How to Cope if Bull Market Ends in 'Ice' Rather Than 'Fire'
Bull markets tend to end for reasons we least expect.
For example, investors lately have been obsessed with inflation. But what if the real threat is inflation's opposite - not rising, but flat or falling, prices?
Inflation pushes up interest rates, pulling investors into bonds from stocks and driving down profits by pinching consumers and increasing corporate expenses. But deflation, or its milder cousin disinflation, can be just as pernicious. They can lead to lower revenues, lower earnings, unemployment and recession.
Amid the euphoria of this bull market, a few smart people have been worrying about deflation. Lately, evidence is beginning to show that they may have a point.
If you find the deflation scenario convincing, the best move, by far, is to buy long-term US Treasury securities. In a deflation, interest rates fall, since fears of higher prices vanish and the economy is so languid that hardly anyone wants to borrow money. Currently, the 30-year Treasury bond pays 6.37 percent interest. If you own such a bond when rates drop to, say, 5.0 percent, then you can either sell it at a huge profit or hold onto its hefty yield.
Billionaire investor Warren Buffett is said to be buying zero-coupon long-term Treasury bonds on a large scale. (Zero-coupon bonds are sold at a big discount to their value at maturity but pay no interest.)
Barton Biggs, chief of global strategy for Morgan Stanley, Dean Witter, Discover & Co., has been talking about what he calls "the ice scenario" for many months now. He's referring to Robert Frost's great little poem, "Fire and Ice," which begins, "Some say the world will end in fire;/ Some say in ice."
Biggs says that, while most people believe that fire (inflation) is what destroys markets, ice, as Frost put it, "Is also great/ And would suffice." Writes Biggs: "Ice is loss of pricing power and a world where prices are as likely to go down as up. Ice is an erosion of profits. Ice is excess capacity. Ice is developing countries with low-cost factories and huge ... labor forces."
His conclusion: "I think stocks are dangerous here, and I still like US Treasury bonds and bills best of all."
What should small investors do? First, don't sell your stocks. Even if the ice scenario sounds logical, it is only a guess - not a reason to abandon a long-term strategic plan. Still, if you find this icy tale convincing, you should:
* Make sure you have enough Treasury bonds and cash (money-market funds, bank certificates of deposit or Treasury bills). If you retire in, say, five years, have about half your portfolio in assets other than stocks.
Zero-coupon bonds, which you have to buy through a broker, are especially attractive. Beware, however, that phantom interest on zeroes is taxable each year.
* Consider small stocks. They should suffer less - or perhaps not at all - if export markets dry up. Bob Carlson's Retirement Watch, a newsletter, likes these small-company mutual funds: Third Avenue Value (800-443-1021), Acorn Fund (800-922-6769) and Baron Asset (800-992-2766).
* Search for great businesses that can survive troubled times. Also seek out companies relatively immune from foreign competition, such as newspapers, restaurant chains or insurance firms.
* Buy value. The best way to protect against a market decline is to own stocks that aren't already in the stratosphere - value stocks. The Legg Mason Value Trust (800-822-5544), a value mutual fund, is up 40 percent this year, with a strong three-year record.
* This column is reprinted from The Washington Post.