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"Do you have to be so negative all the time?" a number of my recent e-mails have asked. "You're so pessimistic that I can't stand to put any money in the stock market."
Despite the fact that I've written recently about the dangers of higher inflation, slower economic growth, and, the worst of all worlds, stagflation, I'm not particularly pessimistic at the moment.
It's just that I believe that any investment strategy has to begin with a close-up look at the dangers ahead. Only by taking the most objective look at potential bad news can you figure out where to put your money, decide what sectors and stocks to avoid, and make a judgment on whether to own stocks at all at the moment.
Fear and hope are the two drivers of stock prices in the near and intermediate terms, and you can't consistently make money if you look only at half of what motivates investors.
So what does looking at the market's fears tell me about where to put my money now? Here are my "Five lessons from the market's fears."
Fear No. 1: A Goldilocks economy vs. the 3 Bears
The Goldilocks economy could be about to come face to face with the Three Bears (inflation, higher interest rates, and slower growth).It's possible that the Federal Reserve will get the economy just right: not too hot, because that would encourage inflation, and not too cold, because that would crimp growth and send earnings into a tailspin. But the market is worried that there is very little room between too hot and too cold.
Look at the July 7 reaction to June's employment numbers. June payrolls climbed by just 121,000, way below the 175,000 the stock market had expected. That was good news for investors worried that fast job growth -- something north of 200,000, for instance -- would persuade the Federal Reserve that it needed to raise interest rates again in August. The jobs number is consistent with economic growth of 2% to 3% once you add in productivity growth -- almost exactly the non-inflationary range that the Federal Reserve would like to see.
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But instead of rallying, stocks sold off and sent the Dow Jones Industrial Average Index ($INDU) down 135 points because hourly wages climbed by 0.5%, bringing the annual rate of wage growth to 3.9%. That was more than the monthly increase of 0.3% Wall Street had expected and a big jump from the 2.7% rate of increase in June 2005. An almost 4% jump in hourly wages is exactly the kind of inflationary sign that would lead the Federal Reserve to stomp down hard on the brakes.
Implication for stocks: Now isn't the time to take risks. Just as higher volatility is good in a rising market (it means your stock is going up faster than most), it's bad in a down market (it means your stock is going down faster than most). So forget about speculative plays in emerging markets, commodities and high price-to-earnings ratio stocks, in general. Instead, advises Wall Street, own "quality," a term with a very squishy definition but one that is often synonymous with large, less volatile and financially solid stocks.
Fear No. 2: Economy will actually grow
Maybe the Three Bears won't eat Goldilocks after all, and the economy will actually grow by 2% to 3%.Then won't all the money managers who ran for cover look silly when their portfolios trail the indexes. It's important to realize that professional money managers are judged on relative performance. If your portfolio stumbles, but the major stock indexes such as the S&P 500 ($INX) tumble more, hey, you just had a good year. But woe to the manager who trails the index or peer group. Do it often enough and you get fired. So there's as much danger right now in going too defensive and giving up on growth as there is in holding too much risk.
Implication for stocks: Wall Street wants to own "safe" growth. Although it's not entirely clear where investors might find this ideal equity, a "safe" growth stock will deliver 8% to 12% earnings growth even if the economy falters, the dollar tumbles, energy prices climb, inflation flares and interest rates rise. A growing number of Wall Street pros are looking for safe growth in a group that they call the Big Uglies: stocks like PepsiCo (PEP, news, msgs) and Procter Gamble (PG, news, msgs). Best of all, of course, are stocks that are likely to deliver earnings growth and that pay an attractive dividend. The dividend is an extra insurance policy that makes "safe" growth even safer.
Fear No. 3: Downward pressure on the dollar
The end of Federal Reserve interest-rate hikes and a slowing U.S. economy will put downward pressure on the U.S. dollar.Remember how the dollar strengthened in May and June when investors decided that the Federal Reserve wasn't done raising interest rates. High U.S. interest rates make dollar-denominated investments such as U.S. Treasury bills more attractive to investors and support the price of the dollar, in general.
Before this dollar rally, we'd seen exactly the other side of the coin. The dollar had slumped for months against the euro and the yen because of the belief that, although the Federal Reserve was done hiking interest rates, the Bank of Japan and the European Central Bank were near the beginning of a series of interest-rate increases that would cut the gap between U.S. interest rates and rates in Japan and Europe. The financial markets expect a replay of the earlier dollar weakness when the Federal Reserve finally does stop raising rates -- whether in August or later.
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