By Amey Stone Investors were an upbeat bunch this summer, cheering an improving economy and surging earnings. Oil at $60 a barrel? No problem. Then came September, when quite literally the dark clouds moved in. The wrath of Hurricanes Katrina and Rita led to an unexpected run-up in both oil and gas prices, trampling investor confidence once more.
Consumers weren't far behind. On Sept. 27, consumer confidence showed an unexpectedly sharp drop. And the march of companies warning that third-quarter earnings will come in weaker than forecast due to the impact of the hurricanes threatens to turn into a stampede. Since a summer high on July 29 of 10,755, the Dow Jones industrial average has fallen 300 points, to close at 10,456 on Sept. 27. It's still off 3% for the year.
Time to panic? Far from it. Come Oct. 1, we enter the fiscal fourth quarter, historically the best quarter for the economy and markets. So use this time to take a hard look at your portfolio and make sure you're positioned to benefit from any rebound in the market -- and that you're protected from any additional shocks.
PLAYING BOTH SIDES. The way to accomplish both goals is to emphasize large-cap, high-quality growth stocks in your portfolio, say professional investors. Although October can be a scary time for stocks, remember that November and December often are marked by rebounds that can last into January. If oil prices fall and the Federal Reserve indicates that it won't keep raising short-term interest rates, stocks could rally from here.
Another trick to being both defensive and offensive at the same time is to make sure you're diversified across sectors -- but put extra care into picking stocks. Consumer, technology, health care, and energy are the sectors most strategists are emphasizing (see slide show, "Where the Buys Are -- and Aren't"). They don't all expect big moves up in the market, but they think stocks that can continue to post strong earnings growth as economic growth cools will be rewarded.
"Companies with financial and economic muscle will rise to the top, says Manisha Thakor, a portfolio manager at Fayez Sarofim & Co. in Houston. Historically, high-quality, large-cap growth stocks enjoy a 5% premium over the rest of the market, but currently they're selling at a 10% discount, she says. That undervaluation means there's "a huge opportunity in large-cap growth."
"HOUSE-BY-HOUSE." Dan Boone, portfolio manager of the Calvert Social Investment Fund, says high-quality growth stocks "represent bargains today." If they don't rebound soon, "it would be the worst performance in history to take place," he adds. John Jares, senior portfolio manager at Founders Asset Management, says the shift from value to growth "is the kind of trend you want to be in front of."
The only problem is that investors who moved to large-cap growth have so far been early -- quite early. "A lot of portfolio managers are sitting around with a lot of large-cap growth stocks in their portfolio that have been stagnant," says Marc Heilwell, portfolio manager of the Marathon Value Portfolio. He's looking beyond traditional large-cap growth names like Microsoft (MSFT) and Wal-Mart (WMT) in favor of stocks tied to corporate spending, such as 3M (MMM) and Automatic Data Processing (ADP).
Good stock-picking will be rewarded if the economy slows. "You really have to go house-by-house," says Nick Colas, head of research at Rochdale Securities. For example, Colas is a big fan of Procter & Gamble (PG), largely due to the Gillette acquisition, but he's avoiding Wal-Mart (WMT), since he worries it's losing market share to Target (TGT) and will need to spend more to stay on top.
EARNINGS PEAK? For large-cap growth stocks to do well in the coming weeks, oil prices need to stabilize, and the Federal Reserve must give at least a hint that it will soon finish with its series of interest rate hikes.
In the current climate, earnings aren't grabbing investors' attention the way they used to. In the third quarter, they're expected to be 16% higher than last year, but strategists believe earnings growth is peaking. Rich Moroney, editor of Dow Theory Forecasts, warns that in this environment, a low price-earnings ratio may be misleading. Stocks that seem cheap now could suddenly look a lot more expensive next year if their earnings growth stalls. "You have to look forward," he says.
Even with slowing earnings ahead, investors could easily return to their optimistic ways this autumn if oil and the Fed cooperate. And even if the stock market's underlying momentum doesn't improve, investors who are diversified across sectors and who hold high-quality companies will prosper in the long term -- no matter what the weather brings.
Stone is senior writer for BusinessWeek Online in New York