Warning Sign, or Just a Hiccup?

Nothing focuses an investor on his or her money like the prospect of losing it.

So it went in global stock and commodity markets last week as revived worries about inflation, interest rates and speculative excess (or “How high is too high?”) crashed what has been a wildly fun party since October.

By the end of trading Friday, some markets were in full-on corrections, the polite term for declines in the range of 10% to 15% from recent highs. Others were fast approaching that level.

It also wasn’t too difficult to find investments that were in genuine bear markets, at least by the classic definition of a 20% or greater drop in price. A Standard & Poor’s index tracking shares of five major home builders, including KB Home and Centex Corp., is down 31% since mid-January.

The India Fund, which invests in stocks of that booming economy, ended Friday at $51.53, a 20% slide in just seven trading sessions from its record closing high of $64.70 on May 10.

Before the gloom gets too thick, however, most buy-and-hold investors will discover that they still are in the black this year. The average U.S. stock mutual fund is up 3.1% year to date, according to Morningstar Inc. Despite the rout last week in emerging markets such as India, the average stock fund that invests in them is up 12.1%.

Which means that if you’re contemplating changes in your portfolio, you’ve got time to think things through.

The gut-level fear is that the markets’ sudden turmoil is a warning of much worse to come. Investors who ignored the first 20% drop in U.S. technology stocks in spring of 2000, and then the next 20%, later regretted that they remained so sanguine. By the end of the bear market in October 2002, the tech-dominated Nasdaq composite index had lost 78% of its value.

Whether we’ve reached a critical tipping point in markets today will be obvious only in hindsight, of course. For perspective, though, it’s worth remembering that some pessimists (or, as they often label themselves, realists) have been cautioning about hot markets in commodities, small-company stocks and foreign shares for two years or longer.

They will be right someday. But they have left a lot of money on the table by being too early in selling out or by refusing to get in.

At the core, what rocked markets last week was rising concern that the global economic expansion was in jeopardy. Two weeks ago, many investors were confident that the Federal Reserve was near the end of its credit-tightening campaign. Now, they aren’t so sure, after a surprisingly large increase in U.S. consumer prices in April fanned worries about inflation and how far the Fed would go to quash it.

If the central bank keeps pushing up short-term interest rates, the risk will grow that policymakers will go too far -- as they often have historically -- and trigger a U.S. recession that spills into the world economy.

If you expect a recession and declining corporate earnings, you aren’t going to be a stock market bull. Neither would you bet on commodities, because a recession could slash demand for raw materials.

Copper, one of the highest-flying commodities of the last few years, has fallen 10%, to $3.64 a pound in futures markets Friday, from its record high of $4.03 reached May 11.

But copper has been on a private moon shot this year, far removed from the fundamentals of supply and demand, said Peter Grandich, a commodities pro who writes the Grandich Letter in Perrineville, N.J.

“I believe it has been ignoring real fundamentals since above $2.50” a pound, he says.

In other words, don’t look to copper prices for an indication of what’s really happening in the industrial economy.

There is no sign that the U.S. economy overall is downshifting dramatically. Last week, the Conference Board said its index of leading economic indicators slipped 0.1% in April, which on its face was a worrisome signal. But the group also revised its March index to show an increase of 0.3% instead of the originally reported 0.1% decline.

“The current behavior of the leading index suggests economic growth should continue moderately in the near term,” the board said.

In Japan, an index of consumer sentiment rose in April to its highest level in two years, the government said last week. That’s important because one key reason to be optimistic about global growth this year is that Japan, still the world’s second-largest economy, is climbing out of a 15-year funk.

Could the Fed kill the expansion? It could. Or the bond market could do the deed, by driving long-term interest rates sharply higher.

The bond market is no longer the pushover it was in 2004 and 2005, when long-term U.S. Treasury bond yields remained remarkably low. Those yields jumped to four-year highs in recent weeks, even ahead of the April consumer inflation news last week.

But by late last week, after two regional Fed presidents talked tough on inflation, the 10-year Treasury note yield had retreated to 5.06% from 5.20% a week earlier.

It could be that some bond buyers are betting on a recession, which could be the fastest way to get yields down.

But let’s say recession fears are misplaced, the economy stays on a growth track and interest rates move higher. Can stocks rise even if rates do?

That’s exactly what has been happening for the last two years, so it wouldn’t be a novel occurrence.

Indeed, “we’re at the point of the economic cycle where stocks and interest rates typically rise together,” said John Bollinger, head of Bollinger Capital Management in Manhattan Beach and a veteran market analyst.

Investors usually have a hard time walking away from stocks for long if the economy is growing and corporate earnings are doing the same.

In the first quarter, operating earnings of the Standard & Poor’s 500 companies were up 14.1% from a year earlier, according to earnings tracker Thomson Financial. Excluding energy companies and their profit windfall, results for S&P; companies still grew at a double-digit rate -- 11.3%, Thomson says.

What’s more, many money managers question why a further modest increase in short- or long-term interest rates -- say, if the Fed goes from 5% on its key rate to 5.5% -- should end the economic expansion or the corporate profit boom.

“The cost of money is still pretty cheap,” says David Dreman, head of Dreman Value Management in Jersey City, N.J.

Somehow, the economy expanded through the late 1990s with a 10-year T-note yield well above 5% most of the time.

Dreman also makes a good point for people who are worried about inflation: If the trend in prices is up, stocks at least offer the potential for inflation protection via higher dividend payments.

Conventional bonds, on the other hand, are always inflation victims. Once you lock in a yield, you’re stuck with it.

As for stocks of emerging markets, the excitement over the long-term outlook for those economies hasn’t died. But investors are relearning how fast inherently risky markets can crumble when too many investors try to exit at once.

“It’s a very small door in the risky-asset theaters,” said Jeffrey Bronchick, chief investment officer at money manager Reed, Conner & Birdwell in Los Angeles.

Bronchick believes that the safest place for stock investors now is the blue-chip sector, which has lagged behind the rest of the market in this decade.

“What’s cheap are the big stocks that haven’t done anything in seven years,” he said. His list of favorites includes Wal-Mart Stores Inc. and cable TV giant Comcast Corp.

That theme has been frequently discussed on Wall Street over the last year. It may be finally winning more converts: The Dow Jones industrial average, at 11,144.06 on Friday, has pulled back 4.3% from its recent six-year high. By contrast, the Russell 2,000 small-stock index has tumbled 7.6% from its recent peak.

What, if anything, investors do with their portfolios at this juncture should depend on how confident they are in the economy and how much volatility they’re willing to contend with.

Those who believe they may be too laden with foreign and small stocks after the big gains of recent years might feel better about moving some money into blue chips, money market accounts or bonds.

Conversely, if you’ve been waiting for a pullback to buy foreign stocks, smaller issues and commodities, you’re getting that opportunity.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, visit latimes.com/petruno.