After April's wild ride, investors should use caution

Feeling queasy about the stock market? Its bumpy path has sent investors on a wild - and mostly downward - ride in the past two months. For the year, the market has lost more than 3 percent of its value. While Wall Street started the year with modest expectations, few predicted that 2005 would be as challenging as it has been.

So what's next? No one can rule out more volatility. Interest rates keep climbing and summertime is usually a weak period for stocks. But earnings remain relatively healthy. So many analysts suggest tweaking portfolios rather than wholesale change.

Of course, investors can be excused for feeling taken for a ride. After flirting with 11000 in March, the Dow Jones Industrial Average sank to nearly 10000 before recovering a little. The broader S&P 500 index now sits 3.4 percent lower than it did at the beginning of the year. Indexes tracking technology and small-company stocks have fallen more steeply.

April proved so dismal that few sectors were left unscathed. Even energy stocks, industrial materials, and capital goods stocks - market leaders in the first three months of the year - weakened last month. Net inflows into domestic mutual funds, a barometer of investors' souring mood, have dropped sharply from year-earlier levels.

Even favorable first-quarter corporate profit reports have failed to offset investor worries about an uptick in inflation, a slowing economy, and the Federal Reserve's ongoing campaign to boost short-term interest rates. Last week, the Fed raised its benchmark Fed funds rate to 3 percent from 2.75 percent, the eighth hike in a year.

"It's been a yo-yo market and I don't see that ending soon," says Fred Dickson, chief market strategist at D.A. Davidson & Co. a Montana-based brokerage firm.

But like many equity strategists, Mr. Dickson is upbeat about the intermediate term. He feels the bull market is just taking a breather.

Trouble in year three

Since 1900, there have been 21 recoveries from bear markets, according to The Leuthold Group, a Minneapolis-based investment advisory firm. In 11 of those cases, stocks declined in the third year. Even factoring in the other 10 periods, the performance average for the third year has been a 3 percent loss.

The current bull market is no spring chicken. In fact, the upswing since October 2002 has lagged the normal pattern in terms of strength, says Leuthold analyst Andrew Engel. "Unfortunately, that doesn't beget outperformance in the third year."

Overall, corporate profits for S&P 500 companies have fared slightly better than Wall Street expected during the first quarter, according to Thompson Financial, which tallies analysts' estimates. Thompson projects year-over-year earnings growth of better than 10 percent for the S&P 500 index in the second half of 2005. Further earnings gains in 2005 are expected to be largely driven by higher sales, not plumper margins. Of itself, a double-digit percentage earnings advance for the year doesn't ensure that stocks will rise in the face of interest-rate headwinds, analysts point out. Still, positive earnings momentum, coupled with moderate price-earnings ratios, should provide important props for stock prices. "A profits slowdown isn't a real problem as long as the level of earnings doesn't decline," says Mr. Engel.

To mitigate market turbulence, some Wall Street strategists are urging investors to tilt their portfolios toward higher-quality stocks with a record of consistent dividends. Many utilities, healthcare, and food companies fit this bill, as do major oil companies.

Like many money managers, David Laidlaw of Laidlaw Group, an investment counseling firm in Katonah, N.Y., is a big fan of global oil players. But he also favors smaller oil and gas producers with North American reserves who are benefiting from buoyant global energy demand. On the other hand, he finds financial stocks unappealing. With interest rates rising, financial-service firms face a profit-margin squeeze, he says. "And in a highly leveraged economy, they are prone to suffer from loan defaults or risk management mishaps."

A cautious approach

As long as the Fed is in a tightening mode, investors should proceed cautiously, Dickson says. He expects the Fed will continue to "tap on the brakes," pushing the benchmark rate upward, possibly as high as 4 percent by year-end. While that level would not derail the economy, its effect on bonds and other financial instruments could cause more trouble for the market, he adds.

In the past, rising interest rates have generally dampened stock prices. When the Fed started to tighten monetary policy in February 1994, for example, the market stalled for 11 months before resuming its lengthy advance. While economic conditions are somewhat different today, the S&P 500's price/earnings ratio has been relatively flat since the Fed began boosting rates over the past year.

A key question is how weak economic data will affect the pace and size of future Fed rate hikes. If oil prices and inflation are restrained, the Fed might pause its tightening - a good sign for stocks, analysts say.

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