How to Cope With This Market? Pick a Scenario

Do you have a bear-market investment strategy? Do you need one?

Those are certainly simple questions to pose, but probably difficult ones for many investors to answer immediately.

“What bear market?” some people may well ask. The Standard & Poor’s 500 index of blue-chip stocks rose for five straight years through 1999, and so far this year is down a mere 3.3%.

The average diversified U.S. stock fund, meanwhile, is down about 2% year-to-date.

With the Federal Reserve, which meets again on Tuesday, desperately trying to slow the economy with higher interest rates, this is the worst the stock market can do?

Investors who bought into the soaring technology stock sector in January or February, however, most probably have a different perspective on things. Their losses, if they’ve held on, may be somewhere in the 20%-to-50% range--a classic bear-market decline.

Last week, tech investors’ patience was tested again, as a further slump in many of the stocks pulled the Nasdaq composite index down 7.5% for the week to end Friday at 3,529.06. The broader market also lost ground, though the damage was modest compared with Nasdaq’s slide.

On the face of it, the tech sector’s plunge could be viewed as the first stage of a broader bear market yet to come.

But then, what do we call last year’s market? The S&P; index managed to gain 19.5% in 1999. Nasdaq rocketed 85.6%. Yet 68% of stocks on the New York Stock Exchange were down for the year.

One popular view among Wall Street pros is that a “stealth” bear market has been in progress since spring 1998, with most stocks faring poorly while a relative handful--until recently, mostly technology names--held up the main market indexes.

Plenty of investors with bleeding portfolios would probably concur with that. Even this year, despite the relatively modest net declines in most stock indexes, and despite the rallies in some beaten-down stock sectors since mid-March as money fled tech for “safer” ideas, 55 of 88 S&P; industry groups--about two-thirds--still show net losses since Jan. 1.

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It’s easier for market historians, and perhaps many investors, when bear markets are clean-cut affairs. Officially, it’s a bear market when major stock indexes such as the S&P; 500 , the Dow industrials and the Nasdaq composite fall more than 20% from their peaks.

The last time they all did so together was in 1990, after Iraq invaded Kuwait. It was a fairly easy decision to make, after Iraq’s move in early August of 1990, to temporarily abandon stocks on the premise that war was coming.

Today, investors looking for a simple premise on which to base their near-term investment strategy are most likely to focus on Wall Street’s old nemesis: the Fed.

If you’re struggling to decide what to do with new savings or your existing portfolio, start with these potential scenarios and ask yourself which comes closer to your current view:

* Scenario One: The Fed will raise interest rates several more times before it’s finished. On Tuesday, Fed Chairman Alan Greenspan is expected to preside over a half-point rate boost, to 6.5% in the central bank’s benchmark short-term interest rate, the federal funds rate.

That would be the sixth rate increase since June. But what if it’s only a prelude to a new series of rate hikes that lifts the Fed’s key rate to, say, 8% by autumn?

Many economists now expect that rate to be at 7.25% by November. But if they are underestimating inflationary pressures in the economy--or simply underestimating the economy’s ability to continue its boom--the Fed may well believe it has to get much more aggressive. And that could spell disaster for an already weakened stock market.

“If they get to 8%, that drives you to a bear-market conclusion,” says Robert Bissell, investment chief at Wells Capital Management in Los Angeles, who doesn’t expect the Fed to go that far.

Many tech stocks, still highly priced relative to underlying earnings, might be hammered worst if the Fed’s rate campaign intensifies.

Shares of banks and brokerages, whose businesses are in many cases far less vulnerable to higher interest rates than in the past, would probably take a hit anyway. Add home builders, appliance makers and, probably, auto makers to that at-risk group as well.

In fact, there may be few places to hide in the equity market if Wall Street is underestimating the Fed. One possibility, however, is the energy sector, already the best-performing sector this year--assuming that higher inflation is in part generated by higher energy costs.

But even if you’re very pessimistic about interest rates, think twice about selling out of your core stock holdings. Why? Because even though money-market funds and Treasury securities might begin to look more attractive as a place to stash cash, the danger of exiting equities entirely is that you will almost certainly fail to get back into stocks when the market finally turns. Instead, you’ll probably wait--and maybe far too long.

* Scenario Two: The Fed is nearly done raising interest rates. This is the scenario to which a majority of investment pros probably subscribe. It is the most bullish scenario, at least with regard to what many people see as the market’s biggest problem now, meaning the Fed.

Ben Hoch, senior investment manager at AIM Mutual Funds in Houston, argues that Greenspan is “a lot closer to the end of his [credit-tightening] cycle than the beginning.”

With inflation still relatively subdued, Hoch can’t fathom how Greenspan could justify a short-term interest rate above 7%. Even at 6.5%, the Fed’s rate would be the highest in nine years.

Hoch looks at the stock market this way: Many stocks have been falling, or lagging badly, since 1998. Since mid-March the last of the market’s high-fliers--tech stocks--have been blasted.

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If the Fed is nearly done, Hoch says, the market’s pattern since 1998 would suggest it’s more likely to be setting up for a rally than another sharp downturn.

What about those high stock valuations? “The average stock is not aggressively priced,” Hoch argues. Tech stocks still command premium price-to-earnings ratios, he allows, but look at the rest of the market, he says: There are many stocks with P/E ratios under 20, based on this year’s estimated earnings.

What’s more, Hoch points out that first-quarter earnings were stellar across many industry groups.

Bissell concurs. In this market, he says, “You’re getting the chance to buy many stocks at prices of two or three years ago.” He likes many of the consumer-products stocks that typically find favor in a slower-growing economy--which is, after all, what we’ll have to expect if the Fed is truly going to be done raising rates soon. McDonald’s, PepsiCo and Procter & Gamble are three names Bissell favors now.

Assuming interest rates are going to remain high for a while, Bissell worries about highly valued tech stocks. The biggest risk, he says, is not that the stocks will plummet drastically, but that they may simply move sideways, or trade in a narrow range, for a long time to come.

* Scenario Three: We’re headed for recession, no matter what the Fed does next. Few Wall Street pros buy into this scenario. But if you do, it’s the best reason to reconsider how much you have in stocks--or whether to add to holdings.

If a recession is coming, it could take down just about every stock sector. Most at risk would be heavily indebted companies. But it’s a fair bet many investors would grow pessimistic about corporate earnings across the board, and shy away from most stocks.

But note: This is the worst-case scenario. And so far, it seems too far-fetched to believe.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com

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Still Too Expensive?

Price-to-earnings ratios for most stock sectors are near historic highs, but by far the most expensive sector is technology. Meanwhile, six of 11 major Standard & Poor’s stock sectors are priced at 20 times expected 2000 earnings, or less. Average price-to-earnings ratios, based on estimated 2000 earnings per share, by S&P; sector:

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S&P; sector Average 2000 P/E Technology 53 Health care 28 Communication services 26 Capital goods 25 Consumer staples 25 Energy 20 Consumer cyclicals 19 Financials 15 Utilities 14 Basic materials 14 Transportation 12

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Note: Data as of end of April.

Source: Lehman Bros.

Winners and Losers This Year by Industry Group

Within the Standard & Poor’s 500 stock index, 55 of 88 stock industry groups are down year-to-date. The top performers, by far, are energy-related groups. On the downside, investors have found reasons to dump or ignore a broad cross-section of stock groups. A sampling of winners and losers:

Winners

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Avg. YTD Group change Natural gas +43.3% Oil-field services +41.9 Oil/gas drilling +41.2 Medical products +25.0 Semiconductors +24.4 HMOs +16.1 Entertainment +15.8 Drugs +14.4 Grocery stores +9.3 Multi-line insurance +6.0

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Losers*--*

Avg. YTD Group change Can/bottle makers -33.6% Hotels/motels -30.9 Computer software -26.3 Specialized services -26.1 Long-distance telecom -22.4 Paper/forest products -21.5 Publishing -18.0 Clothing retailers -14.2 Home building -8.1 Major banks -3.2

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Source: Bloomberg News