Commentary: Educated Investor - An educated guess

Back in August 2002, I wrote an article entitled What is an Investor to Do? If you remember at that time the stock market was in its 29th month of a devastating bear market.

My recommendation was to start cherry picking fundamentally sound stocks that have trading liquidity.

Then in April of 2004, I suggested you be cautious and at the same time liquidate any weak positions you may have in your portfolio. I would reinvest those dollars in a money market and wait for clearer days. In other words, keep some power dry for better opportunities.

This advice was included in my column under the title Keep Some Powder Dry. The full text of both articles can be found at my Web site.

For those of you that took my suggestions seriously, I believe you have been well rewarded since all the indexes had rallied significantly from August 2002 until April 2004.

The big question is: Did I have a crystal ball? Absolutely not! As I have repeated many times in this column, I do not believe anyone can predict the markets with any degree of certainty. But with education, experience and a whole lot of luck, you can make what I refer to as an educated guess.

For those of you that take my thoughts into account when managing your portfolios let me give you my perception of the current financial markets and what you might expect going forward.

Right now the stock and bond markets are about as complicated and unpredictable as I have ever seen in my 32 years of experience.

A mess

On the geopolitical front our country is not only at war with terrorists around the world, but because of an upcoming presidential election our two major parties are at war with each other which I view as selfishness among the elite political powers.

The government tells us if we don't eat, drive our cars and heat or cool our homes, inflation is intact. But I believe because of increasing worldwide demand for basic materials and energy, sooner or later we will feel the effects of global inflation whether we eat and drive or not.

If inflation does increase here at home and our economy continues to slow as it has for the past couple of months, our corporations will be in trouble when it comes to the bottom line.

Without growth in the economy, and I am specifically speaking about a rise in the employment numbers, corporate America will have to slash margins in order to stay alive.

This will tend to diminish profits and therefore give rise to shrinking stock prices. Unfortunately, July's employment numbers were not only lousy, but May's and June's were revised downward.

We also have the problem with interest rates.

They are so low that if our country slips back into a recession, Mr. Greenspan doesn't have much firepower left in his arsenal to give a boost to the economy. If you have the time you might want to review a past article of mine entitled Pushing on a String. Once again it is on my Web site.

Yet, if our interest rates remain too low, our foreign investors won't be inclined to invest in U.S. Treasuries. Japan and China, the major purchasers of U.S. assets, have already drastically cut their purchases during the last quarter.

So Mr. Greenspan is between a rock and a hard place when it comes to interest rates. If he raises rates to attract foreign investment without economic growth here on our shores, we are surely headed for another recession.

Then to complicate manners, our geopolitical situation is a mess. The Middle East wars are costing us a fortune. Someone needs to pay the tab and that someone is you and me.

If taxes are raised to help finance our debt, consumption will decrease even more which will hit our economy hard.

Consumption has already trailed off do to higher oil prices and tax increases will only compound the problem. But sooner or later, just as individuals are required to do, our nation needs to pay down it's debt.

What to do

So with all of the above cross currents and potential combinations what is an investor to do? Personally, I don't believe there is an urgency to be 100 percent invested in the stock market or for that matter, the bond market.

Even under the best scenario I think the stock market will only offer modest returns in the foreseeable future. Currently, I believe at best, the market is only fairly valued. No great bargains.

As far as interest rates are concerned, their future is even more difficult to predict because of our enormous deficit, weak dollar, slowing economy and an inflationary environment, and foreign investment considerations. The balancing act will truly need the best efforts of the federal reserve.

Since it wouldn't be prudent to withdrawal from the stock market completely I would keep some monies invested in large cap dividend paying stocks. I would invest in basic material companies as well as in energy and energy related industries. During inflationary times these sectors have done extremely well.

As a suggestion I would check out Kerr McGee (KMG), Allegheny Technologies (ATI) and Newmont Mining (NEM) for a small portion of an equity portfolio.

As for bonds, I would invest some capital in mortgage backed step- ups which give you some protection if interest rates climb. If you are not familiar with this type of security, consult your financial advisor for advice.

I would continue to keep money in a money market fund earmarked for the stock market in order to take advantage of opportunities as they arise. Even though you are receiving a low rate of interest, liquidity will be important in the coming months as opportunities will present themselves once some uncertainties such as the result of the presidential election are known.

Bottom line, in the current market environment it wouldn't bother me in the least, to maintain 30 or 40 percent of my portfolio in cash or equivalents. I know a 1 percent interest rate isn't appetizing, but security of principal is gourmet.

Investors should also be reducing personal debt that floats with the prime rate as an example. Currently, you might only be paying 4 percent on a home equity loan, but if rates were to jump to 6 percent during the next two years your interest payments would leap 50 percent. If that would hurt your family budget start doing something about the outstanding balance now.

In summary we as investors are in very delicate and complicated financial environments. It is extremely difficult to have an educated guess about the future because of all the cross currents that effect our economy.

So when there is so much uncertainty at one time, I believe it is best to batten down the hatches and weather out the storm. Be extremely conservative with your portfolio and be on the defensive and hopefully in a couple of months or so we will see sunnier skies.

David R. Clogg, ChFC is an account executive at Chapin, Davis. He can be reached at 410-435-3200 or visit his Web site at www.theeducatedinvestor.info.

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