Investors Will Have to Get Off Fence

Imagine you’re the typical money manager getting back to work this week after summer vacation.

If you oversee a U.S. stock portfolio, you’ve earned only about 0.5% for your clients so far this year, even after August’s big rally. That’s about one-quarter what they would have earned just sitting in a money market fund.

If you manage a bond portfolio, you’re in the red to the tune of about 2.2%, as bond yields hover one to two percentage points above year-end ’93 levels despite recent signs of slower economic growth.

Now, summer’s over, everybody’s back in the office, and you’ve got four months left in the year to make some money for your investors--or face their disdain, not to mention that of your superiors, who determine how big (or not) your annual bonus will be.

The reality of the calendar will be bearing down on Wall Streeters beginning this week, and that could help set the tone for stock and bond markets’ near-term trends.

The fact is, many investment pros will have to make some big bets on the markets’ direction over the next few months--up or down--to have any hope of producing hefty portfolio returns for 1994.

“I would pretty much count on everybody . . . getting more aggressive,” said Robert Markman, head of Minneapolis-based Markman Capital Management, which directs $265 million of clients’ assets in mutual funds.

But whether any new-found aggressiveness is more likely to incite stock and bond rallies than selloffs remains to be seen. What seems certain is that many investors will have to get off the fence about the economy, and bet either that it slows further in the fourth quarter or stays on a healthy growth track.

Unfortunately, last Friday’s August employment report didn’t help the fence-sitters make up their minds. The markets rallied in the morning on news that only 179,000 jobs were created in August, then sold off mildly after a closer look at the report showed that the average workweek still is rising, as is manufacturing employment.

The workweek and manufacturing-employment indicators suggest inherent strength in the economy, which many investors these days immediately associate with higher inflation--reigniting the cycle of fear over future potential interest-rate hikes by the Federal Reserve Board.

If you’re growing tired of this tug-of-war over the economy, so are many Wall Streeters. And that, combined with the calendar, could hasten big investors’ decisions to do something substantial with their money between now and year-end: Bet more heavily on stocks, or on bonds, or on cash as a safe haven.

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What follows are a few of the broad investment themes that some pros believe sidelined investors could latch onto in a major way, as the home stretch for markets in 1994 begins:

* Get used to a healthy economy--and take advantage of it. The argument here is that the Fed hasn’t materially harmed the U.S. economic recovery with higher interest rates, and anyway that accelerating growth in the rest of the world will add to U.S. growth what higher rates subtract.

If you want to bet that the expansion goes on and on, some investors advise sticking with industrial stocks, and in particular buying commodity producers like paper, chemical and mining companies--especially if they pull back after their latest run-up.

A growing, all-capitalist world is bound to consume more basic goods. Yet John Lonski, economist at Moody’s Investors Service in New York, notes that even with significant price increases this year, many commodities “are still below levels in effect toward the end of the 1980s.” There’s almost assuredly more to come, he says.

One big believer in commodity producers such as Alcoa and International Paper is Mark Howlowesko, who manages the global Templeton World and Templeton Growth stock funds. “I feel that we’re moving from a period of increasing inflation in financial assets (i.e., stocks) to increasing inflation in hard assets,” he says.

And while some commodity bears worry that supplies will more than keep up with demand, Howlowesko doesn’t see it. With financial assets, he says, “you can produce more with the stroke of a pen” if demand rises. “That’s a lot harder to do with hard assets.”

* Overcome economic uncertainty by sticking with true growth stocks--or with true value. If more investors give up trying to guess the economy’s next move and just feel desperate to put more money to work in stocks, some pros see classic growth issues as the big winners this fall.

The definition of a growth stock is a company whose earnings are expected to rise at a brisk pace no matter what the economic backdrop. To Rod Linafelter, manager of the $2.2-billion Berger One-Hundred stock fund in Denver, that describes such technology stocks as Microsoft and Oracle Systems.

“I’ve got 30% of the portfolio in technology, and I can’t recall a time when I felt more comfortable with the technology earnings outlook,” Linafelter says. Individual tech companies may have their problems, but he sees no evidence that businesses and consumers will significantly slow their pace of investment in computers and related equipment overall.

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Rich Lazarchic, manager of the IDS Managed Retirement fund in Minneapolis, agrees that if the debate is between growth stocks and value stocks (the latter being slower-growing but less-expensively priced stocks), “I think growth is going to work better than value now. There just aren’t that many real values left.”

He includes computer chip leader Intel and soft-drink giant PepsiCo in his growth-stock fold.

If you can find true value, however, that may be as good a place as any to hedge your bet on the broad market’s next move.

Richard Glasebrook, who runs the Quest for Value Opportunity stock fund in New York, regards such stocks as Avon Products and insurer Transamerica Corp. as bona fide values, selling for relatively low price-to-earnings multiples yet boasting very high returns on equity. His portfolio now is concentrated in those types of stocks.

* Small stocks deserve better, in any economy. The average small-company stock, as measured by the Nasdaq composite index, still is down 2.3% year-to-date, even after August’s sharp rally.

Byron Wien, strategist at Morgan Stanley & Co. in New York, argues that small-stock prices in general don’t adequately reflect the companies’ earnings potential. A Morgan universe of “emerging-growth” stocks, for example, is priced at about 15 times estimated 1995 earnings per share, just slightly above the 14 times for the blue-chip Standard & Poor’s 500 index.

Yet the smaller companies’ estimated average annual earnings growth rate over the next five years is 22%, versus the S&P;’s 7%, Wien says.

If markets still work, the price-to-earnings multiple of faster-growing smaller stocks deserves to be much higher than the S&P;’s, Wien notes.

Michael Di Carlo, manager of the John Hancock Special Equities small-stock fund in Boston, agrees. “There’s been an incredible valuation contraction” among small stocks this year, he says, and he believes it can’t last.

* Bond yields may already reflect the worst-case scenario. Almost nobody likes the bond market anymore, but Bessemer Trust Co.’s investment chief, Stan Nabi, argues that bonds at current yields offer stiff competition for stocks.

With seven-year U.S. Treasury notes yielding 7%, Nabi says, “That’s a very decent return considering that inflation is only about 2.5%.” Even if inflation is perking up, Nabi says, real bond yields already reflect that, while he regards many stocks as overpriced.

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Bonds, naturally, are the best bet for anyone who wants to gamble that the economy will slow dramatically this fall. IDS’s Lazarchic, in fact, expects to raise his fund’s bond allocation from the current 10%, to reap any payoff that might occur in bonds should investors suddenly flock to the slow-economy camp--even if it’s only a temporary rush.

* Like Elvis, cash is still king. Short-term money market investments have generally been the best place to hide this year, and Wall Street’s bears--and even some non-bears--don’t think that will change this fall.

Andy Engel, senior research analyst at the Leuthold Group in Minneapolis, says the summer stock rally was only a blip in the trend. “We’re still expecting a prolonged bear market,” he says.

His firm rates the market’s relative value using 30 different measures, including “book” value and dividend yields. The points awarded to the market for those measures can total as much as a positive 1,815 or a negative 1,740.

The current reading: A negative 860, or bear-market territory.

Ron Ognar, manager of the Strong Growth stock fund in Milwaukee, is no big bear. But he cautions investors against chasing stocks this fall. Be patient, and keep plenty of powder dry, he says. “Our tack now is, ‘Be careful, and buy on weakness.’ ”

Wall Street’s Mixed Signals

Is the stock market’s outlook rosy or black? Here’s what some pros are focusing on:

* Underlying demand: It’s still strong. The public stepped up its stock-mutual fund buying in August, and corporate takeovers and stock buybacks are booming.

What’s more, many stock funds were carrying above-average cash levels before the August rally, and those levels haven’t changed much since. That’s fuel for future rallies. “I’ve got 14% cash (in a $2.2-billion fund) and I don’t want to be that high,” says Rod Linafelter, manager of the Berger One-Hundred fund.

* New supply: Down. Securities Data Co. counts 80 initial public stock offerings in the pipeline, expecting to raise $3.2 billion by year-end. So far in ‘94, IPOs have raised an average of $2.5 billion per month.

* Investor expectations: Low. Even after the August rally, only 33.9% of the 140 investment newsletter writers polled weekly by Investors Intelligence in New Rochelle, N.Y., are bullish. Nearly 47% are bearish. The rest expect a new market “correction.” Many pros view a low bullish reading as a “contrary” sign that foretells higher stock prices.

* Corporate earnings: Strong. Earnings-tracker Zacks Investment Research in Chicago says analysts expect S&P; 500 operating earnings to be up 20% in the current quarter from a year ago. With restructurings of recent years, “Even the smallest (sales) increases go right to companies’ bottom lines now,” says Ben Zacks.

* Overall valuation: Not cheap, but not expensive either? The average S&P; 500 stock is priced at 19 times the past four quarters’ earnings per share, and 15 times estimated 1994 earnings. Many Wall Streeters see that as a reasonable valuation. More troublesome, however, is the still-low average stock dividend yield of 2.76%--historically a bear-market signal.

* Seasonal trends: Worrisome, short-term. September is historically a losing month for stocks. In the last 10 years in particular, the S&P; 500 has fallen in September 80% of the time.

End-of-Summer Checkup

Where key stock, bond and commodity indicators stand as Wall Street faces the final four months of 1994:

Indicator Dec. 31 Now Dow industrials 3,754.09 3,885.58 Nasdaq composite 776.80 759.23 S&P; 500 P-E ratio* 23 19 S&P; 500 div. yield* 2.73% 2.76% 3-month T-bill yield 3.06% 4.65% 1-year T-bill yield 3.59% 5.53% 30-year T-bond yield 6.35% 7.49% Gold (ounce) $390.80 $387.10 Oil (barrel) $14.17 $17.52

* based on most recent four quarters’ results