Are You Prepared for a Steeper Down Spell?

By Tom Petruno

May 28, 2006 12 AM PT

Times Staff Writer

Can you afford a bear market?

Millions of investors wish they would have asked themselves that question seven years ago, before 2000-02 brought the worst decline in share prices since the 1930s.

Given the speed with which some stocks and mutual funds have dropped in recent weeks amid worries over interest rates and the economy, the market is forcing the issue again: How much pain can you endure?

Would your retirement or other life plans be threatened if your nest egg temporarily lost, say, 40% of its value? What about 20%?

With portfolio losses, the math can be killer. A drop of 30% requires a rebound of 43% on your principal just to get back to even. Give up 50% and you’d need a 100% gain to restore what you had before.

The problem with even starting this discussion is that it may be perceived as panic-mongering. It could be way premature to suggest that the current bull run is out of gas.

“Our opinion is that it’s not the top of a bull market,” said John Calamos, chairman of Calamos Asset Management in Naperville, Ill., and a 30-year market veteran. He expects the global economy to continue advancing, underpinning corporate earnings and stocks’ appeal relative to the alternatives.

By late last week, Calamos had plenty of company. The U.S. market began to turn up at midday Wednesday, and the comeback continued on Thursday and Friday.

The Dow Jones industrial average ended Friday at 11,278.61, up 1.2% for the week. Smaller stocks and foreign issues, which suffered much greater losses in the recent slump, also rebounded late last week.

Most investors haven’t given up much on paper. The Dow is off 3.1% from its six-year high set on May 10, and even at its closing low last Tuesday the index’s decline was just 4.7% from the high.

The Russell 2,000 small-stock index was down 9% from its May 5 peak to its close on Wednesday. By Friday the loss from the peak was cut to 6.7%.

What’s more, the average U.S. stock mutual fund still is up 3.7% for the year, according to Morningstar Inc. The average foreign fund is up 10.4%.

Nonetheless, for people who can’t bear the thought of losing a large chunk of the savings they’ve accumulated, the markets’ May turmoil should spur some introspection. That will require work: reviewing your entire portfolio and your asset allocation, that eye-glazing term that refers to how much money is in each different investment you own.

It has been easy for investors to simply stay on autopilot for the last three years. One reason why the latest stock sell-off may have seemed shocking is that broad market pullbacks have been so rare in this bull run, which began in October 2002.

A normal “correction” in an ongoing bull market can shave 10% to 15% off major stock indexes before they stabilize and resume climbing.

Yet the Standard & Poor’s 500 index hasn’t suffered a decline of 10% since early in 2003. And as with the Dow, the S&P; got only about halfway to a 10% drop at the worst of its slump last week.

What’s different about this month’s market slide is its velocity. The stock sectors that fell the most -- small-company issues and foreign shares -- in many cases declined much faster than they have in pullbacks of the last few years.

Given how fast they had gone up, particularly in the first four months of this year, the May dive in the hottest market sectors may just have been gravity at work.

John Augustine, chief investment strategist at Fifth Third Asset Management in Cincinnati, sees the flight from traditionally higher-risk markets as a natural reaction to uncertainty over the interest rate outlook.

A month ago, many investors figured the Federal Reserve was almost done raising rates. Since then, concerns about inflation pressures have raised the specter of the Fed continuing to tighten credit in the second half of the year to slow the economy and inflation.

“If the Fed is targeting growth, I want to get out of the riskiest assets” that depend on economic growth, Augustine said, explaining the losses in smaller stocks and foreign markets.

Yet Augustine, who helps manage $22 billion for clients, doesn’t believe the Fed will go too far and drive the economy into recession, which would be a sure catalyst for a bear market.

“In our eyes there’s too much momentum in this economy for a recession,” he said.

Still, he concedes that the bull market could be threatened even if the economy stays out of recession. One nightmare scenario: Growth continues, but at a much slower pace; at the same time, interest rates keep rising because of rising inflation.

James Stack, too, worries about what’s in store for inflation and interest rates, and whether the stock market can cope. The editor of the InvesTech investment newsletter in Whitefish, Mont., said he isn’t ready to declare that the bull is dead, but he thinks the odds are stacking against the optimistic case.

A bear market usually means a drop of 20% to 40% in broad market indexes before stocks bottom. Both historical triggers for bear markets are present, Stack said. One is inflation pressure. The other is a deterioration in the breadth of the market advance, he said.

The technology-dominated Nasdaq composite index peaked on April 19. The Russell 2,000 index followed on May 5. The 30-stock Dow made a final stab at a record high on May 10, and failed.

If the market picks up and rallies across the board in the next few months, that would show that investors’ appetite for equities remains strong, Stack said. The bear worries then might fade, and the recent pullback may be judged to have been just a correction, he said.

Even so, he is playing it safer: His clients’ accounts now are 30% to 40% in cash, Stack said.

“I think the market in the next 12 to 18 months should be treated with a high degree of caution,” he said.

If you’re satisfied that you have a well-diversified portfolio, but you’re still nervous that the stock market could be headed for a sustained decline, the best strategy may be to follow Stack’s lead: Sell some of your biggest stock winners of recent years and build a larger cash cushion.

Nobody ever went broke taking a profit, after all. And the returns on cash today are far better than they were a couple of years ago. The average annualized money market fund yield is about 4.4% now.

In a jittery market, having cash “makes sleeping at night a whole lot easier,” Stack said.

Just be careful not to overdo it: No matter how old you are, you’re going to need some growth investments in your portfolio for the long run. For most people, that means stocks.

To be totally out of equities would spare you the pain of the next bear market.

But can you afford to miss the next bull market?

(BEGIN TEXT OF INFOBOX)

‘Correction,’ or bear’s first growl?

Global stock markets bounced back late last week, trimming their losses from the recent sell-off.

Key indexes’ declines, through Friday, from their recent highs

U.S. indexes

Dow industrials: -3.1%

S&P; 500: -3.4%

Russell 2,000 (small stocks): -6.7%

Nasdaq composite: -6.8%

Foreign indexes*