Some 'What If' Ideas For Those Mulling the Bigger Picture

By THOMAS S. MULLIGAN

Jan. 3, 1999 12 AM PT

TIMES STAFF WRITER

NEW YORK —

Sometimes people who claim to be relatively clueless about stocks and bonds have strong opinions about global affairs or where the broader economy is headed.

And that insight into the workings of the “real” economy and geopolitics can sometimes be more valuable to an investor--in terms of catching a windfall or avoiding a major loss--than knowing the nuts and bolts of the financial markets or individual companies.

To put it another way, sometimes pure gut instinct about the big picture can serve you very well in investing.

Do you feel strongly that there’s a recession on the U.S. horizon this year?

Do you expect battered Asian economies to rebound in 1999 or stay in the doldrums?

What about oil prices--think they’re going to resurge, or dive much deeper?

The right guess on any of those questions, coupled with appropriate investment moves, could serve you very well.

Of course, this is the kind of stuff that big-name economists are paid a lot of money to forecast. Yet they often get it wrong. Which is exactly the point: Your guesses may be as good as theirs.

We’re not talking about making huge, speculative investment bets based on whims about global events. Rather, the point is just to think about the possibilities, and understand how your current investment portfolio could be affected, for better or worse.

Being prepared now means you lessen the chance of being panicked later.

But first, a word of caution: In some cases, the traditional relationships between economic events and financial market consequences broke down in 1998.

“Historical precedents got turned on their ear,” said Hoenig & Co. economist Robert J. Barbera.

Last January, for example, if you believed that Fortress America was immune to foreign troubles and that economic growth would keep perking along, then you might confidently have bet on rising U.S. interest rates--and thus waited to buy Treasury bonds.

What actually happened was that while the U.S. economy did remain strong, a “flight to quality” by worried investors pushed Treasury yields sharply lower for the year.

Another example: If you had thought that the downturn in Asia would bring U.S. corporate earnings growth to a halt in 1998, you might not have figured on another year of double-digit gains for blue chip stocks.

So what happened? You were half right: Corporate profits indeed weakened, but the blue chips still soared.

But as tricky as 1998 was for a market strategist, Barbera joked, pity the poor political consultant! If you’d known a year ago that President Clinton would be caught in an affair with an intern, he said, you might have predicted a resignation--but Newt Gingrich’s? Bob Livingston’s?

There is no reason to suppose that equally strange things won’t happen on the investment front this year.

If . . . Then Propositions

With that caveat in mind, let’s consider some If ... then propositions for the economy and investments. Let’s try a worst-case scenario first.

If you think that the trouble in Asia, Latin America and Russia is finally going to drag the United States and Europe into global recession, experts say you should probably be buying Treasury bonds or other high-quality bonds, and lightening up on stocks.

If the major economies all shrink at the same time, interest rates and inflation almost certainly will fall, which is good news for high-quality bonds.

Normally, falling interest rates are also good for stocks. But that positive would be outweighed by the damage that a recession would cause to most companies’ earning power. It’s hard to raise prices or boost sales in a recession.

However, some stock market sectors normally perform better in a downturn than others, so if you want to keep some money in stocks, it pays to be choosy.”In a recession, stock selection has to be more focused on electric utilities, health care, pipeline companies [oil and natural gas] and property/casualty insurers,” said Jack Shaughnessy, chief investment strategist at Advest in Boston.

What those sectors have in common is that they offer goods and services that people keep buying even when the economy turns sour. Furthermore, the high dividends paid by utility companies look especially attractive when interest rates are falling.

Other such “defensive” stocks are the Baby Bell local phone companies and real estate investment trusts, both of which offer good yields, said Joseph Battipaglia, strategist at Gruntal & Co.

Also considered more recession-resistant are food processors such as Heinz and General Mills; high-quality financial service firms; and companies that generate lots of cash flow, including cable TV and entertainment companies, strategists said.

Sectors to avoid in a recession are those where purchases can be deferred. Retailers, auto makers and the housing sector all fall into that camp.

Airline stocks can also suffer, despite the advantage of low fuel prices. “If your seats are empty, it doesn’t matter that gas is cheap,” Barbera noted.

Let’s try another scenario. Suppose that against all odds, the Japanese economy begins to show solid signs of recovery this year. Experts say that would mean a rising yen against the dollar and an economic rebound for the rest of Asia, which is highly dependent on Japan.

If Asian consumers started spending again, U.S. beneficiaries might include multinational consumer giants such as Coca-Cola and Gillette. Others with a significant beachhead in Asia--for instance, Boeing, Caterpillar and Federal Express--could also rise.

A bounce-back in Asian demand might also lift commodity prices, helping chemical, mineral, metal and paper companies, as well as oil producers.

The makers of computer memory chips and other technological building blocks--Advanced Micro Devices and Micron Technology, to name a couple--also would benefit from rising demand, said Shaughnessy.

On the other hand, a turnaround in Japan could mean an end to deflationary pressures in the world economy and thus most likely an end to falling interest rates, Barbera said.

That could be bad news for the Treasury bond market. In that case, it could make sense to start beefing up your cash holdings--money market accounts and short-term bank CDs, in anticipation that the Federal Reserve might begin raising rates again.

However, most economic seers think it more likely that Asia will recover only fitfully and that global deflation will remain a threat.If you agree, then you’ll want to steer clear of commodity investments (like gold), despite their depressed prices.

Another tip for operating in a deflationary environment is to pay attention to your household balance sheet: reduce your borrowings if possible.Just as inflation helps borrowers by allowing them to pay back their loans with “cheaper” dollars, deflation hurts borrowers.

Deflation hurts stocks, too, many experts argue, because it makes it hard for companies to boost profits by the traditional means of raising prices. So if the world faces another round of serious deflation scares this year, stocks could be hammered again.

Some see an upside, however. Lawrence Kudlow, chief economist for American Skandia Investment Services, thinks falling oil prices are going to have an “enormous positive impact” on corporate earnings this year. Cheap oil, Kudlow said, is “the single most underrated factor” at work in the stock market.

Two Growth Scenarios

Early last fall, after the Russian bond default and the near-catastrophe involving the big hedge fund Long-Term Capital Management, many people believed that the U.S. would enter a recession this year.

The subsequent recovery of the bond and stock markets turned much of that thinking around. Some prognosticators are calling for even stronger U.S. economic growth this year than in 1998.

If you are among them, Gruntal’s Battipaglia thinks you should be 100% invested in stocks, with emphasis on technology, pharmaceuticals, transportation and capital goods, autos in particular.

But strong growth would probably dissuade the Fed from further rate cuts. That would hurt bonds, particularly since bond yields already reflect the widespread expectation of further Fed easing.

Finally, if you think growth will be positive but slower than in 1998, some think there is still value in the bond market. Some market strategists said the best bond bargains are in municipal bonds. Nervous investors last fall bailed out of all but the safest Treasury obligations, causing the yields of even slightly riskier securities to jump.

In the case of municipal bonds, the yields still haven’t fallen enough to reflect the biggest advantage of “munis”: they’re tax-free.

On the stock market side, the slower-growth-but-no-recession scenario implies slower profit growth too. In such an environment, experts said, there would normally be a premium on careful stock picking, with the best candidates being those with dependable earnings and moderate valuations.

Finding such stocks in a market where the average big-company stock is selling at a stratospheric 25 times annual earnings may be the toughest trick of all.

Thomas S. Mulligan can be reached by e-mail at thomas.mulligan@latimes.com

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Investing Made (Relatively) Simple

Want a quick reference sheet for the potential investment winners and losers in 1999 under different economic scenarios? Here are some ideas:

Forecast: Global Recession

Likely to fare well:

Treasury bonds

High-quality municipal bonds

“Defensive” stocks

Money market accounts

Likely to fare poorly:

Most stocks