Expect the Best--but Be Prepared

So the U.S. economy continues to grow and generate more jobs.

This is bad?

The major event in financial markets in the first quarter was the February employment report released on March 8. News that 705,000 jobs were created in February so shocked Wall Street that long-term bond yields jumped to seven-month highs and the Dow industrial average tumbled 3% in a matter of hours.

By now, most individual investors understand the markets’ paranoia about economic growth: If it’s too fast, inflation might revive, the Federal Reserve Board might tighten credit, production bottlenecks might occur, etc., etc.

Yet most people also understand that it’s economic growth that ultimately makes the stock market a winning investment: Over time, growth means higher business sales and, usually, higher business profits and dividends.

Nobody ever invests in stocks, after all, hoping for no growth.

It’s probably not just happenstance, then, that stocks largely recovered from the March 8 dive, even though the bond market did not. The February employment report, even if overstated (as some analysts argued), seemed to make clear that the economy was not about to fall into recession. So why sell stocks?

The Standard & Poor’s index of 500 blue-chip stocks gained 4.8% in the first quarter, adding to last year’s stunning 34.1% rise. The Dow jumped 9.2% in the quarter.

But can that same growth-is-good mentality toward the market prevail this spring, and for the rest of 1996? There are, as usual, a million ifs. Among them: if bond yields don’t rise much more; if inflation stays subdued; if corporate earnings remain robust.

Rather than try to predict the future, some experts suggest a pragmatic approach toward stocks now: Invest with the expectation of economic growth, because that is the norm, not the aberration. But also think about what could go wrong for this aging bull market--they all eventually stumble--and how you would react.

The bullish case for stocks is much the same as what has prevailed since 1991. The economy has grown since then, mostly at a moderate pace. Corporate earnings have risen. If that trend persists, stocks--or many of them, anyway--have continuing appeal.

In 1991, health-care giant Johnson & Johnson earned $2.20 a share. This year it should earn about twice as much. Little wonder that J&J; stock is now at $92.25, or double its 1991 median price.

It hasn’t been straight up for J&J; stock, however; in fact, the price went nowhere between 1992 and 1994, even though earnings advanced steadily. But investors who five years ago bet on the company’s long-term growth have been rewarded for staying put.

Many Wall Street pros, surveying the U.S. economy, say they can’t find a good reason to fear a cessation of the 5-year-old expansion. They cite American companies’ financial strength, continued job growth, and interest rates well below levels of the 1980s.

“I think we are very much in an elongated business cycle,” says Philip Orlando, investment chief at Value Line Asset Management in New York.

Allen Sinai, chief economist for brokerage Lehman Bros. in Boston, calls the current economic picture “as well-balanced an expansion as we’ve ever had in U.S. history.”

Moreover, some veteran investors argue that the relative speed with which the integrated global economy and the markets react to fix “imbalances”--in commodity prices, say, or interest rates--helps keep things on an even keel.

“I think the problem many people have is that they keep thinking in terms of boom or bust” for the economy, says Robert Bissell, senior vice president of Wells Fargo’s $55-billion-asset stock management unit. “We reject the idea of either a boom or a bust.”

Yet other pros say an aging economic expansion is bound to begin developing dangerous excesses. Some say the best example is the rise and fall of the semiconductor business over the past 12 months, riding a surge, then an abrupt slowing, of demand for personal computers.

Likewise, the rapid buildup of consumer debt over the past few years has sparked fears of soaring delinquency rates and a collapse of consumer spending as many Americans finally come to grips with their debt burdens.

Charles Clough, chief strategist at Merrill Lynch & Co., says worrisome consumer debt levels are a big reason he believes that, despite the February employment report, “the risk of recession is high.”

Even without a true recession, he argues that corporate earnings have peaked in this expansion and will fall with a weaker economy.

If investors have been buying stocks on specific short-term assumptions about earnings growth, Clough’s scenario obviously could be devastating for stock prices.

At current prices, the average blue-chip stock in the S&P; 500 index is priced at about 15.5 times analysts’ consensus per-share estimate for 1996 operating earnings (i.e., earnings before one-time write-offs), according to earnings tracker IBES Inc. in New York. That is not far above stocks’ historical average price-to-earnings ratio, or P-E, of about 14.

But if blue-chip earnings overall remain flat this year with last year’s level, the S&P; index’s P-E ratio rises to 17.2, historically well above average. And if earnings decline, as Clough expects, the P-E ratio begins to approach 20--a level that historically has often signaled the onset of a bear market.

The central point that many bearish analysts make today is that they believe there is no room for error in the outlook for the economy or stocks, after more than five years of growth and with blue-chip stocks last year having recorded their biggest one-year price gains since 1958.

Certainly the issue of risk is paramount. If, for whatever reason, the stock market were to fall dramatically, perhaps losing as much as 40% of its value, are you so heavily invested in stocks that your net worth would be severely damaged? Would you be able to ride out a decline of that magnitude even if you had to wait many years just to get to even?

If the answer is no--and for some pre-retirees, for example, that may indeed be the reality--you have several options. You can sell a portion (perhaps 25%) of your stocks and build a cash buffer or invest the proceeds in, say, three-year U.S. Treasury notes that yield about 5.9% and guarantee your principal back.

Or you can trade some of your general U.S. stocks for investments that might function as “hedges” against a market decline: foreign stocks, commodity-related securities (gold or energy stocks) or real-estate-related securities.

But the danger in becoming too caught up in bearish market talk is that you can forget why you’re in stocks to begin with: to profit from the economy’s long-term growth, regardless of the inevitable hiccups and periodic bear markets.

This bull market, which began in October 1990, has lifted the Dow Jones industrials from 2,360 to 5,587 currently, or 137%. But it has hardly been a cakewalk.

Drug stocks suffered their own private bear market in 1992-1993; auto stocks collapsed in 1994; since last fall technology stocks have plunged. But none of these sector gyrations has been enough to derail the bull market for long.

Why not? As Wells’ Bissell noted, the market has continually cleaned up its own internal excesses while being broadly underpinned by the growing economy.

Yet as the February employment report demonstrated, the stock market’s fear of recession is rivaled only by its fear of too-fast growth that fuels rising inflation and rising interest rates.

This spring, if economic data continue to point to a revival, the demonization of growth is likely to resurge--especially if there is upward pressure on annual wage increases from the 2%-to-3% (or less) range of recent years.

Indeed, there may be no more contentious issue in America today: Most workers think they deserve better wage increases than they’ve gotten lately, as corporate downsizing has held wages hostage.

Yet Wall Street is petrified of faster wage growth, because the implication could be higher inflation and higher interest rates. Federal Reserve Board Chairman Alan Greenspan helped send bond yields back up to near seven-month highs last week by publicly warning of early wage-acceleration signs.

Moreover, some economists see the threat of heftier wage increases, and the general public resentment over continued corporate cost cutting, as removing a key prop from the bull market.

“It’s safe to assume that the days of open-ended corporate restructuring are now over,” declares Stephen S. Roach, economist at Morgan Stanley & Co. in New York. If corporate devotion to cost control wanes, “that spells nothing but trouble for the low-inflation, expanding-profit-margin scenario that has produced the extraordinary bull runs in bonds and stocks in the 1990s,” he argues.

The bull market dies because some Americans earn slightly bigger paychecks? That may be hard for many investors to fathom.

After all, higher incomes would end up in one of two places: in the economy, helping to sustain growth and probably without fueling much inflation (if 1994’s brisk economic growth/low inflation experience is any guide); or in investments, as aging baby boomers save more. Directly or indirectly, Corporate America would benefit.

The point worth remembering is that, despite many challenges, phony inflation scares and an interest-rate roller-coaster, the stock market since 1990 has fulfilled its promise of sharing the wealth generated by a growing economy. More important, it has fulfilled that promise over any long period of time in this century.

You own stocks for growth. And fortunately, that’s the economy’s usual mode.