Investing in a Manic-Depressive Stock Market

With the stock market staging a sharp rebound from its summer-time selloff, there’s hope that the worst is over. But there are plenty of land mines ahead.

Sean Kelly

Stocks have staged a swift comeback in October following the 12% drop in the Dow Jones Industrial Average during the third quarter. Since hitting its 2011 low on Oct. 3, the Dow has bounced back 11%. For the week, the Dow was up 1.4%. The Standard Poor’s 500-stock index finished 1.1% higher, while the Nasdaq was off 1.1%.

To some degree, investors are caught in a tug of war. On the positive side, the U.S. economy seems to be avoiding recession and instead is muddling along in a slow-growth mode that could be supportive for stocks. Corporate earnings have remained robust.

 But Europe remains on the precipice of financial turmoil and recession. Until the debt crisis is decisively dealt with, it could be tough for stocks anywhere around the world to enjoy any kind of sustained gains. Furthermore, markets are likely to remain exceptionally volatile—taking investors through the kind of wild ride seen over the past few months.

 The Dow has moved up or down more than 1% on 43 days since June 30—the kind of frequent big swings not seen since the worst of the 2008-2009 financial crisis.

First, Europe

This weekend, European officials are gathering as part of critical meetings to again try to move closer to ending the nearly two-year-old debt crisis. “Europe is the story—everything else is a sideshow,” says Robert Doll, chief equity strategist at money manager BlackRock. “No matter what we get this weekend, it’s not the end of the story. There’s still a lot of work left to do.”

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It’s not just the saga in Europe that presents potential trouble spots for stock investors. Next month, the budget mess in the U.S. will be back in the limelight as the congressional supercommittee faces a Nov. 23 deadline to come up with massive cuts to the federal deficit. And in the background are worries about China’s economy and financial system.

Fueling the stock market’s rebound has been a run of news on the U.S. economy that came in much better than economists had predicted. That included a stronger-than-expected report on the jobs market for September, buoyant retail sales and perkier-than-anticipated news on manufacturing.

“We’ve had a pretty nice stack of good news,” says Liz Ann Sonders, chief investment strategist at Charles Schwab.

These reports helped soothe fears that the U.S. economy was about to slide back into recession. “Saying that the U.S. isn’t likely to have a recession is easier to say [now] than two weeks ago,” says Mr. Doll.

Not only have the data come in better than expected, he says, but as BlackRock analysts talk to companies, “through this period, they’re saying ‘My business is OK.’ “

Ironically, the ability of the U.S. to avoid recession—usually defined as two consecutive quarters of declining economic activity—may be that much of the economy never recovered from the 2008-2009 downturn.

Housing and autos, for example, “are still in the basement,” notes Mr. Doll. Meanwhile, “corporations don’t have excess inventories and don’t have excess workers. In fact, that’s why corporate earnings have been so much better than the economy.”

Muted Optimism

But investors shouldn’t get too exuberant about the outlook for the U.S. economy. “None of the [recent data] suggest a booming economy,” says Schwab’s Ms. Sonders. “They just point against a recession.”

Unfortunately, the mess in Europe presents real risks. With the crisis approaching the end of its second year, European officials are struggling to find a way to manage the fact that Greece is basically broke and unable to pay its debts.

The big economies of Spain and Italy remain threatened by spillover from Greece. And Europe’s largest banks face big losses on holdings of Greek and other European government debt.

The fresh challenge is that the crisis is finally taking its toll on Europe’s economy and many economists believe a recession on the continent is imminent. Even if Europe avoids an actual downturn, efforts by governments to slash spending mean growth is likely to remain extremely weak for some time.

This is no small matter for even U.S. stocks, says Vadim Zlotnikov, chief market strategist at AllianceBernstein Investments. Roughly 20% to 25% of the profits earned by companies in the SP 500 come from Europe, he says.

“If you don’t have a resolution in Europe, or the resolution is an extremely painful one…it would not only affect U.S. companies’ earnings, it would cause a faster deceleration of the economy in China and put additional downward pressure on commodities,” he says.

As long as Europe avoids the crash-and-burn scenario, Schwab’s Ms. Sonders says U.S. stocks could actually do relatively well even if the U.S. is in a muddle-though economy.

A slow-growth environment “tends to offer fairly consistent returns,” she says. Expecting that kind of slow-growth landscape, Ms. Sonders likes technology, thanks in part to continuing business investment, and industrial stocks, for their strong balance sheets and expected pickup in capital spending. She expects defensive sectors, such as consumer staples and utilities, to underperform in an environment where investors feel more comfortable with the stock market.

Cash Is King

BlackRock’s Mr. Doll thinks in the near term, the stock market will be stuck bouncing back and forth until there is clarity on Europe.

Apple (APPL), Microsoft (MSFT), Phillip Morris International (PM) and Exxon Mobil (XOM).

Mr. Zlotnikov at AllianceBernstein also leans toward companies with strong cash flows, but he worries it’s too much of a popular trade. He prefers to balance out a portfolio with cheaper cyclical stocks, such as those in the semiconductor capital-equipment industry, media, autos and housing.

In a manic-depressive environment, where the market swings back and forth between hope and fear, the strategy is to harvest profits when one side of the portfolio gains and put it into the portion that is lagging. That side should then gain when sentiment shifts. “Then you should do OK almost irrespective of the market,” Mr. Zlotnikov says.

Write to Tom Lauricella at [email protected]

Article source: http://online.wsj.com/article/SB10001424052970204485304576642960176415644.html

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