How To Navigate The Storm

By Daniel Kadlec

So you got a little careless. You didn't rebalance your portfolio as tech stocks soared a year ago. Maybe you hung on to that dotbomb until it exploded, and then made things worse by running up your credit cards. Or while your investments were booming, you decided you could afford to save less. With stocks cratering and the economy slowing, you don't feel so flush anymore. It's time to get real and fix those giddy-times mistakes.

In some cases, the fixes will take time. The NASDAQ just turned in the worst year of its 29-year existence, falling 39%. The Dow and the S&P 500 were also losers last year. The more than $2.5 trillion of vanished stock-market wealth since March won't be easy to get back. The NASDAQ, for example, would have to rise more than 15% a year for five years to return to its high. Meanwhile, consumer debt (excluding mortgages) has doubled over the past decade and averages nearly $15,000 per household. It will take years for borrowers to pay down those debts--and for lenders to deal with defaults.

Still, it's important at times like this to step back and count your blessings. Inflation is no longer on top of Alan Greenspan's worry list, so the Fed chief has room to cut interest rates, probably starting late this month. Corporate profits, though slowing, will still be up in the coming year. Mortgage rates have declined sharply, putting a floor under home values. That's critical because despite the explosion of stock-market wealth over the past decade, the most valuable asset most Americans own is their home. The unemployment rate remains low at 4%, and many economists believe that even in a recession it wouldn't go much higher than 4.5%, so you'll probably keep another of your major assets--your job.

Even in the stock market, if you have been investing for two years or longer, you're probably still ahead. The past year's declines have wrung many excesses out of the markets, and the shares of many solid companies are now available at bargain prices. So although there's danger dead ahead, there are also opportunities. Here are some ideas for dealing with both:

INVESTMENTS

The most important concept to grasp at this point is how the stock market interacts with the economy. Both run in cycles. But because investors focus on the future, the stock-market cycle is usually ahead of the economic cycle by six months to a year. With an unprecedented 49% of all American households owning stocks, and so much information available immediately via the Web and financial TV channels, this linkage is tightening. But there will always be a gap between the market and the real economy. That means stocks may be at their lows just as a slowdown becomes apparent. Where are we today? The slump is just now smacking us in the face, but the stock market started discounting it 10 months ago.

That doesn't necessarily mean stocks have already bottomed. If the slowdown becomes a deep recession, the stock market is likely to fall again--and soon--because such a recession isn't generally expected. But if we're through the worst of it in the next six months, as many economists believe, then the stock market could begin to recover right away as it looks ahead to the next expansion. That's how bull markets are born. Indeed, many on Wall Street predict double-digit returns from the Dow and S&P 500 in 2001. The tech-laden NASDAQ they see as more problematic, but still going higher.

Not even the pros can consistently pick the market's tops and bottoms. That's why individual investors are well served by a disciplined approach: investing a certain amount each month, perhaps in a broad-based index fund like the Wilshire 5000. Such dollar-cost averaging ensures that you'll buy more shares when prices are relatively low. And there's also no better time to start a regular investing program.

Diversification, a concept that fell out of favor in the tech boom, will be critical in 2001. If you've still got more than 20% of your money in tech stocks, consider selling the ones with no earnings or with price-earnings ratios that far exceed their projected growth for this year. Those are ultrasensitive to even minor adjustments in what investors believe the companies will earn in future years. That was dandy in the bubble, when expectations were running high. Now we're seeing the downside of extreme volatility, and it isn't pretty.

There are plenty of stocks that still carry obscenely high prices relative to their expected earnings. Internet infrastructure kingpin Cisco Systems, for example, has seen its share price cut by more than half over the past year, to $38, but it still carries a forward P/E ratio of 47 vs. a 21 P/E ratio for the overall market. Yet Cisco's earnings this year are expected to grow by only 28%. There are far more attractively priced tech stocks: for example, Dell, expected to grow earnings at 21% and selling at a P/E of 16, or WorldCom, which has hit a few bumps but is still averaging long-term growth of 26% a year and selling at a P/E of 12. If you invest in individual stocks, the past year should have taught you to do your homework rather than rely on stock analysts from the big brokerages. Most of them were of little use in warning investors of trouble brewing in their stocks--especially the stocks of companies that do business with the brokerage.

Replace the tech stocks that you shed with a mix of steady growers like food and drug stocks; companies that benefit from falling interest rates like banks, insurers, utilities and real estate investment trusts; and beaten-down cyclical stocks like home builders and retailers, which will rebound with a recovery. Some stocks in these groups have risen sharply in the past year, especially utilities, so pay attention to valuations. Or you can diversify easily through value-oriented mutual funds, like Clipper and Berger Small Cap Value.

Mutual funds are especially helpful in gaining exposure to stocks in other countries, and when reaching down to smaller, less understood companies. Exposure to both areas is a good way to further diversify and reduce risk. Small-cap stocks have outperformed large caps this year. And they can help you even overseas. A recent study by Kirk Butler, a finance professor at Michigan State University, finds that especially in down markets, the fortunes of multinationals across the globe tend to move together. That's because they all sell their stuff everywhere. That's less true of small companies, though, which are more hinged to local economies. So for maximum diversification think small when you think international. Two top-rated funds that invest in smaller foreign companies are T. Rowe Price International Discovery and Wanger International Small Cap.

Your goal is to move toward an all-weather portfolio that seeks the higher returns that stocks historically deliver but also includes enough bonds and cash to cover any financial obligations you expect over the next few years--for example, college tuition. Part of this process is ratcheting down your investment expectations. Having come through five consecutive years of stocks gaining more than 20%, we can now expect something closer to the 11% a year that stocks have averaged since 1926. So bonds and cash won't hurt as much as you think.

Among bonds, Treasury securities that mature in five to seven years offer the best combination of safety and potential total return. For cash, six-month bank CDs probably beat money funds, where interest payments will float lower as the Fed cuts short-term interest rates.

CAREER

Only a few months ago desperate companies were wooing a broad range of new hires with signing bonuses and stock options. Suddenly blue-chip companies including GM, Whirlpool and Gillette are letting people go--and there are no dotcoms to snap them up. So stop waiting for the next offer and make yourself useful. That means being versatile. Take full advantage of training courses--especially ones that will teach you to apply new productivity-enhancing technologies. No matter what you hear, says Jeff Joerres, CEO of the staffing firm Manpower, "most people prefer to stay where they are, and, by the same token, employers want loyal workers."

Joerres believes the biggest hurt will be on those in entry-level positions, for many of whom the minimum wage will again become the norm. But there remains a great need for mid-level and skilled employees. "Even if we move toward 5% unemployment," Joerres says, "you are still going to find companies saying they can't find the right people." The most secure jobs are in information technology, finance, engineering, nursing and teaching, Joerres says.

The slowdown is also a reminder of the need to constantly network inside and outside your company. "Time and again people work very hard and are good at what they do but they don't know anybody," says John Challenger, CEO of Challenger Gray & Christmas, an outplacement firm. "They put their head down and spend no time developing social capital. When they're let go, they have a hard time finding a job."

HOME

If you're house hunting you may finally get a break. As the economy slows, more homes will become available at attractive prices. And mortgage rates should decline as the Fed cuts short-term rates. But don't wait too long; mortgage rates will head higher as a recovery takes shape. With the job market expected to stay fairly strong, others will be bidding against you, so don't hold out for a screaming bargain.

If you're happy where you are, look for a chance to refinance. The average rate on a 30-year fixed-rate mortgage is now 7.44%, according to HSH Associates. That's down from 8.82% in May, and represents a saving of $241.49 a month on a $250,000 mortgage. The 30-year fixed rate is the best deal in town at the moment because long-term rates have come down sharply while short-term rates haven't moved much. That dynamic will change as the Fed starts cutting rates. But for now the average rate on a one-year adjustable is 7.02%, not much lower than a 30-year fixed-rate mortgage with which you'll never have to worry about yearly adjustments that could go much higher.

Another opportunity may exist for those in a mortgage just over the break point between so-called conforming and jumbo loans. In 2000 the break point was a loan value of $252,700. It just rose to $275,000 for 2001. You may have a chance to refinance out of the more costly jumbo into a conforming mortgage. For rates and options, check out hsh.com eloan.com and bankrate.com

CAR

If your auto lease is coming due, consider buying the car instead of leasing another. You may be able to keep your vehicle for less than the buyout, or residual, value stated in the lease. That's because a glut of cars coming off lease are driving prices lower amid slack demand.

INSURANCE

The less financial security you have, the more important it is to protect what you own. Consider taking higher deductibles to drive down premiums, and maybe you can drop comprehensive coverage on an aging vehicle. But don't skimp on homeowners' or your umbrella liability policy. Burglaries tend to pick up in tough times, and some folks look to lawsuits to make ends meet. Double-check coverage on jewelry, art and antiques. Such items can decline in value during a slowdown, and many policies pay only what the item would cost at the time of the loss. "You want a cash-value policy that pays at least what you paid," says Mary Ann Avnet, marketing manager at Chubb's personal-insurance division.

CREDIT CARDS

Whittling down high-cost debt is the most important thing you can do to get ready for a period of relative job insecurity and meager pay raises. Put off purchases of things like cars and appliances. They'll get cheaper as the economy slows and manufacturers try to lure back consumers. Pay off your high-rate debt first and fixed-rate debt ahead of variable-rate debt. As interest rates decline, so will variable rates. Try to build a cash cushion equal to three months' living expenses. That's less important when you are debt free and have access to borrowed money. But no one ever lost sleep because they saved too much.

--With reporting by Bernard Baumohl and Carole Buia/New York, Colette McKenna Parker/Atlanta and Leslie Whitaker/Chicago

With reporting by Bernard Baumohl and Carole Buia/New York, Colette McKenna Parker/Atlanta and Leslie Whitaker/Chicago