Friday, November 27, 1998

Now is a good time to consider the market risk

By FRANK A. JONES

Scripps Howard News Service

The stock market is only distantly related to economics. It's a function of greed, apprehension and panic, all superimposed on the business cycle. - Raymond F. DeVoe Jr.

What a market! I am completely awed and amazed by the strength of the rebound in stock prices since a testing of the lows on Oct. 8. And the greatest surge was in the smaller company stocks that have been so hard hit this year.

I'm certainly not complaining. I just didn't anticipate such a fast and broad market surge. My mood has changed, my clients are happier, the office is once again a pleasant place. It is simply more fun in the financial world when the market goes up.

The Dow Jones Industrial Average has shown a spectacular "round-trip" since its then-record high of 9,338 on July 17. The closely watched average of 30 industrial stocks hit a so-called "double bottom" on Sept. 2 and again on Oct. 8 when the Dow touched the 7,400 level. Technicians and chartists look at this as a turning point.

The fact that small stocks have rebounded faster than the Dow and the S&P 500 is also considered by some market strategists as a meaningful event. Usually small stocks lead the market out of a recession. We have not had a recession, but the fear of a recession was one of the factors that led the market down in the third quarter.

What has caused this sudden reversal in the market's direction? Is it justified? Is it for real?

In my opinion, the drastic sell-offs in August and September were not rational. The large stocks in the Dow and the S&P 500 had reached very high valuations, but the majority of stocks of small and midcap companies were well below their yearly highs. Prices were driven down by the cumulative effect of everyone believing that their worst fears might turn out to be true.

Now there is hope that these fears will not come true because:

- The Federal Reserve made an unusual move, lowering the discount rate between scheduled meetings of the Open Market Committee. This gave many the confidence that the Fed would provide all the liquidity the markets needed to prevent a recession.

- The Japanese politicians gave some indication that they would finally do something about the lingering recession in their country.

- Congress appropriated funds to the IMF.

- The IMF and the United States moved to support the efforts of Brazil in its crisis over the possible devaluation of the cruzeiro. Brazil maintains that it will pass necessary measures to correct its balance of payments problems.

- The results of the elections promised more stalemate in Congress with less chance of either lavish new federal spending or budget-threatening tax cuts. President Clinton appears more secure in his job but with less influence to change agendas. Stock markets hate change. As Will Rogers once said, "Never blame a legislative body for not doing something. When they do nothing, they don't hurt anybody. When they do something is when they become dangerous."

There are many opinions about the market and it is an amazing recovery from the depths of gloom. The optimists agree with stock analyst Abby Cohen who believes the Dow is headed to 9,500 over the next 12 months.

I believe the surge in prices of smaller company stocks is long overdue. Prices of small-cap stocks were selling at much lower prices relative to large-cap stocks than was justified.

Marshall Acuff of Salomon Smith Barney expresses my views about the near future. In a recent article in Barron's, he says, "I think while everyone is breathing easier, the underlying issue of growth in profits and its potential constraint on equities' performance is yet to be resolved." Acuff believes that next year's profits will likely be down.

William Spitz, as treasurer of Vanderbilt University, is responsible for a large and complex endowment that includes many strategies - much more esoteric and exotic than a simple asset allocation plan of the average investor. In a recent letter to clients of Diversified Trust, a Memphis-based trust and investment advisory firm where he is a shareholder and director, he said:

"Since none of us has all the answers, I think it is critical to consistently focus on risk relative to our long-term goals.

"Specifically, I believe each investor should adopt the following statements:

"Uncertainty and negative surprises are a part of life.

"While it will be imperfect, I will adopt a plan for dealing with risk.

"I will demand full disclosure from the parties with whom I do business.

"And finally, I will be a responsible investor."

In the concluding paragraph, Spitz says, "However two statements can be made with confidence. First, investors who abandon their strategy will frequently do so at exactly the wrong time. Second, diversified portfolios will fare better over time as compared to all-or-nothing strategies."

I hope that no one panicked during the recent lows. With the market back close to its July peak, now is the time to adjust your plan for dealing with risk.

(Frank A. Jones, investment adviser and a former director of the Eighth District Federal Reserve Bank, writes about mutual funds weekly at The Commercial Appeal in Memphis, Tenn.)