October 2008

Nice guys finish last, baseball manager Leo Durocher once said. But good companies may enjoy a much better fate.

Although, as of this writing, economic and market conditions remain unsettled and uncertain, it’s not too early to begin thinking about positioning for a potential turnaround. When the market does begin to rise, it can rise fast, so you want to be ready.

In August 1982, interest rates were in the double digits, jobs were scarce, and the U.S. economy was in the throes of a nasty recession.

So what happened next?

That month, stocks hit bottom and embarked on the greatest bull market of the 20th century, one that would take prices higher by almost 1,400 percent over the next 18 years.

Few experts predict a reprise of those glory days any time soon. The current credit crunch has created significant liquidity issues in the financial markets. In addition, economic conditions are much different today. Ironically, they’re actually better, because inflation and unemployment are lower. But stocks aren’t as cheap now, either. And the outlook for key areas like housing, energy and banking is murkier.

Normal pattern
Though the jury is still out on whether the U.S. economy is in a formal recession, there is no doubt that a significant slowdown is underway.

Not surprisingly, stocks have tracked the downward trajectory of economic growth, slipping into the first bear market (generally defined as a drop of 20 percent) in almost five years.

But recessions don’t go on forever. There have been 10 recessions since World War II, with the average lasting a little less than a year. However, consensus is that this one may last longer.

Stocks anticipate the economy’s direction, falling sharply before a recession starts and during its first several months, then begin a recovery well in advance of an economic upturn.

In fact, stocks typically peak about seven months before the economy heads south and start a new bull market roughly five months before the recession ends.

Merging traffic
So with some analysts predicting a pickup in economic activity later next year, is it time to position your portfolio in the fast lane?

“Now is a good time to check your rearview mirror and prepare to turn on your blinker,” says Peter Jacobs, Northern Trust senior vice president and mutual fund product manager. “But I don’t recommend making any sudden or dramatic moves.”

In recent months, many investors have tried to rev up their portfolios in anticipation of a bull market, only to find the passing lane taken away quickly amid a bevy of orange construction barrels.

“No one knows what’s going to happen to the economy in the short run,” Jacobs says, “It’s counterproductive to make investment decisions based on forecasts that might not work out.”

Yet Jacobs acknowledges that dogging it in the right-hand lane carries its own set of risks.

“Being too cautious can be expensive in a different way,” he says. “Bull markets are very profitable and a lot of the gains often come during the first year.”

Historical data confirms that being in the slow lane when the bull run begins can be an expensive mistake.

According to Ned Davis Research, U.S. stocks shot up by an average of 15 percent during the first three months of the 10 post-recession bull markets since 1945. After six months, the average gain was 24 percent, and after 12 months it was 32 percent.

In other words, stocks already were up by almost one-third before the recession was even over. That’s why some famous investors like to buy straw hats in winter.

But averages can be misleading. Some bull markets begin with a whimper, others with a bang. In 1982, stocks jumped 38 percent during the first three months of a new bull market. Yet in 1990, the initial three-month gain was a relatively meager 7 percent.

Playing it safe
Given the uncertainty over the economic outlook, Jacobs advises that investors step back, take a deep breath, and assess whether their portfolios are positioned for the next bull run, whenever it starts.

“It’s important to make a financial plan, a road map that tells you where you’re going and how you’re going to get there,” he says. “And now is a perfect time to do it.”

The centerpiece of your financial plan should be your target asset allocation ratio, or how money is divided between stocks, bonds and cash. Your age, employment situation, liquidity needs and risk tolerance all are factors to consider in setting your allocation.

But there’s no one single route that gets everyone to the financial promised land. One person’s road to riches could be another investor’s dead end.

For example, some experts recommend a roughly 60 percent-35 percent-5 percent split between stocks, bonds and cash for a middle-aged individual with 15 to 20 years remaining in the workforce. But if you are insecure about your job or facing a raft of bills, those numbers might be too aggressive.

“You don’t want to be forced to sell stocks during a bear market just to raise money for an expense that could have been foreseen,” Jacobs says.

Nervous drivers
In addition, some people aren’t comfortable with the volatility that usually comes with heavy exposure to stocks. They check financial web sites daily (or hourly) and fight the urge to trade too much when prices fluctuate.

Volatility tends to be highest during periods of uncertainty about the economy — like now.

“You have to be able to sleep at night,” Jacobs says. “Even if all the textbooks say you should have X amount in stocks given your age and various other factors, you should pull back if you’re not comfortable.”

And if you’re the type of investor who doesn’t worry about short-term fluctuations, “Then you can tolerate more risk,” Jacobs says, “which probably will translate into higher returns over time.”

Jacobs recommends talking with your relationship manager about custom fitting a target asset allocation ratio that satisfies your head and stomach, as well as your wallet.

Speed bump
Once you have your target asset allocation set, the investment portion of your plan is ready to go. The next step is to bring your portfolio in line with the numbers. In the lingo of Wall Street, that’s called rebalancing.

Chances are good that you’ll have a lot of rebalancing to do.

Asset classes don’t usually move in lockstep. So even if you established an asset allocation ratio recently, it still might require some tinkering.

But move slowly. You don’t have to fix things overnight.

If your holdings have strayed quite a distance from your target allocation, it’s usually best to address the problem in several stages over many months. That’s because periods of extreme volatility increase the chances that your timing will be all wrong.

“If you move all at once, you run the risk of shifting just when the market has made a major move in either direction,” says Jacobs. “You can mitigate the impact of volatility by moving gradually.”

Avoid shifting money on days when volatility might be high, such as when the Federal Reserve meets or when employment numbers are announced on the first Friday of each month. Days when inflation figures are released often are turbulent as well.

“There are obvious events that can cause big waves in the market,” Jacobs says. “We know what those are so they can be avoided. The worst thing you can do is to try to anticipate what the numbers will be and trade in advance of them.”

Lead change
Within an overall allocation to stocks, some investors like to emphasize certain sectors at different points of a market cycle.

And while every bear-to-bull transition has many unique aspects, there are some clear patterns as well.

For example, cyclical industries like financials, information technology, industrials, consumer discretionary, and materials tend to fall the fastest in the final stage of a market decline.

During the last three months of the last 10 bear markets, those sectors tumbled by an average of 17.6 percent, compared to a decline of 8.8 percent for the five best-performing sectors. Yet those same laggards morphed into market leaders during the early days of the ensuing rally.

Over the first three months of the new bull market, for instance, information technology stocks soared an average of 27.7 percent, beating the S&P 500 a whopping 80 percent of the time. Each of the other four cyclical industries noted earlier also gained more than 20 percent, handily beating the return of non-cyclical industries like utilities, consumer staples and health care.

Other distinctions can be made as well.

Small stocks often lag behind their large-cap counterparts during the final down-leg of a bear market, then outperform when the bull returns. Similarly, value stocks tend to fare worst in the final days of the bear market and then do best when a new bull market is born.

Slippery road
All of which begs the question: When will the next bull market begin?

“No one knows,” says Jacobs. “That’s why we recommend being very careful about placing big sector bets based on where we might be in the economic or bear-bull cycle.”

Besides the unreliability of short-term forecasts, the economic and financial system liquidity environment is so different today that old patterns might not hold.

In the 1970s and early ’80s, bear markets usually ended when the Federal Reserve became satisfied that inflation was under control. That caused interest rates to fall, sending a torrent of money gushing into the equity market and propelling prices upward.

That hasn’t been the pattern recently.

Over the last decade, asset prices have been distorted by bubbles in technology and housing, the latter of which has impaired the ability of banks to lend.

Given the heightened risks to the financial system, the Fed has kept interest rates low, thus removing a reliable leading indicator of economic growth — and the stock market’s future direction.

In fact, the unusually sluggish start noted earlier to the 1990 bull market may have been related to problems in the savings and loan industry. Those difficulties also caused credit to remain tight for an extended period. This may be happening again now.

“Even professional investors struggle to time sector rotations correctly,” Jacobs says. “Most individual investors just don’t have the time or experience to do it well.”

Ease in
So with the dawn of the next bull market unclear, what’s an investor to do?

Above all, Jacobs recommends keeping a long-term perspective and maximizing diversification.

“Make sure you have exposure to all sectors of the market,” he says. “If you diversify as much as possible and don’t make any rash moves, you should be fine over time.”

So look over your shoulder and be prepared to turn on your blinker.