Some Points for Investors to Take Up as Stocks Go Down

Eight years ago this week, Saddam Hussein sent Iraqi troops into Kuwait, triggering the first bear market of the 1990s on Wall Street.

And so far, that stands as the only bear market of the 1990s. For nearly eight years, the bulls have ruled as U.S. stocks overall have soared, driven by falling interest rates, surging corporate profits and an unprecedented public hunger for equities.

With the market in a steep decline in recent weeks, however, Wall Street pros increasingly are debating whether this extraordinary bull run might be ending. But why now? And if a true bear market is in fact on the horizon, what’s the best course of action for individual investors?

Here’s a look at what’s happening to stocks and some points investors should consider in evaluating their portfolios:

Q: How much has the stock market fallen?

A: Measured by blue-chip stock indexes, the drop hasn’t been dramatic. Since it peaked at 9,337.97 on July 17, the Dow Jones industrial average has fallen 551.23 points, or 5.9%, including Monday’s 96.55-point slump.

Another key blue-chip index--the Standard & Poor’s 500, a favorite investment of small investors via index stock mutual funds--has fallen 6.3% from its July 17 peak.

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Q: But declines of that magnitude don’t constitute bear markets, do they?

A: No. A bear market is usually defined as a drop of 20% or more in major indexes such as the Dow or S&P; 500. Some market pros say the threshold is 15%. In any case, the last time the Dow fell more than 15% was between July and October 1990, when it slid 21% in advance of the Persian Gulf War.

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Q: So some analysts think we might be in the midst of a decline that steep, or steeper? On what basis would someone make that prediction?

A: One big worry is the plunge in the market overall in recent months. While blue-chip stocks such as General Electric and Coca-Cola have held up reasonably well, the vast majority of stocks have been falling since early April.

The damage has been particularly acute among shares of smaller companies, which make up the vast majority of stocks. The Russell 2,000 index of smaller stocks fell 1.5% Monday and now is down 15.9% from its April record high. By that measure, many smaller stocks already are in a true bear market.

Investors in many small-stock mutual funds have seen their 1998 gains evaporate completely in recent weeks. The average small-stock fund was up just 0.9% year-to-date through Thursday--a gain that disappeared altogether as stocks fell further Friday.

By contrast, the S&P; 500 index still is up 14.6% year-to-date, through Monday.

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Q: But wait--we’ve had so-called corrections in the market several times in this decade, meaning the major stock indexes drop between 5% and 15%, then stabilize, and soon start rising again. Why should this time be any different?

A: It might not be different this time. As brutal as the declines have been for many smaller stocks this year, they typically drop more than blue chips in market corrections.

As for the Dow, it fell nearly 12% last October (during the first stage of Asia’s economic collapse), then quickly stabilized. So the drop of less than 6% so far could easily double and the market would still be in the confines of another garden-variety correction.

Still, analysts warn that some things are different today versus last fall.

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Q: Well, Wall Street always finds something to worry about. What is the big worry today?

A: The pronounced slowdown in corporate earnings growth--to the slowest pace since 1991.

Last year, even as Asia’s economic collapse unnerved markets in the second half, investors still could depend on solid earnings growth from major U.S. companies.

Year-over-year profit growth was 10% for the S&P; 500 companies in the third quarter of last year, and about 7.5% in the fourth quarter. Those were respectable numbers in an environment of very low inflation and relatively low interest rates.

Let’s not forget: Profits are what ultimately underpin stock prices. When you invest in a stock, you’re effectively buying a future earnings stream from that company. The alternative--no growth, or a profit decline--would suggest a lousy investment.

Now, Wall Street has had to cope with two consecutive quarters of earnings growth in the low single digits for the average blue-chip company, as measured by the S&P; 500. The problems are manifold: Asia’s crisis is depressing U.S. exports; many companies are paying higher wages to attract and keep workers in a tight labor market; and with the growing crush of competition in so many industries, few if any companies have the ability to raise prices for their products or services.

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Q: Do stock prices always decline when earnings growth slows?

A: Not always. But because U.S. stocks already had been selling for such high prices relative to underlying earnings--indeed, unprecedented heights, for many issues--there was no room for disappointment. As investors focus on the possibility that this slowdown in earnings growth could last well into 1999, they are rethinking how highly stocks should be valued.

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Q: So how much might stocks have to come down before shares are priced reasonably again?

A: What’s “reasonable” depends on investors’ collective mood at any given moment. Stocks’ latest slide obviously indicates that most investors don’t think these prices are reasonable--but there’s no telling when that judgment might change. Note, too, that the market remains supported by some strong fundamentals: low interest rates, low inflation and record merger activity.

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Q: If we assume the worst case--that another bear market has begun, and stocks will fall 20% or more--should I sell some of my equity holdings now?

A: Here’s the best way to go about answering that: Could you stand to see your overall stock portfolio decline by 20% or more? If your answer is something to the effect of, “I’m a long-term investor”--and you really don’t need your capital for at least 10 years--there might be no good reason to sell.

Moreover, if you already have a diversified portfolio, meaning stocks, bonds, cash (such as bank CDs), a home and/or other assets, then a temporary drop in your stocks’ value might not be a big deal to you.

But if you’re heavily invested in stocks and you will need some of that capital in the next few years, or if a 20% stock loss, on paper, would make you uncomfortable--and a 30% loss would frighten you--then taking some money off the table now might be a smart idea.

Note: It doesn’t have to be, and probably shouldn’t be, an all-or-none proposition: You don’t have to sell all of your stocks--just enough to give yourself a good comfort level, should the market be headed for serious trouble.

Moreover, by shifting some profits into bonds or cash, you will create a pool to tap for reinvestment in the market, as share prices get significantly cheaper.

That’s a key point to remember: The deeper the market sinks, your appetite for stocks should rise, not fall. Many smaller stocks already may be great bargains. You want to be in position to use a bear market as an opportunity--not a time to panic.