Looking for the bottom

If you feel like a deep-sea diver plunging to new depths in this murky and perilous stock market, you've got lots of company.

Returns for equity mutual funds during the third quarter of 2002 were way down near the thermal vents and those odd-looking fish that give off their own light.

Stock funds dropped 17.5 percent in their worst quarter since the third quarter of last year. After that, you have to go back to 1987 to find a bleaker three-month stretch.

Now, if you were in bond funds, you had a little bouyancy. Most fixed-income funds returned profits. But stock funds – including some stalwart sectors of the year such as gold – sank. Only 89 of the 10,300 stock funds tracked by the financial- information company Lipper Inc. rose in value last quarter.

In fact, the only solid gainers for the quarter were "bear funds." These investment products attempt to profit from a slumping market by using complex investment strategies such as hedging and trading in derivatives.

Alas, analysts say, the downward drift in stocks is far from over. Last week saw some gain for equities. "But that could be a [short-term] bear-market rally," says Alan Ackerman, chief market strategist with financial services firm Fahnestock & Co., in New York.

"Bear-market rallies can be very sharp," Mr. Ackerman adds, but they usually prove illusory.

"We're now in a cycle of uncertainty that few investors have experienced before, [one] in which most traditional strategies don't seem to be working," Ackerman says.

Wall Street's woes include sagging investor confidence following corporate accounting and governing scandals, downward revisions in corporate-earnings estimates, high jobless claims, and an unwillingness by corporate leaders to boost capital spending.

Also hanging over the market is the specter of war with Iraq. Wall Street, which dislikes uncertainty more than any other factor, will not be able to let go of its inhibitions until the war issue is resolved one way or another, experts agree. (See story, page 14, on "war-proofing" a portfolio.)

For the quarter and the year, all major market indexes are down sharply. The Dow Jones Industrial Average finished down 17.9 percent for the quarter.

The Dow's 12.4 percent decline in September alone was the worst for that month since 1937.

What's troubling is that the market is now entering its most dangerous period, October and November, when every obscure rumor carries the possibility of triggering massive selloffs.

It now appears likely that 2002 will be the third year in a row of market losses – and, in fact, the worst three-year period in the past half century.

So again the question surfaces: Are we near some kind of bottom?

"Unfortunately, bottoms are proven out over time, usually taking three to nine months to round out a market. So it could be some time before we even know," says Larry Wachtel, a vice president and longtime market-watcher at investment house Prudential Securities Inc.

Areas that look promising, says Mr. Wachtel, include home-building and home-building supplies, refinancing companies, healthcare, hospital chains, pharmaceutical firms, and – perhaps a surprise to a lot of investors discouraged by the market – "big blue-chip firms that should do well during a recovery. This market requires just a lot of patience," Wachtel says.

"The market continues to be very risky right now," says Martin Vostry, an analyst with Lipper Inc., in Denver.

"The future direction of stock prices is now dependent on factors outside the stock market," he says, including the possibility of war as well as continued relatively high unemployment and the possibility of a drop in consumer spending as families hunker down.

"There have been few places to hide in this market," says James Stack, who publishes InvesTech, a newsletter.

Going forward, not all indicators are gloomy. Interest rates and inflation remain low. Valuations, such as price-to-earnings ratios, are fairly good by historical measurements. The p/e ratio of companies in the Standard & Poor's 500 Index is about 17 percent, based on future earning projections, notes Joe Tigue, managing editor of "The Outlook," a financial review published by S&P.

That figure is as low as it has been in "at least a couple of decades," he says.

In addition, Standard & Poor's has revised upward its asset-allocation model for all investors to accommodate more stocks, rising from 55 percent equities last summer to 60 percent now, Mr. Tigue notes.

S&P fills out the model with 15 percent of assets in bonds and 25 percent in cash.

"I'm always optimistic" laughs Mr. Tigue, who points out that he favors long-term investing to avoid the pitfalls of overreacting to adverse market news.

"Investors should always be in the market," he insists. That way, they will be well positioned when the market does finally rebound, he says.

Still, many investors shed their stock holdings during the third quarter, often moving into fixed-income instruments. (See story, page 16 and chart, page 14.)

In doing so, they were joined by investors from abroad, who also shifted to bonds, according to the Securities Industry Association, a trade group in New York.

But bonds can have downsides. Many bonds have already rung up tidy profits, says Mr. Vostry, of Lipper. If you are not already in a solid bond fund, you may be too late, he says.

Yet Vostry still likes US Treasury bonds (for their safety and decent yields), and high-quality corporate bonds. Examples of high-grade corporates: Ford and GE.

For those still committed to stocks, be certain to shop with care, says Ackerman of Fahnestock & Co.

"Look for companies with good cash flow, a high quality of management, brand uniqueness," and a record of riding out downturns, he says.

For his own personal portfolio, Tigue buys individual stocks through dividend reinvestment (DRIP) plans, where middleman – broker – costs are eliminated or very low. "[I've] been doing that for years," he says.

For mutual-fund holdings, he recommends index funds, especially those that track the entire stock market. "Look for funds with very low expense ratios, such as through Vanguard," he says.