A broad retreat from risk-taking may be ahead

By Tom Petruno

July 1, 2007 12 AM PT

Times Staff Writer

AT the halfway point of the year, you probably have substantial portfolio gains to celebrate.

Now, how best to hold on to them?

Financial advisors seem virtually unanimous in warning clients to be prepared for a stormy time in stock and bond markets in the second half of the year. In part, that’s just standard professional caution. But it also reflects the clouds that have materialized in recent weeks.

The woes of the U.S. housing and mortgage sectors continue to deepen. The corporate takeover wave, which has underpinned share prices worldwide, is threatened as lenders pull back on the easy credit terms that greased the deal machine for much of the last few years.

And the inflation-wary Federal Reserve keeps sounding as if it wants to raise short-term interest rates more than cut them.

There also is a general sense on Wall Street that stocks simply are overdue to give back some ground, after a rally that lifted the Standard & Poor’s 500 stock index 5.8% in the second quarter, 6% in the first half of the year and 18.4% over the last 12 months.

The problem with any admonition to be careful about stocks is that investors have heard this plenty of times since 2002. Yet every decline has been short-lived -- and a good time to buy. Any pullback this summer might well be more of the same.

But Richard Weiss, who as chief investment officer of City National Bank in Beverly Hills oversees $55 billion in client assets, says he can’t shake the feeling that the global bull market moved into a dangerous “greed is good” phase in the last six months. Many investors abandoned any pretense of prudence in their search for rich returns on their money, he says.

The sudden trouble that corporate buyout firms are facing in securing cheap loans, as lenders rethink the potential for deeply indebted companies to get into financial trouble down the road, could be signaling a broader retreat from risk-taking, some market pros say.

It’s an environment, Weiss says, in which the threat of loss outweighs the possibility of more rewards from some investments in the short run.

“Our overall take is that paring back some of our riskier investments is a smart idea,” he says. City National has been trimming in sectors such as emerging-market stocks, real estate investment trust shares and corporate junk bonds, Weiss said.

Of course, younger people who have decades to hang on to their investments may not care to change anything. For them, any market decline could be more of an opportunity than a problem.

But for older investors who’ve racked up handsome gains in markets in recent years -- and who may need to begin tapping their assets for living expenses soon -- it’s time to consider harvesting some profits, financial advisors say.

Selling a portion of your holdings in highflying stocks, they say, would be like taking out an insurance policy of sorts. You’d still be in the game but not as exposed to loss if markets dive.

Here are some of the strategies that advisors are suggesting to clients:

* Pull back from stock sectors that are sensitive to higher interest rates. Long-term bond rates worldwide have risen sharply since winter amid strong global economic growth, worries about inflation pressures and some lenders’ concern that they’ve made credit too easy.

Higher bond yields present more competition for stocks that traditionally have been attractive in large part for their dividend payments. Two of those stock sectors -- real estate investment trusts and utilities -- have been hit by selling in recent months. Both are popular with individual investors.

A Bloomberg index of 130 REIT shares has slumped 18.8% from its record high reached Feb. 7. The Dow Jones utility stock index is off 7% from its record high reached May 21.

Yet many long-term investors still are sitting on large gains in those sectors, and that may fuel more selling if interest rates stay up or rise further, analysts warn. The Bloomberg REIT index is up 99% since the end of 2002. The Dow utility index is up 131% in the same period. By contrast, the broad-based S&P; 500 index is up 71% in that period.

“We’ve been negative on REITs for about six months, and we’re pulling back” further, said Randy Bateman, president of Huntington Asset Advisors in Columbus, Ohio.

* Be objective about foreign stocks. Yes, foreign markets hold enormous promise over the long run. And this year, healthy economic growth overseas, even as the U.S. economy has slowed, has drawn more American investors to foreign shares, helping to boost them. Rising foreign currencies also have enhanced the stocks’ performance in dollar terms.

But investors who’ve become enamored of foreign stocks may be forgetting how risky they can be. If a sell-off sweeps global markets this summer, history suggests that many foreign issues could be hammered.

The last significant pullback in stock markets occurred in May and June of last year. The German market slumped nearly 14% in that sell-off. The declines were much worse in some emerging markets. Brazil’s main market index tumbled 22%. The Indian market dived 29%.

No one is recommending bailing out of foreign issues completely. But in the fifth year of hefty gains for overseas markets, U.S. investors who’ve been riding this wave should think about cashing in some chips, many experts advise.

The rules of basic portfolio construction dictate that you decide how much you want to have in various market sectors and stick with those percentages. That means rebalancing your portfolio periodically, cutting back on investments that have ballooned while adding to those that have lagged.

If you’ve made no changes to your portfolio, “you have a bigger allocation to risky asset classes than you did two or three years ago,” said Liz Ann Sonders, chief investment strategist at Charles Schwab Corp. in New York.

The idea behind portfolio rebalancing isn’t to eliminate risk of loss but to keep it manageable by selling high and buying low.

* Favor bigger stocks over smaller issues. You’ve heard this before, no doubt: If things get rough in markets, large-company shares ought to hold up better than small-company shares, for several reasons. One is that bigger stocks are more liquid and therefore tend to be less volatile. Another is that many big firms pay cash dividends, which can help buttress share prices in a falling market.

Experienced investors also know that those advantages haven’t mattered much for the last six years, as stocks of U.S. small and mid-size companies have mostly trounced blue chips such as General Electric Co., 3M Co. and Procter & Gamble Co.

But that’s another reason some investment pros are tilting toward big-name stocks now: Their lagging performance makes them more of a bargain.

“That area looks cheap to us,” said Keith Wirtz, chief investment officer at Fifth Third Asset Management in Cincinnati.

Maybe the tide is turning: In the second quarter, the S&P; 500 gained 5.8%, ahead of the 5.5% rise of the S&P; 400 mid-size stock index and the 5% rise of the S&P; 600 small-stock index.

Huntington’s Bateman also favors the biggest U.S. companies. With continuing globalization of the economy, “the best companies to take advantage of that are the mega-caps,” he said.

* If you can’t bear to sell anything now, think about when you might. No matter how optimistic you may be about high-risk assets, if they should plummet there will be a point at which you’ll question your strategy. Better to think in advance about your threshold for pain.

With any investment, “you’ve got to have an intelligent exit strategy,” says Barry Ritholtz, head of Ritholtz Research & Analytics in New York.

To put it another way, it’s always better to have the option of selling when you choose, as opposed to feeling forced into it by the market’s vagaries.

tom.petruno@latimes.com

Begin text of infobox

A mixed market picture at midyear

Long-term interest rates have jumped slamming some stock sectors but overall global equity markets are up sharply

Year-to-date gains in key market indexes*

Market/index

Brazil/Bovespa -- 22.3%

South Korea/Kospi -- 21.6%

Germany/DAX -- 21.4%

Turkey/ISE-100 -- 20.4%

Mexico/IPC -- 17.8%

Hong Kong/Hang Seng -- 9.1%