The Stock Market Takes It On The Chin

Nation's Business, Nov 1, 1998 by Randy Myers

Randy Myers, formerly a writer and editor for Dow Jones & Ca., Inc., is a financial writer in Dover, Pa.

Like a circus tiger turning on its trainer, a stock market that had seemed so tame for so long bared its fangs in the third quarter. In what might have been the prelude to the first bear market in eight years, the average domestic stock mutual fund fell 15.02 percent for the quarter, brought down by fears that tumbling economies in Asia and Russia would weaken others around the globe.

That loss more than erased all of the gains the average stock fund achieved in the first half of this year.

While some money managers are already scrounging through the rubble for bargains, the problems that triggered the market's decline-a near collapse of Russia's political and economic system, a severe recession in Japan, and imploding economies in many emerging markets--have yet to be resolved. That makes caution the watchword for prudent investors for at least the next quarter and perhaps for the next year.

"I think there's a high probability that the late August low [7,400 on the Dow Jones Industrial Average] will prove to be the low, but there will be a lot of chaos before we see any meaningful gains in the stock market," warns Don Hays, director of investment strategy for Wheat First Union, a brokerage firm based in Richmond, Va. "I don't expect a recession, but something that feels like it in much of the economy.

Hays notes that in September, for the first time in "quite a while," consumer confidence fell for a third consecutive month. Although confidence is still strong, Hays says his firm already expects the Christmas selling season to be weak.

Meanwhile, Wall Street analysts expect that profits for the nation's biggest companies probably fell, on a year-to-year basis, in the third quarter for the first time since 1991.

"We could continue to see declining profits on a year-to-year basis for the next three to four quarters," says Alan Levenson, chief economist for T. Rowe Price Associates, a Baltimore-based mutual-fund company. He says economic growth could come in at 2 percent to 2.5 percent for the third quarter, then will slow to below 2 percent for the fourth quarter and at least the first half of 1999.

Widespread Selling

Almost no segment of the stock market was immune to selling pressure in the latest quarter, but shares of small companies were clearly hurt the most as investors sought safety in blue-chip issues.

The average small-cap fund tracked by Lipper Analytical Services, a research firm in Summit, N.J., lost 21.52 percent in the third quarter. By contrast, funds that mimic the Standard & Poor's 500 index of big-company stocks lost 9.99 percent. (All performance figures include capital gains and reinvestment of dividends.)

Financial-services stocks were hit hard as investors worried that banks and brokerage firms would be stung by their exposure to customers in emerging markets overseas.

By far the best-performing stock funds were those that invest in gold stocks. Lipper calculates that they earned 4.3 percent on average in the third quarter. Funds that invest in utility-company stocks were the next-best performers, falling 1.4 percent on average.

Those figures aren't surprising. Gold is a traditional safe haven in times of turmoil, and utility stocks usually hold up well when the stock market and economy tumble.

Why? First, most utilities still operate in a monopoly environment, meaning that their earnings aren't pressured by competition when the economy slows. Second, because they are usually big borrowers, their debt-servicing costs decline when interest rates fall, as usually happens when the economy slows. Finally, most utilities pay hefty dividends, which can help to offset any decline in the value of their shares.

Escaping To Bonds

Of course, for some investors, no stock is defensive enough, not even a utility stock. That explains why billions of dollars were funneled out of the stock market in the third quarter and redeployed in the bond market, particularly in U.S. Treasury bonds.

Treasuries are widely perceived to be the safest, most secure investment in the world, and they turned in big gains in the third quarter as investors engaged in a classic "flight to quality."

Their frantic buying pushed the yield on the Treasury's bellwether 30-year long bond to 4.9 percent by the end of the quarter, the lowest level for long-term rates since 1967. (Interest rates go down as bond prices go up, and vice versa.)

Mutual funds that invest in long-term Treasury bonds had a great third quarter as a result, gaining an average of 4.85 percent.

The average taxable domestic bond fund didn't fare as well, earning just 1.36 percent, largely because corporate bonds didn't keep pace with Treasuries. Investors were worried that a slowing economy could jeopardize the ability of corporate issuers to repay their debt. Funds that invest in long-term corporate bonds earned 2.78 percent in the third quarter on average, according to Lipper Analytical, while those that invest in high-yield or 'junk" bonds lost 7.19 percent.