No Time for Defense

By Daniel Kadlec Tuesday, Mar. 25, 2003
    • ILLUSTRATION FOR TIME BY MICHAEL KLEIN

    Wartime investing isn't what it used to be. The Iraq war won't require any massive buildup of materiel that would stoke heavy industry and the profits of defense contractors. America's military might helped the conventional fighting go quickly in the war's early days. But the generals on Wall Street, expecting as much, have been shooting down defense stocks for months. Yet stocks overall tend to do well after the U.S. engages in hostilities, and this time should be no exception. The Dow ran up 8.4% last week — its best weekly gain in 20 years — and moved into positive territory for the year.

    Most stocks are expensive today, with an average price-earnings ratio of 19. But a quick military victory in Iraq, and a further celebratory surge in stock prices, would bolster consumer and business confidence and boost the sluggish economy. Alan Levenson, chief economist at fund company T. Rowe Price, expects a healthy annual growth rate of 3.5% in the second half of this year and 4% in 2004, assuming — as any bullish case must — that the war keeps going well and there is no major terror event. Byron Wien, chief U.S. market strategist at Morgan Stanley, says investors who wait for a stock pullback will be disappointed. "The economy has done remarkably well in the face of high oil prices, a cold winter and the geopolitical concerns," he says. "Take those away, and it should really improve." He predicts that the market will rise 10% in the next few months and hold the gains.


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    Business inventories are lean and will be rebuilt at the first whiff of resurgent demand, and there's a pent-up need for capital equipment — especially technology to boost productivity. Two-thirds of U.S. corporate financial officers say their firms are spending cautiously on capital goods — or not at all — because of the Iraq conflict, according to a survey by Financial Executives International, a trade group, and Duke University. Lift that cloud, and managers will spend.

    To be sure, the economy faces new problems like trade tensions, and old ones like heavy consumer debt. But investors have made a lot of bad decisions lately, and hunkering down now would be another one. Most money-market funds yield less than 1%, and after three strong years, bonds are vulnerable to rising interest rates. Yet those are two assets into which money has been flowing. The participation rate in 401(k) plans is the lowest in a decade, and those who are enrolled are contributing less.

    What should you do? Don't make any huge bets — do keep some cash on hand — but lighten up on bonds in favor of stocks. If you don't want to research individual stocks, invest in a low-cost, broad-based mutual fund like Vanguard Total Stock Market Index. For a more targeted approach, consider:

    OIL
    Crude prices are coming down sharply and should stabilize in the $20-$30 range, from a high three weeks ago of $37.78 per bbl. Friday's price was $26.91. This decline hurts Big Oil — ExxonMobil, ConocoPhilips — but parts of the transportation industry will benefit, especially truckers like Roadway and roadside lodging firms like Cendant, as travelers favor the road over the air. Avoid big airlines. Their cost structures require more business than they're likely to get anytime soon, and even JetBlue and Southwest will struggle. If you think firms like engineering giant Fluor can do well rebuilding Iraq's oilfields, you're right — but late. Fluor's shares have risen 64% since October.

    RETAIL
    As consumers regain confidence and enjoy more cash in their pockets through lower energy costs, they'll shop. Best bets in a still tepid economy are firms known for delivering value: Costco, Kohl's, Target, Wal-Mart.

    CAPITAL GOODS
    Tech will draw a lot of attention as companies invest in productivity. Computer chip — makers like Taiwan Semiconductor and Intel should benefit. And so should industrials like General Electric and DuPont.

    SAFE HAVENS
    Dividend-paying stocks like drugmakers Merck and Schering-Plough and utilities (Consolidated Edison, Southern Co.) should do well as investors tiptoe back into the safest stocks they can think of. Consider a yield-oriented stock fund like T. Rowe Price Capital Appreciation, which recently yielded 2% and gained 11% annually the past three years. If things go poorly for the U.S. in Iraq or elsewhere, this at least will provide some cushion and keep you in the game.

    FOREIGN
    They're riskier, but consider Israeli stocks — they have been pummeled on fears of Iraqi strikes. World-class Israeli companies like Check Point Software and Comverse would be bargains with a quick peace. Amidex Israel Technology fund is a direct tech play; for more diversification consider First Israel, a diversified closed-end fund traded in the U.S. Another region to consider is Asia, where emerging markets are fairly well insulated from the war. They will benefit quickly from falling oil prices, and they have great growth potential linked to that of the powerful Chinese economy.

    You can e-mail comments to Dan at danielkadlec@aol.com