3 The long-awaited market correction may be here.
Some institutional investors, anticipating a correction, became more defensive even before the Federal Reserve boosted short-term interest rates, while a number of strategists now are telling clients to take more defensive positions.
Although one or two 7% to 10% market corrections wouldn't be unusual in a typical cyclical bull market, this has not been a typical bull market, said Chuck Zender, managing director at the Leuthold Group, an investment strategy and research group in Minneapolis.
This run-up has lasted longer than most (beginning in October 1990), has not lifted stock prices as much as most and has not seen any 7% to 10% corrections, he noted.
Also in a typical cyclical bull market, Mr. Zender said, the stock market gains 100%. This bull market has lifted stock prices only about 60%.
Not everyone has turned chilly on the markets. Early last week, Thomas Johnson, president of Tom Johnson Investment Management Inc., Oklahoma City, said he had "put some money in the market when stocks started falling" the previous week. And there was still "a little more buying" to do.
Robert Pharr, chief investment officer of Eastover Capital Management Inc., Charlotte, N.C., was looking to go back into the bond market "at any time." The firm's fixed-income portfolio has been 100% in cash since last fall.
But the preponderance of those queried by Pensions & Investments sense a late winter chill hovering over the marketplace. The widespread perception is the revival of economic growth in the United States, while beneficial to corporate profits, has spurred the Fed to thwart any would-be inflation. Further Fed tightening is expected - although not by everyone - to keep the economy on track and inflation-free.
"Salomon thinks the federal funds rate is on its way to 4% by June," said David Shulman, investment strategist for Salomon Brothers Inc., New York. That rate was 3.31% at press time.
The stock market's jittery response is what Mr. Shulman calls a "correction, not a bear market." But Salomon continues to believe the risk-reward ratio for equities remains generally unfavorable, and the firm is maintaining its recommended allocation of 45% equities, 30% bonds and 25% cash.
Two weeks ago, C.J. Lawrence/Deutsche Bank Securities in New York lowered its suggested stock allocation to 60% from 65%, raised cash to 15% from 10% and held bonds at a 25% exposure for balanced accounts.
"The bias is now toward tightening for the first time in years. Now it's an earnings ballgame" in the stock market, said Mark Spellman, portfolio strategist. "When you get a change like this, you get increasing volatility."
Foreseeing more Fed action soon, John Ryding, senior economist with Bear Stearns & Co., New York, recommends raising cash, since "both the bond and stock markets are vulnerable to a correction."
"Our forecast for long bonds is that they will rise to 7% to 7.5%," vs. 6.81% March 1.
Not surprisingly, some money managers said they had positioned themselves before the seeming correction began.
In mid-1993, M.D. Sass Investors Services Inc., New York, began acting on perceptions that interest rates were at or near their bottom, said Hugh Lamle, executive vice president. Key features: the firm opted for shorter-maturing bonds, and in the taxable area, increased its exposure to mortgage-backed securities while "gradually moving out of Treasuries," said Mr. Lamle. The firm saw good value in mortgage-backed securities, believing the mortgage pre-payment risk was diminishing, said Mr. Lamle.
While M.D. Sass undertook no major shifts in equities in the past six months, it has favored stocks that benefit from economic strength, such as U.S. automakers and consumer durables among other areas.
For several months, the $13 billion, in-house managed Tennessee Consolidated Retirement System, Nashville, has held about a 30% exposure to U.S. equities, the bottom end of its allocation range. In addition, the fund last year gradually switched to higher-quality bonds - choosing governments over corporates - and shortened durations to its benchmark 5.35 years, said Charles Webb, chief investment officer.
In February, as models suggested a neutral stance, PanAgora Asset Management, Boston, slashed its equity exposure to its benchmark posture of 60% from 95%.
If rates continue to rise, it's likely that equities will be further reduced. "But I hope to stay where we are," said Edgar Peters, asset allocation director of the $5 billion managed in a tactical asset allocation strategy at PanAgora.
Some investors have taken refuge abroad - which lately has proved fortuitous. Comparing total returns, the Morgan Stanley Capital International Europe Australasia Far East Index in dollar terms climbed 8.79% for the first two months of 1994 and 32.95% for calendar year 1993. On the other hand, the Standard & Poor's 500 Stock Index returned 0.59% for the first two months of this year and 10.1% for 1993.
For the past year, Bailard, Biehl & Kaiser, San Mateo, Calif., has been underweighted in U.S. markets. As Arthur Micheletti, chief economist and investment strategist pointed out, "the time to adjust is before something happens." The firm's allocation is 25% U.S. stocks, 30% foreign equities, 10% U.S. bonds, 20% international bonds and 15% real estate. As a result, the firm was able to "catch the rally abroad," said Mr. Micheletti.
Since Dec. 1, R.M. Leary & Co. Inc., Denver, which invests only in mutual funds, has been selling most of its aggressive growth U.S. equity funds and investing half those assets in money market funds and half in foreign stock funds. The last time R.M. Leary, which manages about $50 million, used international funds to such an extent was between 1985 and 1987, said Kate Lee, president.
What would it take for her to return to U.S. equities? Evidence "of improved corporate earnings and signs that the Fed would not be raising rates again," she said.
Of course, U.S. market cheerleaders are still audible, especially those awaiting higher earnings amid a strengthened U.S. economy. Robert Turner, chairman and chief investment officer of Turner Investment Partners Inc., Berwyn, Pa., is "definitely optimistic about the market and what individual stocks are telling us."
The perceived unattractiveness of bonds and money market instruments sustains interest in equities, even as corporate earnings should exceed expectations, he believes.
He points to the reported earnings of Deere & Co. as an example. For the company's fiscal quarter ended Jan. 31, Deere's earnings were $1.02 a share vs. 48 cents a year earlier.
Suresh Bhirud, president of Bhirud Associates, New York, isn't fearful of much higher rates, since he doesn't expect the Fed to tighten sharply. He believes "stocks are the only game in town right now. You (should) stick with equity here and you buy bonds on weakness," he said.
Nor is R. Stewart Eads, chief investment officer of Eads & Heald Investment Counsel, Atlanta, worried about Fed actions. "We think the increase in short rates is a shot across the bow of the economy to keep inflation sentiment under control," he said.
Turner Investment likes cyclical stocks, especially companies that have been diligent about controlling costs, and consumer stocks with European exposure - such as Procter & Gamble Co., Gillette Co., Clorox Co. and Colgate-Palmolive Co. - companies that have not only controlled costs but also should gain from the expected economic pick-up in Europe, Mr. Turner said.
He also likes long-distance telephone companies and electric utilities, but avoids most regional telephone companies. For the majority, he said, the prospects aren't glorious as competitive forces increase, even as local telephone business stagnates, he said.
Salomon Brothers also recommends cyclical stocks, especially those involved with capital spending and housing.
Among them: General Electric Co., Ingersoll-Rand Co., Eaton Corp. and Trinity Industries Inc. In housing, picks include Georgia-Pacific Corp., Centex Corp. and the Federal Home Loan Mortgage Corp.