Third-Quarter Review of Investments and Personal Finance : Does It Get Any Better Than This? : Savor Your Gains, but Have a Plan in Case Trouble Looms

It’s rarely as easy to make money in financial markets as it has been this year. And that’s the problem.

With the average U.S. stock mutual fund up a spectacular 28% through the first three quarters, and the average fixed-income fund up a handsome 11%, 1995 is on track to record the best market gains since 1991.

For individual investors, now comes the tough part: controlling your emotions if those paper profits evaporate, and sticking with a long-term investment plan should other investors’ time horizons shrink to barely cover the next afternoon.

Those challenges are on the minds of many market pros these days. Nine months ago, optimistic Wall Streeters forecast that this could be a great year for stocks and bonds if the economy managed a “soft landing”--a slowdown in growth without recession.

Bingo.

“The soft landing is now a matter of history,” declares Donald Straszheim, chief economist at Merrill Lynch & Co. And the markets have loved it, as predicted.

But in recent weeks the euphoria has begun to fade. The conundrum increasingly dogging investors is the perennial one: What happens next?

Already, fears of widespread weakness in third-quarter corporate earnings are chipping away at stocks, leaving the Dow industrial average at 4,789.08 as of Friday, hovering just below its all-time high of 4,801.80 set on Sept. 14.

In the bond market, the summer conviction that the Federal Reserve Board would continue to lower short-term interest rates has been dissipated by some stronger-than-expected economic data.

And underlying every investment decision, at least to a degree, is the Goldilocks question: Will global business activity in 1996 be too hot, too cold or just right?

Of course, markets’ primary job is to worry, so some investors may ask what’s really different today. The answer is that the surge in stock prices this year, and the sharp decline in bond yields, have built into financial assets certain expectations that may be tough to fulfill.

For example, with many stocks at or near record highs--and at prices that, historically, are at least average (as opposed to cheap) relative to earnings per share--any disappointments in earnings can provide jittery investors with a reason to sell.

Hence, the slew of major American companies that have recently warned of lower-than-expected third-quarter earnings have generally seen their shares pummeled, undercutting the market overall.

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In the bond market, the slide in the benchmark 30-year Treasury bond yield from 7.88% on Jan. 1 to 6.50% now--near a 19-month low--amounts to a strong investor vote of confidence that the economy won’t dramatically reheat and that annualized inflation will remain under 3%.

Any evidence to the contrary, therefore, is enough to unnerve trigger-fingered bond investors.

Exactly what the collective expectations of stock and bond investors amount to isn’t knowable, and in fact during market rushes like this year’s it’s arguable that many investors aren’t quite sure what they want--except for the bullish trend to continue.

That’s precisely what makes the stock market, in particular, so dangerous now, bearish analysts argue. The most pessimistic believe stocks have been caught up in a mania, with technology shares at the center, and that this investor “pile-on” has driven the market to heights that allow no room for error.

“If interest rates are destined to keep declining, if inflation is a dead issue, if corporate profits are to experience uninterrupted growth . . . it may well be that almost any price paid for equities today can be justified,” says Norman Fosback, the bearish editor of Market Logic newsletter in Deerfield Beach, Fla.

“But if inflation or interest rates ever jump, or earnings or the economy ever slump, today’s [stock] prices will be viewed retrospectively as an aberration,” Fosback insists. His advice to investors: Keep 60% of your assets in money market funds and wait for stocks to fall to bargain levels again.

For many individuals, however, the idea of trying to time financial markets’ moves goes against everything they’ve learned about investing. Americans have been exhorted to save and invest more, to do so on a regular program (such as through 401[k] retirement plans), to be well diversified and to think very long-term.

Are U.S. stock and bond markets so out of whack with history and with reality that it’s time to abandon them completely?

Most Wall Street veterans don’t think so. While this year’s stock gains are well above historical averages, they follow a small decline in share prices last year and mediocre returns in 1993 and 1992. Thus, 1995 could easily be viewed as a period of catch-up.

What’s more, it isn’t unusual for a big year like this one to be followed by another up year. It happened in 1985 and 1986, and again in 1988 and 1989.

If the economy and interest rates cooperate, “We might just see something akin to a typical year in stocks in 1996,” meaning a rise of about 10%, says James Solloway, research chief at Argus Research Corp. in New York.

Even more wary Wall Street pros say it’s wise to guard against over-pessimism.

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“A secular bear market is waiting out there, sometime before the millennium,” warns Barton M. Biggs, investment strategist at brokerage Morgan Stanley & Co. in New York. But for now, he says, “there is no denying that slow [economic] growth and disinflation are bullish” for markets.

While the U.S. economy grew briskly in 1994--causing the Fed to double short-term interest rates--many economists view that as a spurt within a modest-growth trend, and few expect a resumption of sustained fast growth.

“It’s not just America that is struggling to hold on to its economic momentum,” notes William Dodge, strategist at Dean Witter Reynolds in New York. “Europe is plagued by high unemployment and slow growth, Japan is mired in a struggle to escape a deflationary grip, and Latin America continues to limp through the aftermath of the currency crisis in Mexico.”

What slow growth and low inflation help ensure is that interest rates will remain under control, which in turn tends to put a floor under stock prices and forces savers to look for alternatives to keeping money in the bank.

At the same time, the demographics of the world’s richest countries--aging populations whose consumption rates should decline while their savings rates rise--provide a further dampening effect on economic growth while bolstering the pool of funds searching for investments. So, too, do major Western governments’ efforts to balance their budgets.

Finally, there is the perhaps unprecedented corporate slavishness to enhancing “shareholder value,” manifesting itself in continued restructurings, cost cutting, stock buybacks and mergers, all aimed at making stocks more appealing for investors--including corporate executives themselves, whose compensation increasingly depends on stock performance.

When money manager Marc Kelly looks at the stock market, he sees plenty of shares that are overpriced, he admits. But overall, “there are more positive than negative things going on for stocks,” says Kelly, principal at Spectrum Asset Management in Newport Beach.

Morgan Stanley’s Biggs also is unable to identify a catalyst that could spark a market collapse. “The principal risk is that an unimaginable financial accident of some kind out of the blue triggers a sudden bear market, but the odds of this look low enough” to preclude simply shunning stocks, he says.

Yet that by no means suggests that the U.S. stock market is without risk. On the contrary, there is a significant risk that the two loudest Wall Street camps--the bulls who expect a 5,000 Dow soon and the bears who expect a 3,500 Dow (or lower)--both will be wrong.

Instead, the market may be primed to experience what few investors are prepared for, even though history is replete with them: a good old-fashioned “correction.”

In a classic correction within a bull market, major stock indexes like the Dow and Standard & Poor’s 500 would be expected to lose 10% to 15% of their value--about half what is usually lost in a bona fide bear market.

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Last year, despite the doubling of short-term interest rates, the declines in the Dow and the S&P; were held to within the 10% range. Officially, then, the market escaped a true correction. That means we’ve now gone five years (dating back to the 1990 Persian Gulf War bear market) without a meaningful pullback in stocks as measured by key indexes.

History says we’re overdue. Yet most independent market newsletter writers, as polled weekly by Investors Intelligence of New Rochelle, N.Y., are either bullish (45.5%) or bearish (36.6%) today. Only 17.9% expect a correction.

Could the minority have it right, as is often the case in markets?

Some Wall Streeters think they can see the potential trigger for a correction: a slowdown in corporate earnings growth, courtesy of the same sluggish economy that makes for low inflation and low interest rates.

After stellar double-digit growth for most of the past two years, “I see earnings growth rolling over to single-digit gains” over the next few quarters, says Douglas D. Ramos, Pasadena-based co-manager of the New England Balanced mutual fund.

While that probability is widely discussed in the financial community, “it still could be a problem for the market,” Ramos notes, “because in their heart of hearts money managers are still expecting companies to beat expectations.”

If disappointing earnings spark enough widespread profit taking, the high-flying U.S. market could easily lose more than 10% of its value in a short time, analysts say.

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And then the question becomes: Can a market that hasn’t experienced a 10%-plus decline in five years easily halt its slide between the 10% and 15% parameters that history so neatly prescribes for a simple correction?

Obviously, many new investors would be sorely tested by a real correction. In a panic, many could quickly lose sight of the same long-term bullish fundamentals they now recite by heart. Stocks could fall more than they logically should. Remember October, 1987?

Yet the fundamentals would remain. Interest rates are contained. Inflation is at 30-year lows. U.S. companies are extremely competitive worldwide. And there is no sign of outright recession to end the economy’s gradual uptrend.

All of which suggests that, for individual investors, the best strategy isn’t to fear the stock market, but to respect history and be ready for any possibility.

How? If you follow a disciplined investment program that involves regular investment, reasoned asset allocation/diversification and accelerated buying of desired stocks, bonds or funds when prices dip, you can probably consider yourself amply prepared for anything.

If that sounds old-fashioned, it should: That strategy has made for successful investing for as long as there have been markets.

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