Money Talks as Bull Market Balks, so Fewer Risks Taken

In its worst moments, the stock market’s temperament is only marginally better than that of a 2-year-old child. As Mr. Greenspan has so famously intoned, investors can collectively be “irrational.”

And so it has seemed in recent weeks, as the Dow Jones industrial average has swung in 100-point-or-greater increments, up and down, with wearying frequency.

Can’t people just make up their minds about where they think stock prices should be?

In fact, quite a few minds are made up about the market. That may not be apparent in the yo-yo-like action of the 30-stock Dow, but it is increasingly evident in other, less-remarked-upon trends. Here are a few of them:

* Investors’ appetite for risk-taking is waning markedly. What makes an investment “high risk” or “low risk”? Academics describe risk as the measurable possibility of losing, or of not gaining, value in something. But for many investors, risk is perceived in the gut, not the brain.

In the seventh year of this economic expansion, with the Federal Reserve Board tightening credit again, and with cracks appearing in the economy’s facade (rising consumer debt problems, for one), it seems only logical that investors would consciously or subconsciously begin to shy away from adding more risk to their portfolios.

And so they have: The general unwillingness of individual and institutional investors to buy smaller stocks today, even as they fall to extremely depressed levels, is perhaps the most visible sign that people have become more risk-averse in the U.S. stock market than at any time since 1990.

It is silly to argue that investors are “wrong” to feel this way. It’s enough to know that they do--that in itself says something powerful about the prospects for different segments of the market in the near term.

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But are smaller stocks, at these prices, really more risky than big, blue-chip stocks? Many investors simply equate risk with uncertainty: The less certain you are about the future, the more likely you will be to avoid investments that could fall most sharply if things go wrong.

And late in an economic cycle, with the next dollar of corporate earnings far less certain, “survival of the fittest” becomes a basic criteria for stock selection, notes Richard Bernstein, earnings analyst at Merrill Lynch & Co. in New York. That mentality naturally favors bigger companies over smaller ones.

Which raises another question: If the survival issue dogs small stocks today, how soon before it barks at the gates of the junk-bond market?

* Strong profit growth still gets investors’ attention. The first-quarter earnings-reporting season is in the home stretch, and by all accounts, companies’ results have been better than expected, on average. But do investors care?

Perhaps not to the extent that company managers think they deserve. Yet it just isn’t true that the market is failing to reward convincing trends in profit strength.

Airline stocks, for example, have rocketed this month as investors have clued in to the industry’s dramatic turnaround. Ditto for such industrial giants as Caterpillar, whose stock has surged 10% since the company reported first-quarter earnings up 33%.

And among multinational consumer growth stocks such as Bristol-Myers Squibb, robust earnings reports have served as a reminder that these firms shouldn’t be underestimated.

“These companies are not lumbering dinosaurs,” said James Solloway, research chief at Argus Research in New York. “They are a lot more flexible” than perhaps at any time in this decade, he said, thanks in part to the wide-reaching benefits of productivity-enhancing technology in every aspect of their businesses.

Of course, in a market beset by many worries, strong earnings still may not guarantee higher stock prices. But they could at least put a floor under prices and maintain the relatively rich price-to-earnings ratios of multinational stocks, assuming investors also trust that the economic expansion can continue with low inflation, said Robert Bissell, chief investment officer at Wells Capital Management in Los Angeles.

* Interest rates are going higher before they go significantly lower. Who says? The stock market says.

Stock groups that are particularly sensitive to interest-rate swings continued to slump last week, even as yields in the bond market remained below their recent peaks. The Dow Jones utility-stock index, for example, fell to 209.47 by Friday, the lowest since last July. The Standard & Poor’s financial-stock index has fallen nearly 13% since early-March and lost more ground last week.

And real estate investment trusts, a sector that held up remarkably well in last summer’s market pullback, have tumbled in recent weeks, by late last week falling to their lowest levels since December.

Historically, investors’ aversion to these groups has often been a harbinger of higher interest rates--a better predictor, in fact, than what comes out of the mouths of most economists. (Money talks, as the saying goes.)

This week, stock and bond markets will face a host of economic reports that could confirm what the utility, bank and REIT stocks already seem to know: The Fed, eager to slow the hot economy, is virtually certain to raise its benchmark short-term interest rate at least an additional quarter-point, to 5.75%, when it meets May 20.

Among the reports due this week: March new-home sales (Monday), the first-quarter employment cost index (Tuesday), March personal income and consumption (Thursday) and April employment (Friday).

* All things considered, many foreign stock markets are more appealing than the U.S. market. Despite Wall Street’s woes, the bullish stock trends in many foreign countries haven’t been interrupted this year--at least not for long. Germany’s key market index is up 17% since year-end in native currency; Mexico’s is up 12%; Argentina’s 10%; Taiwan’s 25%; and Sweden’s 9%.

In contrast, the blue-chip U.S. Standard & Poor’s 500 index is up 3% year-to-date.

For many U.S. individual and institutional investors, the attraction of foreign markets isn’t just that they are beating the U.S. market this year for the first time in a long time. The appeal is much more deep-rooted: Corporate profit growth in many foreign economies has lagged that of American companies’ but should begin to catch up--either because of a speed-up in world economic growth, the spread of American-style corporate restructuring worldwide, the stronger dollar (good for foreign exporters) or all of the above.

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Of course, there are also peculiar risks for Americans in foreign markets as well. The strong dollar can automatically reduce returns (German stocks, for example, are up just 4% in dollar terms); most foreign markets are far less liquid (and thus more volatile) than the U.S. market; and political risk is significant.

Even so, more U.S. investors apparently are becoming persuaded by academic studies that show diversification into non-U.S. stocks can lower the overall volatility of a portfolio--in other words, act as a risk-reducer in the long run.

Werner Keller, head of Sherman Oaks-based FundMinder Inc., which directs more than $800 million in mutual fund assets for individual clients, has 35% of clients’ assets in foreign funds now, as high as that figure has ever been, he says.

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Correction: The column last week said James Cloonan’s “shadow stock” portfolio of little-known smaller stocks had beaten the S&P; 500 on a risk-adjusted basis over the last four years, but not on an absolute basis. In fact, the portfolio has topped the S&P; on an absolute basis as well, Cloonan says.