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8 ways to play a shaky market
By the end of 2003, the Dow might hit 10,000 or it might hit 5,000. There are reasonable arguments for both scenarios. But here are strategies you can follow right now.
By Jim Jubak
Dow 10,000 by the end of 2003? Or Dow 5,000?
In recent weeks, well-respected Wall Street strategists have predicted both extremes for the Dow Jones Industrial Average. And given the last several years, I have to take both of these projections seriously.
That creates a problem for investors trying to rebuild self-confidence after three years of a bear market. (For more on these two topics see my Jan. 14 column, Rebuild your investing confidence, and my Jan. 17 column How to climb the all important risk ladder.) How is any investor going to pick a solid, proven investing strategy and have the confidence to stick to it in the face of this kind of potential market risk? And, more practically, whats the point of meticulously weighing the risk and reward of individual stocks if the stock market as a whole presents such extremes?
I think you need to take two steps to develop a strategy at a time like this.
First, any effort to control market risk has to begin with an understanding of what has to happen for either projection -- Dow 10,000 or Dow 5,000 -- to become reality.
Second, each investor needs to create a personalized risk ladder for the stock market as a whole -- much like I did in my last column for individual stocks -- and then decide on a strategy that stays within an investing confidence zone. This isnt any time to push yourself into strategies that feel uncomfortable.
The valuation debate
The difference between the Dow 5,000 and Dow 10,000 forecasters comes down to valuation. Says the Dow 5,000 camp: Despite a three-year bear market, stocks are still too expensive by any historical measure. Not so, says the Dow 10,000 camp. Stocks always look expensive at the bottom of an economic trough. Valuations are actually quite reasonable if you consider current low interest rates and the rebound in corporate earnings that will take place in the second half of 2003.
Certainly the Dow 5,000 camp has a point. If you look at actual trailing 12-month earnings -- that is, the earnings companies have actually reported instead of forward earnings that are only projections -- the Standard & Poors 500 Stock Index ($INX) trades at a price-to-earnings ratio of 30. And thats way over the historical average for the stocks in the index. Depending on how you calculate that number and what period you use, the average is anywhere from 12 to 17. A big range, but still clearly below 30.
Looking ahead to projected earnings doesnt bail the stock market out either, says the Dow 5,000 camp. Economic growth dropped to just 0.5% in the fourth quarter of 2002, and 2003 is likely to be a lot weaker than anyone now expects. Earnings are likely to climb only a modest 5% to 7% in 2003, less than half of current Wall Street projections. That disappointment will send stock prices tumbling. It also doesnt help that energy prices and interest rates are likely to rise this year under the combined impact of a war in the Middle East and huge budget deficits in Washington.
The Dow 10,000 camp sees stock valuations in a totally different light. Theres no point in looking at trailing earnings at the bottom of an economic cycle because price-to-earnings ratios always look outrageously high when theyre based on depressed earnings. Looking forward to earnings in the second half of 2003 gives a much better picture. Industry analysts are currently projecting 14% earnings growth for all of 2003 and stronger 15% and 22% growth for the third and fourth quarters of 2003, respectively. The S&P 500 is trading at about 16.5 times projected 2003 earnings. If you do the calculations to normalize earnings to take into consideration where we are in the business cycle, the year-end price-to-earnings ratio comes out to 15.8, according to First Call.
The interest rate factor
Further, with interest rates this low, stocks are hugely undervalued, says the Dow 10,000 camp. Using a Federal Reserve formula that calculates a fair value for stocks by looking at the yield on Treasury notes (now about 4% on the 10-year note), First Call comes up with a fair value price-to-earnings ratio of 24.9 for the stock market on full year 2003 projected earnings. That would make stocks undervalued by about 35%.
Theres a lot to quibble with in both analyses. Using trailing 12-month earnings at this point in the business cycle, as the Dow 5,000 camp does, will indeed result in a deceptively high price-to-earnings ratio. On the other hand, as First Calls Charles Hill has pointed out, the Federal Reserves interest-rate-based formula for calculating fair value breaks down when interest rates fall to extremely low levels.
But rather than picking holes in these two arguments, Im interested in the assumptions that they share in common. First, they both assume that earnings growth in the second half of 2003 is critical to stock prices. If the earnings growth Wall Street is now projecting doesnt materialize later in 2003, then theres no way that the Dow will hit 10,000. Conversely if the earnings come through, then the Dow isnt likely to sink to 5,000. Second, the speed and magnitude of any increase in interest rates will determine how much lift stocks get from any increase in earnings per share. Too fast an increase in rates -- due to fear of inflation or a bond market thats spooked by deficits or a collapsing dollar -- and stock prices wont get much benefit from a recovery in earnings.
Isolating these two elements gives an investor the ability to ballpark the likelihood of each of these extreme scenarios. Pretty much everything has to go wrong for the Dow to hit 5,000. Dow 5,000 depends on anemic growth for all of 2003. And Dow 5,000 also demands a climb in inflation and interest rates even while the economy continues to limp along.
On the other hand, pretty much everything has to go right for the Dow to hit 10,000. Earnings projections have to hold up at current levels -- even though they have been cut by analysts throughout other recent years. Interest rates have to stay low, even in the face of a growing federal deficit and a reviving economy.
A middle-of-the-road prediction
A middle-of-the-road result is much more likely than either of these extreme scenarios. In that scenario, earnings recover, but later and not as strongly as Wall Street now projects. Interest rates stay low but begin to show signs of creeping upward at the long end of the yield curve. And inflation, while remaining low, makes it back onto the Federal Reserves radar screen as a result of rising energy costs and a continuing climb in the cost of services, especially in the healthcare sector.
The result of this scenario is a stock market stuck in a trading range -- and one that finishes 2003 pretty much where it began the year. The scenario also calls for plenty of volatility as investors react to fears that things are worse than they really are and to hopes that theyre better than they finally turn out to be. A secondary result of such a market would be that valuations would end the year at more reasonable levels as prices stagnated and earnings grew modestly.
What you can do now
With these scenarios and these factors in mind, lets now build a ladder of strategies with graduated market risk. My ladder starts with the lowest-risk strategy and then adds risk with each rung.
Stay on the sidelines. Theres nothing wrong with waiting until the market and the economy give clearer signs of where theyre heading. Sure, you wont make much in short-term Treasurys or a money market account, but you wont lose anything either. The long-term advantage to this short-term strategy is that it gives the market time to establish a trend, and it gives you time to calmly look for long-term opportunities without worrying about volatility that inevitably accompanies a transitional market.
Use dividends to get paid while you wait. A decent dividend helps provide support to a stocks price in a down market and puts money in your pocket if the recovery youre counting on takes longer to arrive than expected. I think this works best with stocks with very solid balance sheets and growth fundamentals -- say a Pfizer (PFE, news, msgs) with its 2% yield. Buying preferred shares of common stocks you like has roughly the same effect, although the yields are higher and the potential capital gains lower.
Hedge your bets. The idea here is to find an asset class or a group of stocks that will move up if youre wrong about the direction of the market and the rest of your portfolio heads down. Its tricky, however, to find a hedge that will go up strongly when the rest of your portfolio is falling, yet one that wont fall so hard itself that the tumble wipes out the gains from the rest of your portfolio. Energy stocks, such as Apache (APA, news, msgs) and EnCana (ECA, news, msgs), fit the bill at the moment since theyre likely to climb on any major disruption to energy supplies -- just what would hurt the rest of the market -- but they should also benefit if economic activity picks up and energy demand climbs.
Turn to turnarounds. The stocks of individual companies that are putting disordered houses in order can move up even if the market as a whole stalls or falls modestly. Thats because the revenue and earnings story at such a company is relatively independent of improvements in the stock market as a whole. It also doesnt hurt that stocks like these usually begin from very depressed valuations.
Trade the range. Over the last few months, many stocks -- RF Micro Devices (RFMD, news, msgs) and Dell Computer (DELL, news, msgs), for example -- have established what look like clear trading ranges, just as the market as a whole seems to be stuck in a trading range. Investors have made decent returns by buying when a stock dropped near the bottom of that range and selling when it neared the top. This strategy has the advantage of holding down risk, too, because an investor is buying low and getting out relatively quickly.
The 15% solution. Some companies, actually a very few companies such as Stryker (SYK, news, msgs) and Sysco (SYY, news, msgs), have been able to show solid 10% to 15% earnings growth through the collapse of the stock market bubble and despite an economic recession. Their stock prices havent soared during the bear, but theyve held up remarkably well and in some cases actually produced more-than-respectable returns. They wont be the biggest winners if the economy booms and the stock market rallies big-time (which I think is possible but unlikely), but they also wont sink like stones if growth is lackluster or worse.
Keep your eyes on the prize. You know the long-term record of the market, so you decide that you dont need to worry about the ups and downs of the next year. Just keep putting money away regularly in solid equities such as American International Group (AIG, news, msgs) or PepsiCo (PEP, news, msgs) or mutual funds. Maybe using dollar-cost averaging. And wait for the return to 7% or 10% or whatever annual growth that stocks have traditionally produced over the last three-quarters of a century. This strategy probably has a lower long-term risk factor than some of the strategies listed above. But in the short term, many investors will find it hard to stick with the long term. There will be enough volatility in the coming year that holding to this strategy will be more than some investors can manage.
Go for it. Since you believe you know which way the market will turn, you build a portfolio leveraged to that scenario. For example, if you believe in the Dow 10,000 scenario, you increase youre exposure to stocks that are currently on the floor -- J.P. Morgan Chase (JPM, news, msgs), Continental Airlines (CAL, news, msgs) or Flextronics International (FLEX, news, msgs), for example -- but that will soar if growth comes in at the high end of expectations. You can do the same with the Dow 5,000 scenario by shorting growth-dependent stocks. This maximizes your return if youre right and maximizes your losses if youre wrong.
I dont know where you come down on this market risk ladder. Thats something only you can figure out. But one last word of advice for anyone about to begin the task: Dont be too much of a purist about any strategy. You can mix and match to find your own comfort zone. Theres nothing wrong with putting half your portfolio into cash equivalents and dividing the rest among conservative equity strategies. And nothing wrong, either, with making up your own hybrids of these strategies. For example, you can divide a single stock into a long-term core holding and a trading position. The long-term shares stay put for the long term while you trade the range with the rest.
Just work at it until you come up with something that you think you can stick with, no matter what short-term curves the market may throw at you.
New developments on past columns
Dogs and darlings of the biotech sector
On Jan. 22, Icos (ICOS, news, msgs) announced that the first shipment of Cialis, the companys drug for treating erectile dysfunction, had been sent to European distributors. Cialis should be available for sale in Europe within the next few weeks. The European Union had granted marketing approval to Cialis in November 2002, and the company and its marketing partner Eli Lilly (LLY, news, msgs) had been projecting that sales would start in Europe in the first half of 2003. The U.S. Food & Drug Administration is still expected to release its own decision on Cialis in the second half of 2003. Still getting the drug to market in Europe is an important milestone for Icos that should provide the company and investors with important data on how Cialis does against an entrenched competitor, Pfizer (PFE, news, msgs) and its Viagra.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group, Apache, Continental Airlines, Pfizer, RF Micro Devices and Sysco. He does not own short positions in any stock mentioned in this column.
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