AFTER YEARS OF PALTRY YIELDS in savings accounts, certificates of deposit, and money market funds, cash finally flexed its muscles in the first half of 2006. As we moved into fall, you could have earned better than 5 percent in online savings accounts and money market mutual funds. Top-yielding six-month certificates of deposit had broken through the 5.5 percent barrier, risk free. That’s awfully enticing, particularly compared with stocks, which on average crawled into the second half of the year with almost nothing to show for the ups and downs that had toyed with investors since January.
So what’s ahead in the final months of 2006 ... and into next year?
First, we at Kiplinger do not foresee a recession, despite preliminary estimates showing that economic growth slowed abruptly in the second quarter. A sharp dip in the pace of growth — an annualized rate of 5.6 percent in the first quarter dropped to an estimated 2.5 percent in the second — isn’t unusual after a growth spike such as we saw in early 2006. There’s no reason to assume that third-quarter growth will suffer another significant pullback. In fact, we’re looking for growth in gross domestic product (GDP) to average just a tad below 3 percent in the current half, which would leave GDP up 3.4 percent for the year. That’s actually faster than the increase for 2005. Next year, the pace is likely to slow to around 2.5 percent — still not too shabby for the sixth year of this economic expansion.
A slowdown in growth is not necessarily all bad, either. It means the Federal Reserve Board can finally stop raising interest rates. If history is any guide, in fact, by next spring, the Fed may feel the need to reverse course and start cutting rates. If the pause in rate hikes is music to the ears of the stock and bond markets, the return of rate cuts could be a full-fledged symphony.
GO FOR QUALITY
But let’s not kid ourselves. There are plenty of reasons for investors to be on edge. So what’s a prudent way to move ahead in this environment? Simple: focus on quality. Why add to the risk by taking unnecessary chances? It also makes sense to shift some money from small-company stocks and mutual funds to large-company stocks and funds. Pay special attention to dividend-paying stocks and the funds that specialize in investing in them. Investing globally makes more sense than ever too. Here, we prefer funds that focus on developed markets rather than emerging markets.
The economic and stock market recoveries of the past few years shed important light on today’s landscape. Typically, small-company stocks perform well in the early stages of a rebound because, among other things, it takes less capital to move these stocks. As a result of their healthy run, the price/earnings ratio of small-company stocks relative to large-company issues has risen to its highest level in more than 20 years. This has left large-company stocks cheaply priced by several measures. The Standard & Poor’s 500 index price/earnings ratio of 14 is about half its average over the past 10 years.
High-quality large-company stocks present attractive opportunities. But what are “quality” stocks? They are shares of companies with solid balance sheets; strong, consistent growth in earnings and cash flow; and the ability to hold steady and even expand in a flagging economy. Many of these firms steadily raise dividends and do substantial business overseas. A good chunk are found in sectors such as consumer staples and health care, which do well in both good and bad times.
Alan Skrainka, chief investment strategist at Edward Jones, believes companies that regularly boost their dividends should perform well in the current climate. He says the record shows that since 1972, dividend-paying stocks returned 10 percent annualized, compared with just 4 percent for stocks that don’t pay dividends. Even better: Companies with a pattern of raising dividends returned about 11 percent a year.
THE CASE FOR FOREIGN STOCKS
This is no time to turn your back on overseas markets. For one thing, the long-term trend for the dollar is almost certainly down because of the nation’s yawning trade and budget deficits. Dan Fuss, the ace bond manager at Loomis Sayles, thinks that over the long term, expanding budget deficits will drive up inflation and cheapen U.S. currency. Buying foreign stocks is one way to take advantage of the falling dollar because money you invest in firms priced in yen, euros, and the like gets translated back into more greenbacks.
In addition, many of the best companies, with the best growth prospects, are based abroad. Jeremy Siegel of the University of Pennsylvania’s Wharton School, author of The Future for Investors (and a Kiplinger’s columnist), recommends that U.S. investors place 20 percent to 40 percent of their stock holdings in overseas investments.
THE BEAUTY OF BONDS
One obviously smart move for the first half of 2006 was to keep maturities on your fixed-income investments as short as possible. At 5 percent, savings accounts at online banks and money market mutual funds have been yielding close to the payout on a 10-year Treasury note. There’s been little payoff for extending maturities, and rising rates during the first half of the year ate away at principal. But that will change.
According to Lord, Abbett & Co., when the Fed stops raising rates after a prolonged series of hikes, longer-term bonds rally like crazy (as measured by the Lehman Brothers bond index). Lord, Abbett cites five 24-month periods starting with the month of the final Fed increase. During those periods, the Lehman index earned annualized returns of 9 percent, 11 percent, 12 percent, 21 percent, and 23 percent — not too bad when you consider that you can earn this in high-quality bonds or bond funds.
As always, a carefully selected mix of stocks, bonds, and cash is the key to your success. Kiplinger’s believes that most investors are best served by the professional management and diversification delivered by no-load mutual funds. It’s a good time to review your portfolio to see if your desired asset allocation has gotten out of whack. If so, it may be time to rebalance.
— Kevin McCormally
