5 ‘Warning Shots’ Investors Should Heed to Duck a Downturn in the Stock Market

As are most of the people who rely on him for advice, Richard E. Cripps, chief market strategist at Legg Mason Inc., is heavily invested in stocks--85% of his personal portfolio--and the rest is tucked away in a money market fund.

“I would be foolish not to” be in stocks, Cripps said. “I view stocks as the best way for individuals to achieve their financial goals.”

But stocks involve risk. And Cripps, who views himself as a conservative risk taker, has come up with five “warning shots” that would prompt him and his employer, a Baltimore-based brokerage and financial advisor, to reduce their risk in the stock market.

Cripps said if two of the five warning shots occur, he would immediately double his personal cash holdings.

Here are the signals Cripps is watching for:

* A 15% rise in the stock market over the next six months. Why would that be bad? If it happens, Federal Reserve Board Chairman Alan Greenspan will take action to raise interest rates, Cripps said. Greenspan jolted the market in February when he again raised the question of whether investors’ expectations about stocks might be “irrational.”

“We have the liquidity to drive this market up 15% in a heartbeat,” Cripps said. “If we did that, it would be considered something very dangerous. I think the Fed would come in and act.”

* Weakening corporate sales. This is one of Cripps’ biggest concerns.

Sales growth could fall to 2% to 3% in the fourth quarter, from about 7% a year ago, because of intense competition from troubled Asian economies, which are slashing prices on the products they export.

Companies are boosting profits not by selling more cars, computers or food, but by cutting costs.

“Shareholders are interested in profit growth, not sales growth,” Cripps said. “The issue that starts to concern us is that at some point you reduce costs so much that you put yourself in the position that you are not able to grow sales.

“The inevitable starts to happen. Your operating costs start to rise, and if you don’t have the infrastructure [employees and plants] to ramp up sales, your profit margin will decline.

“If you have rising operating costs and slowing sales growth, you could have a jolt to earnings. That is the fear that I have. That is the fear that the market has really been reacting to.”

Cripps worries that companies are overly concerned with stock performance.

“They run [the company] to make their stock price go up; they are not running it to increase sales,” he said.

* A slowdown in the profitability of banks, an important economic barometer.

A surge in bad loans might suggest that borrowers, whether they are consumers or corporations, are struggling and that the economy is weakening.

Problems at savings and loans surged in 1987, helping to usher in the October stock market crash that year. Bank failures shot up three years later, and stocks again tumbled.

“We have had two market declines of 20% or greater in the last 15 years. Each of those corrections had been preceded by noteworthy weakness in financial or banking stocks,” Cripps said.

Cripps said he will start to worry if bank stocks lag the Standard & Poor’s 500 in performance for four consecutive months. Banks have trailed the index in November and December, he said.

* Fewer acquisitions with stock instead of cash. Seventy percent of all acquisitions in 1997 were done with one company exchanging its shares for the other’s, Cripps said.

Because stock prices have remained high, shareholders of the company being acquired have been eager to do the deal.

“This keeps encouraging the companies to make more and more transactions,” Cripps said.

But if shareholders grow angry because their holdings are diluted, and profit of the acquirer suffers after the acquisition, fewer deals will be done. Cripps said this will become evident if the stock prices of acquiring companies fall by at least 10%. As a result, the stock explosion in companies viewed as takeover targets could end and drive down the market. “At some point, the market is going to say, ‘No, this game isn’t going to work anymore,’ ” Cripps said.

* A surge in initial public offerings and secondary offerings, and a slowdown in the amount of money flowing into mutual funds.

If IPOs and secondary offerings continue to rise, and there is a slowdown in money flowing into mutual funds, those are signs that demand for stocks may be weakening.

“It will be a negative for the market,” Cripps said.

Cripps said he came up with these warning shots because he wanted guidelines to explain when and why investors’ exposure to stocks should be reduced.

He’s convinced that some of these warning shots will occur and that stock investors will benefit if they pay attention to them.

Investors are “going to respond . . . to evidence that makes sense,” he said.