Flexibility May Be Investors’ Best Strategy to Deal With ’96

What investors could really use these days is a consensus opinion.

Blue-chip U.S. stocks, off to a great start in 1996 after a spectacular 1995, seem to be saying that the economy will be fine and that no recession is in sight.

Ditto for foreign stock markets, most of which have been red hot since Jan. 1.

But smaller U.S. stocks are struggling, which is troubling because their fortunes are closely tied to the domestic economy’s.

More disturbing, the price of gold is up nearly 7% this year, suggesting that higher inflation looms somewhere on the horizon.

Meanwhile, the U.S. bond market has developed a split personality: Shorter-term yields are at 17-month lows thanks to the Federal Reserve Board’s latest rate cut. But long-term yields have begun to surge, taking a cue in part from gold.

To some Wall Streeters, financial markets have begun to resemble the Republican presidential field: A lot of noise and too many crosscurrents mean it’s so far a total tossup as to where to make a logical bet.

No wonder Prudential Securities strategist Greg Smith in New York recently advised clients that “a reasonably good strategy to deal with 1996 is for investors to stay very flexible in their thinking.”

Of course, one month doesn’t make the year. But many investment pros pay close attention to January market action because the month has historically been a highly accurate predictor of the general trend for the year, at least for stocks.

Since 1950, the January change in the Standard & Poor’s 500 index of blue-chip stocks has foreshadowed the full-year change (up or down) in 39 of 46 years, for an 85% accuracy rate.

Unfortunately, the batting average of this “January barometer” has been a less-impressive 67% thus far in the 1990s, having already erred twice: in 1992 and--most devastatingly--in 1994, when the market failed in January to foresee that the Fed was about to begin raising interest rates.

Could the stock market be blinded again by its own light, after 1995’s radiant performance? Are balky long-term bond yields signaling that the economy is in much stronger shape than believed? And what, if anything, does gold know that other markets don’t?

Here’s a sector-by-sector look at what is driving different markets in 1996, and the near-term prospects for each:

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Blue-chip U.S. stocks: The Dow Jones industrial average is still large and in charge. After soaring 33.5% in 1995, the Dow has shot up 5% so far this year, reaching a record 5,405.06 last Thursday before dipping 31.07 points on Friday.

The S&P; 500, up 34.1% last year, has gained 3.2% this year.

Blue-chips’ advance has helped pull the average U.S. stock mutual fund up about 2% this year, according to Lipper Analytical.

Big-name stocks are the primary beneficiaries of investors’ trust in the Fed. By cutting interest rates three times since July--most recently last week--the Fed is demonstrating its resolve to keep the economy out of recession.

And historically, when the Fed is on stocks’ side it’s usually a good idea to bet on a bull market.

Wall Street also has been pleasantly surprised by fourth-quarter corporate earnings, which have on balance beat expectations despite the economy’s marked slowdown.

“Three weeks ago our biggest worry was that earnings would disappoint,” says Gail Bardin, manager of the blue-chip Hotchkis & Wiley Equity Income stock fund in Los Angeles. “But I’m really impressed with how energetic U.S. companies are” in keeping their bottom lines growing, she says.

Indeed, corporate America’s devotion to generating higher earnings is the driving force behind the restructurings, share buybacks and takeovers still sweeping industry. “The stock market rewards what it sees as a sustainable increase in business productivity,” says Thomas McManus, strategist at Morgan Stanley & Co.

Goldman, Sachs & Co. strategist Abby J. Cohen is one of Wall Street’s most ardent optimists about 1996. At the start of the year she forecast a 10% total return for the S&P; index in ‘96, including dividends. Based on estimated ’96 operating earnings for the S&P; companies, Cohen says the average blue-chip stock is priced at about 15 times earnings--a historically average price-to-earnings ratio.

That is why, unless bond yields rocket higher or the economy suddenly falls into recession, many pros don’t see why big-name stocks are vulnerable to anything more than a minor pullback. “There just aren’t any signs that a serious correction is imminent,” says Ralph Bloch, analyst at brokerage Raymond James & Associates in St. Petersburg, Fla.

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Smaller U.S. stocks: Although the Dow index has zoomed, many smaller stocks have lagged this year--a repeat of 1995.

The Russell index of 2,000 small stocks is up just 0.6% this year, compared with the Dow’s 5% gain.

What’s ailing small stocks this year? Some analysts say U.S. mutual fund managers were surprised by the inflow of cash they got from individual investors in January, and that in quickly putting that money to work the managers naturally sought the biggest, most liquid stocks available.

The sell-off in technology stocks in January also weighed on small-stock indexes because so many tech firms are relatively young.

But some Wall Streeters say investors’ suspicion toward smaller stocks is a function of the U.S. economy’s slowdown: Smaller companies tend to be more dependent on the domestic economy for their sales and earnings, while blue-chip companies do much of their business overseas. If you’re at all worried about a U.S. recession you might naturally gravitate toward bigger stocks.

Jack Laporte, manager of the T. Rowe Price New Horizons small-stock fund, argues that the longer smaller stocks lag blue chips the more attractive the former become from a “value” viewpoint.

Yet Laporte concedes that for now, “The market seems to be infatuated with big companies.”

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Foreign stocks: Like smaller U.S. stocks, most foreign markets lagged U.S. blue chips in 1995. This year is a vastly different story.

Measured in their native currencies most major foreign stock markets are far outpacing the Dow since Jan. 1. Brazil’s key index is up 25.9%, Hong Kong’s 13.9%, Germany’s 8.8% and Japan’s 5.2%.

As in the U.S. market, falling short-term interest rates have bolstered big-name stocks worldwide, as investors bet that easier credit from world central banks will keep the global economy growing.

But the main appeal of foreign stocks is that many of them have been dead money since 1993. Wall Street is pushing the idea that there is terrific value overseas.

Merrill Lynch & Co., for example, predicts Hong Kong’s economy will grow at 5% or faster this year and Singapore’s at 7% or better. Yet their stocks are, on average, priced the same or cheaper than U.S. shares relative to estimated 1996 earnings.

“They’ve got very attractive growth rates that we don’t expect to see in Europe or the U.S.,” says Douglas Clingott, manager of global stock strategy at Merrill.

Of course, the risks in foreign issues also are huge--as investors saw in 1994, when many markets collapsed as interest rates rose.

Shifting currency values also can be a big risk. So far this year the dollar has been rising, trimming Americans’ gains in some markets. The Japanese market’s 5.2% rise, for example, is a 2.4% rise for U.S. investors.

Even so, barring a global recession many big investors believe that foreign markets have momentum on their side now. “If we are correct in our favorable U.S. market view, it is quite likely that U.S.-based investors will become increasingly comfortable buying non-U.S. securities in 1996,” predicts Goldman’s Cohen.

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Gold: One ounce sells for $414.70 on futures markets now, a six-year high and up $26.60 since Jan. 1.

Why the rush to gold? Many Wall Streeters admit that they aren’t sure what to read into the metal’s price gain. Commodity markets are notoriously volatile, and speculators are by definition bandwagon-jumpers, quickly driving prices way up--or way down.

At best, gold’s rally simply reflects rising demand for gold jewelry, particularly in Asia, while mine production has continued to lag. That has been the story for several years, but analysts say that in recent months both buyers and sellers (the latter including mining companies and world central banks, which hold huge reserves) have begun to recognize the extent of the supply shortfall.

Prudential analyst J. Clarence Morrison thinks gold should reach $425 purely based on current supply/demand fundamentals.

But if gold is saying something else--that inflation is going to revive worldwide--the metal’s price could conceivably go much higher as speculators pile in.

“I’m not a gold bug,” says Lucille Palermo, manager of the Van Eck International Gold mutual fund in New York. “But if all paper currencies are going to go down in value [because of higher inflation] all that can hold its value is gold.”