Will Stocks Revisit 9/11 Lows?

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This isn't how it's supposed to work. The recession is over, so stocks should be going up. After every recession dating back to World War II, the S&P 500 has notched a double-digit gain in the ensuing year, with increases ranging from 11% to 37%. Nothing so upbeat seems to be happening today. The recession probably ended in December, but stocks have been sinking so persistently that many are approaching their post-9/11 lows.

The stock slide isn't so much about the economy, which grew at a heady though unsustainable 5.8% annualized rate in the first quarter. It's more a reflection of investor confidence, which was shattered by big losses and evidence that accountants and analysts endorsed companies they knew were rotten.

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The good news is that investors have shown they are willing to overlook the bad climate when specific company fundamentals improve. Last week tech giant Cisco reported a quarterly profit that was 1[cent] a share better than expected — and the market soared for a day. Especially encouraging were Cisco's wider profit margin and depleted inventory. But it will take a drumbeat of such news to turn around negative market psychology.

Despite the rally last Wednesday, the S&P 500 is down 8% for the year, the NASDAQ has fallen 18%, and the Dow is down 1%. None of the major averages have dropped to their September low, though the NASDAQ 100 (made up of the biggest stocks on that market, including Microsoft and Intel) is close. And already 1 in 8 stocks in the S&P 500 is below those September thresholds, including AOL Time Warner (which publishes TIME), Corning, EDS, Halliburton, IBM, Lilly, Merck and Verizon, reports Salomon Smith Barney.

Investor gloom may well overshadow improving economic fundamentals through the summer. "The market has not bottomed," asserts Woody Dorsey, editor of Market Semiotics. "Bottoms are always made on capitulations of some type, and one may be close at hand."

Not everyone is so gloomy. Barton Biggs, chief global strategist and longtime bear at Morgan Stanley, says the "lows should hold, but it will be scary." Richard Bernstein, market analyst at Merrill Lynch, expects the NASDAQ to drop to new lows. He sees the broader market avoiding that fate yet delivering subpar returns for the next few years. He and others are concerned that many stocks remain expensive relative to earnings. The S&P 500 trades at 28 times last year's earnings. A multiple of 18 to 20 would be normal coming out of a recession. Investors normally focus on future earnings. But those are tough to estimate in this choppy recovery, and it doesn't help that analysts and accountants are no longer trustworthy as guides.

Should you stay clear of stocks? No. But go slow, and be prepared for further losses before the market regains its footing. As ever, a rounded portfolio of individual stocks or mutual funds is best. For diversification at low cost, indexing is your best choice. To add stability to your portfolio, keep some bonds and cash or their equivalents (though not more than 15% cash, lest you miss a swift rebound). With interest rates likely to rise and push down bond prices, Treasury Inflation-Protection Securities, or tips, are a great choice. They guarantee you'll earn about 3% more than the inflation rate. Not bad when so many other things are falling.

Further up the risk spectrum, junk bonds can be an attractive option for picking up some income. The worst news on bankruptcies and defaults is already factored into junk-bond yields of 11% or more on many funds, which are the best way to invest here. But stay away from those laden with still troubled telecom bonds. Two quality junk-bond funds are Northeast Investors Trust and Pimco High Yield.

Those who like to pick stocks should stay with themes that have worked well this year. Stocks that tend to benefit from a recovery have risen, including industrials such as Boeing, Bandag, Cooper Industries and DuPont, all of which have trailing PEs of less than 19. But some, like power-systems giant Eaton, have become expensive. Even if rates rise, banks like Bank of America and Bank One, which have below-market PEs, should rise as loan demand and credit quality improve. And it may pay to think small. In general, small-cap and mid-cap companies have more attractive valuations. Focus on well-run mutual funds that invest in companies with market values of less than $5 billion. Two solid choices are CGM Focus and Armada Small Cap Value. Remember, eventually stocks will rally.

Questions? You can contact Dan at his e-mail address: Danielkadlec@aol.com