expected a recession by 1987. Already, some economists are getting fidgety.

Historically, this economic recovery has lasted ``too long,'' says Robert Eggert, economist and editor of Blue Chip Economic Indicators. ``The economic cycle in peacetime averages 29 months. We're already five months beyond the length of a normal cycle. It would be very unusual to have the cycle extend beyond 1986.''

Another concern is that consumer debt has risen to unprecedented levels. If consumer spending should contract, the recovery could stall. ``While consumer debt is going up, it supports the economy,'' Mr. Eggert says. His latest monthly survey of 50 top economists shows they expect household debt to rise, but more slowly in 1986.

Why not a recession sooner in 1986?

Well, consumer spending continues at a brisk pace. Recent economic indicators show signs of strength, not weakness. Factory production, retail sales, and home building starts are up. Declines in the value of the dollar against foreign currencies may increase United States exports by early 1986. Monetarists say the money supply has risen so much in the past six to nine months that a rebound is highly probable. Also, a number of economists expect a mini-boom late this year, based on inventory replenishme nt.

In 1986, inflation is expected to rise, but only slightly, most economists say. Up about 3.5 percent this year, a 4 percent inflation rate is the average figure given by economists in Eggert's October survey. Some economists say, however, that inflation won't remain quiescent: The money supply has grown just too much. And if the dollar weakens further, some price increases from foreign producers may occur. But others say foreign manufacturers would rather swallow smaller profit margins than raise pric es and endanger their market share.

The economists say interest rates will remain within a relatively tight range. Most of those surveyed expect an increase of only about half a percentage point. Depending on how much inflation kicks up, the Federal Reserve Board may tighten credit, pushing rates slightly higher. ``The minute inflation raises its ugly head, Mr. Volcker [chairman of the Fed] will pull in on the money supply,'' says Eggert.

Where, then, does one invest for 1986?

If low inflation continues to prevail, that suggests financial assets (stocks and bonds) are preferable to inflation-hedging hard assets (real estate, collectibles, precious metals).

Indeed, in another survey by Eggert, 36 economists rated bonds as the top investment vehicle for '86. Next came stocks, foreign currency, Treasury bills, artwork, US coins, gold, ceramics, real estate, silver, stamps, diamonds, oil, stocks, bonds, real estate, and Treasury bills took the top investment spots. Fixed-income securities

``I see yields in the long-term markets -- Treasuries, corporates, or municipals -- as being higher than anything else in 1986,'' says Roy E. Moor, chief economist at the First National Bank of Chicago. ``I don't see potential gains in the stock market as sufficient to compensate for the downside risk.''

Over the last year, interest rates have fallen. Still, the real rate of interest on bonds remains high. Historically, the spread between inflation and interest rates has been about 3 percent. At present, long-term government bonds are paying about 10.5 percent. That gives investors a secure investment at about twice the ``normal'' real rate of interest.

Financial planners often suggest a balance of long- and short-term fixed-income securities to hedge against interest rate changes. At present, short-term Treasury securities and bank certificates of deposit are selling at rates between 7 and 9.5 percent (down from 11 to 12 percent last year at this time). Government National Mortgage Association certificates (Ginnie Maes) are pegged at about 11.5 percent now. Corporate bonds, depending on the investment rating, offer a return of 11 to 14 percent.

``I think we'll see some slight declines in short- and long-term rates,'' says Mr. Moor, who expects the economy to muddle through 1986 with a growth rate of 1.5 to 2 percent. ``So on top of the yields, you'll get some capital appreciation.'' Stocks

Most stock market analysts are naturally bulls over the long run. But with the Dow Jones industrial average trading near its all-time high, the downside risk seems greater than the upside potential, at least until early 1986. Some even voice doubts about stocks outperforming bonds.

Still, weakness in stock prices presents a buying opportunity. And a diversified portfolio (bonds and stocks) is a way to hedge if the majority opinion should prove wrong, as it so often has.

Elaine Garzarelli follows 60 industries for Shearson Lehman Brothers. Asked which sectors would outperform the stock market in 1986, she cited ``the soaps -- Procter & Gamble, Lever Brothers, and Clorox.'' Restaurant stocks and pharmaceuticals are also on her list.

These issues ought to best the 10 to 12 percent earnings growth she predicts for the Standard & Poor's 500 stocks as a whole. ``In a basically steady, slow-growing economy these stocks should be the steadiest growers,'' she says.

By comparison, the Value Line Investment Survey recently ranked financial services, food wholesalers, toys and school supplies, industrial services, and newspapers as the most timely stock purchases.

Value Line analyzes some 1,700 stocks in 91 industries. Each company is given a timeliness rating based on its expected performance in the year to come. The average timeliness rating for each industry is calculated and then ranked against the 90 other industries. Real estate

``In general, real estate returns will be weak over the next couple of years, because there's been so much overbuilding,'' says Richard Kateley, senior vice-president of the Real Estate Research Corporation in Chicago. ``The stock market may outperform the real estate market in the short term.''

But cross stocks and real estate and you end up with real estate investment trusts (REITs). And that is an appealing investment, says Mr. Kateley -- especially if one is looking to diversify one's stock holdings.

A REIT is basically a publicly traded stock in a corporation that owns mortgages or specific kinds of real estate. Because of the current pessimism surrounding real estate, ``many REITs are selling at a discount now,'' Kateley says.

Another important advantage is that one can buy REITs that target specific geographical areas and types of real estate. For instance, a REIT that has a stake only in shopping centers built and owned by a well-known Atlanta developer, or a REIT focusing on apartment buildings in southern California.

The Real Estate Research Corporation has just released its 1986 industry forecast. Kateley, who was co-author of the report, advises investors to think twice about REITs and limited-partnership syndications investing in hotels and office buildings. Most of the major markets are overbuilt, he says. And contractors have pushed through a lot of multifamily apartment buildings to beat the enactment of federal tax reforms that may limit financing.

He predicts that the hot market in 1986 will be in buildings for light industry: warehouses and ``flexible space'' buildings that can be partitioned to serve as factory, office, storage, and showroom.

On the home front, Kateley expects housing prices to be relatively stable. The National Association of Realtors basically agrees. Its chief economist, Jack Carlson, predicts a 3.9 percent rise in existing home prices over 1985 and a 3.6 percent increase in '86. To put it another way, the median home price is expected to rise from $75,100 to $77,900 by the end of next year.

Mr. Carlson predicts that a sluggish economy will ease the average 30-year fixed-mortgage rate from the current 12.5 percent to 11.5 percent by the fourth quarter of 1986. The NAR's affordability index is at a five-year high, meaning lower mortgage rates and stable prices enable more people to qualify for home loans.

But Kateley, at the Real Estate Research Corporation, doesn't advise buying a house as a one- or two-year investment now. In most parts of the country, except perhaps in New England, ``If you run the numbers through on buying a home versus renting, owning doesn't pay unless you stay from three to five years.'' Precious metals

Gold has defied the experts for some time now. Many expected it to rebound as the dollar fell -- it has, but only marginally. Many expected the political rumblings in South Africa to jack up gold prices, but that hasn't happened, either.

``We have had a number of events that should have pushed gold higher. So I see a weaker structure under gold than one would normally have expected,'' says Jeffrey N. Mosseri, gold and currency analyst at Goldsmith & Harris in New York.

``We're in a long-term disinflationary mode; as such, gold is a poor investment,'' Mr. Mosseri says. He would hold gold only as a disaster hedge, devoting no more than 5 percent of a portfolio to it. Mosseri does allow that if there is ``an absolute onslaught on the dollar'' and inflation comes charging back, gold will rebound.

Charles Stahl, for one, has staked out a site in the inflation camp. ``I believe next year both gold and silver will be higher. Exactly how much higher is too early to say,'' comments the editor of the investment newsletter, Green's Commodity Market Comments, published by the Economic News Agency in New York.

Mr. Stahl figures a falling dollar will increase the cost of imports to US customers, causing an uptick in inflation.

If one decided to pocket some gold for 1986, that investment can take the form of actual bullion, coins, or mining stocks. If you choose stocks, Mosseri recommends staying away from the South African mining companies -- ``not necessarily for ethical reasons but because of the political risk of strikes and sabotage. I would pay the premium for North American mining stocks, starting with Canada, rather than take the risk in South Africa.''

Finally, silver tends to be influenced by currency fluctuations and industrial use. Although roughly tracking gold, ``silver is more in tune with the economy, and its moves will probably be more dramatic,'' Mosseri says. Silver prices may rise if the economy expands in 1986.

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