3 ways to invest for Dow 12,000

By Tim Middleton

The view from this side of Dow 12,000 is a little different than it was on the way up.

The benchmark's record caps four consecutive years of supercharged growth in corporate earnings, averaging 17%. But with the Federal Reserve reining in frantic growth with higher interest rates, that cannot continue.

"What really matters to the stock market is earnings, and the growth rate of earnings is going to slow," says Hugh Johnson, the chairman of Johnson Illington Advisors in Albany, N.Y. By this time next year, the growth rate could be down to 2%, he says.

That's what an economic "soft landing" is: growth, but at a slower pace. For stocks, that implies more of what the 21st century has already brought us: a stock picker's market, in which certain elements do much better than others. Anemic performance in general would be a drag on broad-based index mutual funds, including funds such as the exchange-traded Diamonds Trust (DIA), which mimics the Dow Jones Industrial Average ($INDU).

A market rolling over to a new, quieter level also implies new leadership, in which this year's most successful themes won't necessarily be repeated. Fidelity Select Brokerage & Investment (FSLBX), which invests in financial-services companies that benefit from a rising stock market and which has spurted 15% this year, won't do as well in a less ebullient marketplace.

By the same token, it's quite possible that some of this year's laggards will show their real worth in more difficult circumstances. Exchange-traded fund Health Care Select Sector SPDR (XLV), which is trailing the market by 4 percentage points this year, is one example. This group's earnings are suffering; next year's numbers will be better.

Health care is one of three ways I think you can play Dow 12,000. The other two are small companies and global ones. All three plays rely on the same premise: Stronger earnings will be harder to find, but they can be found.

Consider a return to health

Since the stock market's previous peak in 2000, the health-care sector has endured tumult atop anxiety. Billion-dollar drugs have lost patent protection, and new blockbusters have been rare. The group lost less than average in the bear market of 2000-02, but it has come back less, as well. The result has been what market technicians call base building: A durable floor has been built beneath drug-stock share prices.

The most straightforward way to buy the group is Health Care Select Sector SPDR. It owns all the top names in their order of importance in terms of market capitalization. Its five largest holdings are Pfizer (PFE, news, msgs), Johnson & Johnson (JNJ, news, msgs), Merck (MRK, news, msgs), Amgen (AMGN, news, msgs) and Wyeth (WYE, news, msgs).

Drug stocks account for just more than half of the sector's total weighting and have actually been its strongest component recently. Medical-equipment makers and hospitals have been much weaker, so any strengthening there will bolster the group even more.

Think small and smart

Small companies have the capacity to grow much faster than large ones. Investing legend Warren Buffett has demonstrated that: As his assets under management increased, his performance decreased. Peter Lynch, the best-known stock investor in the 1980s, proved the same thing at Fidelity Magellan (FMAGX).

But stocks are purchased by human beings, whose judgment is not inerrant, and small companies sometimes endure periods of neglect. The average small-growth mutual fund has beaten the big-cap S&P 500 Index ($INX) every year this decade except for two. Small-cap stocks suffered badly in 2002, at the bottom of the bear market, and again this year, at the peak of the bull.

When the market's eye turns toward its most neglected elements, however, they can rebound smartly. That average fund soared 46.1% in 2003, beating the S&P by more than 17 percentage points.

Picking small-cap funds is tough. Most of the best are closed, and many are second-best because they didn't close and got too big. The safest defense against such pitfalls as these is indexing, and my choice among those funds would be iShares Russell 2000 Growth (IWO). This is another exchange-traded fund, meaning it can be bought and sold like a stock.

This fund owns the half of the Russell 2000 small-company index constituents that are growing the fastest. If earnings growth indeed slows in 2007, and if investors react by seeking out the fastest-growing stocks, this fund will benefit.

Look overseas

Foreign stocks have been giving their domestic rivals a drubbing in recent years, in part because the U.S. dollar was depreciating steadily. Lately, the dollar has stopped falling, but international stocks haven't stopped going up. Through Friday, Vanguard Global Equity (VHGEX) was ahead 16% this year.

Most people think of Vanguard as strictly an index-fund company, but it's not. Indexing forms Vanguard's core, but the firm also operates a large number of excellent funds that are actively managed by outside companies hired by Vanguard's funds.

This $4.19 billion behemoth has three subadvisers: Marathon Asset Management, Acadian Asset Management and AllianceBernstein (AB, news, msgs). The first and last of these are value-oriented stock pickers; Acadian uses computer modeling to make its choices.

As its name makes clear, Vanguard Global Equity can own domestic as well as foreign stocks, and currently U.S. stocks make up about 40% of assets. There's nothing wrong with a pure foreign-stock mutual fund, but this one has the advantage of being able to buy anybody's stock, and the best companies aren't always the foreign ones.

The fund's top holdings include ING Group (ING, news, msgs) and BNP Paribas (BNPQY, news, msgs) of Europe, China Mobile and two U.S. names, Caterpillar (CAT, news, msgs) and Nucor (NUE, news, msgs).

In the 1990s, you could own one or two index funds and earn better returns than most investors. These days, that doesn't work. Maximizing returns takes a bigger investment of time, and this effort should be spread over a well-diversified array of funds.

All three of these funds could fit comfortably in almost anyone's portfolio. You may already own funds targeting these same goals. If you don't, however, now is a good time to consider whether you ought to correct that oversight.

At the time of publication, Tim Middleton owned the following security mentioned in this article: Vanguard Global Equity.