Where to invest now

Kiplinger's Personal Finance Magazine, Jan, 1998 by Manuel Schiffres

Greed is out and fear in as investors contemplate the prospects for 1998. An unusually large number of nettlesome issues is roiling world markets and bringing anxieties to the fore. Chief among them:

* Was the fast-as-lightning 11% fall in the stock market last autumn a sign that the bull market in stocks -- the longest-running in this century at more than seven years -- is tottering?

* Can U.S. companies -- facing slower economic growth, rising wages and the yet-to-be-determined fallout from Asia's currency crisis -- keep generating the higher profits that have fueled the rise in stock prices?

* Will individual investors -- the "little guys" that Wall Street professionals used to sneer at -- continue to come to the rescue of the market? Or will these millions of key players turn tail when one of the market's periodic 10% dips threatens to become something worse?

To the last question, David Steinberg responds with an emphatic "no." Steinberg, a 31-year-old newspaper editor in San Francisco, cannot conceive of the circumstance that would provoke him to unload the stock funds in his employer-sponsored 401(k) retirement plan or to cut back on the 15% of salary that he contributes to it annually. "This is money I can't touch for another 30 years, and I assume that the economy of this country will continue to go up," he says. "I can't see anything that would scare me out of the market."

Of course, whether Steinberg actually sticks to his plan in the face of a severe decline remains to be seen. Since 1990 individual investors have embraced stocks with fierce devotion. In fact, they have been conditioned by the market's relentless upward push to "buy on dips." Occasional, brief market declines appear to have been fueled by professional investors, as was the case in late 1997.

Yet there are limits to everything. Pete Caritis, a schoolteacher in Weirton, W.VA., has given notice that his affection for stocks isn't boundless. He has been contributing $9,500 per year to his 403(b) retirement program, investing it all in stock funds (he'll contribute $10,000 this year, the new maximum allowed). While acknowledging that it's impossible to time the markets, Caritis, 56, says he wants no part of a long-term downward trend and adds that he will switch to a more defensive position when this occurs. "I won't watch the market go down for six months to a year," he says. "I will move my money around."

If enough ordinary investors reach the same conclusion and join trigger-happy Wall Streeters in a selling barrage, that would mark a profound turning point. You can't rule it out, especially because most fund investors have never experienced a bear market -- that is, a drop of at least 20%.

But for the year ahead it's hard to envision a scenario that would cause investors to stampede out of stocks. We think the economic backdrop for 1998 will be similar to that of the past several years: moderate growth, modestly rising profits, quiescent inflation, long-term interest rates moving within a relatively narrow band but with a bias toward lower yields. "It's the ultimate Goldilocks scenario," says Susan Byrne, manager of Westwood Equity fund -- not too hot, not too cold, but just right.

Stocks, as always, are vulnerable to unpredictable, external shocks, such as war in the Middle East or an implosion of Asian economies, and with valuations as high as they are -- the market sells at 19 times estimated 1998 profits -- a calamity could cause stocks to swoon again. Otherwise, the just-right economy means that modest profit growth and mildly falling interest rates should set the stage for another winning year for the stock market.

* The expectation of stock strategists surveyed by First Call is that profits of companies in Standard & Poor's 500-stock index will rise 7%. Throw in the market's meager dividend yield of 1.7% and you get a total return approaching 10%. That assumes investors continue to attach the same value to earnings as they do now.

But stocks will likely get a boost from lower interest rates, which encourage investors to pay a higher price for each dollar of corporate profits. And that -- are you ready for this? -- would mean another year of double-digit gains for stocks, the fourth in a row.

* But suppose those earnings don't come in as forecast. Productivity improvements and lower interest rates may not offset slower economic growth, higher labor costs and the impact of a stronger dollar overseas. For instance, Robert Morris, director of equity investments at Lord Abbett & Co., sees profits growing not at all to no more than 5%. If he's right, the returns from big-company stocks may be flat, and the chances of a bear market are heightened.

Stocks of small companies should outpace those of larger ones. Small companies tend to be more U.S.-oriented and shouldn't feel the impact of the stronger dollar as much as their bigger brethren. Plus, they still seem to offer better value. According to First Call, the price-earnings ratio of the Russell 2000 index, which measures small-company-stock performance, is roughly the same as that of the S&P 500. Yet small stocks are expected to deliver more than twice the earnings growth of the large-stock-oriented S&P in 1998. For some specific small-stock choices, see the picks of two top-notch money managers in the boxes on pages 70 and 71.