What You Can Do Now

By Daniel Kadlec

When you've been riding so long with the breeze at your back and the sun on your face, a return to the vagaries of normal weather can feel downright depressing. And make no mistake, that's what we're experiencing right now in the stock market: a return to normality, not a "crash" or disaster. But after eight fat years, we've returned to a world where stocks go down as well as up, where our engagement in the global economy brings risks as well as rewards. We're leaving behind the fantasy world where stock prices bear little or no relation to earnings, especially for companies whose names end in com

The era of 20% average annual returns from stocks is officially over. Accept it. The market, up as much as 19% this year, has given it all back and could easily finish the year with more losses. We're only weeks from hearing corporate confessionals about depressing third-quarter results. And with Asia's ills spreading to Russia and Latin America, profits overall--for global companies, most acutely--could well decline in the next few quarters. That's part of what has Wall Street so angst ridden, and it's why the investment game has changed fundamentally over the past few weeks. When the market is priced for perfection, a lot can go wrong. So this seems a good time to review some basics.

--Stocks remain your best bet for long-term security; that is, for any money you won't need for at least three years. In 50 rolling three-year periods since 1946, the market produced losses only twice--the periods ending in 1974 and 1975, according to the Schwab Center for Investment Research. The average annual return to stocks in the postwar period has been about 11%--far more than for any other financial asset. But as last week reminded us, we do get bear markets. If you'll need the money sooner than three years, it belongs in a bank CD, a money-market account, a short-term bond fund, or possibly a Guaranteed Investment Contract (GIC).

--Wide price swings often signal major shifts in the market's direction, but sometimes they simply reflect confusion. Birinyi Associates reports that daily market moves of greater than 1% are occurring this year nearly twice as often as the historical average. You can make volatility your friend by sticking to a program of regular investing in stocks or stock funds, preferably through automatic payroll deductions. By investing a set amount each month (known as dollar-cost averaging), you naturally buy more shares when prices are low and fewer when they are high. It's foolproof, so long as your stocks eventually rebound, as they always have in the past.

--Valuations matter. There are companies behind those pieces of paper we call stocks. If a company's fortunes sink, so eventually will its stock. Beware of any company whose price-earnings multiple is greater than the expected annual growth rate for its earnings over the next few years. For example, Coca-Cola's P/E, even now, is 40; its earnings could rise 15% a year. That's definitely not the real thing.

So, what should you do now? That depends on what you've been doing the past few months. I've been suggesting all summer that it was time to prepare for just this kind of drop. If you've done that, and have some cash and a list of stocks you want to own at cheaper prices, now is a good time to start picking them up. No hurry, though. Based on earnings, most stocks are still at the high end of their historical valuations. Knowing that prices could fall more but that you're unlikely to spot the bottom, this is a good time to start dollar-cost averaging.

If you want to stay in the game but are looking for a relatively safe harbor, consider Real Estate Investment Trusts, whose 6% yields offer unusual protection. Or buy other high-yielding stocks--especially blue chips that you can count on to thrive long-term. High yield today is anything over 3%, a level that may indicate the stock has been unfairly trashed and will do well in coming quarters. Among the highest-yielding Dow stocks are Philip Morris (4.1%), J.P. Morgan (4.4%) and General Motors (3.5%). Other stocks to own might include those of consumer-products companies, a group that lost far less ground than the market this summer. You could also look for value-oriented stock mutual funds, such as Oakmark Fund (which has some of my money) or Mutual Shares (which has been carrying 20% in cash and thus was positioned to scoop up bargains as the market fell).

More conservative plays, but ones that still have an equity component, include convertible bond mutual funds, which hold high-yielding debt securities that can be turned into stock if the market rises far enough; or preferred stock, which carries secure, higher-than-normal yields and is relatively immune to stock market gyrations. If you really want to run for cover, a money-market account is the place. Long-term bonds can be a safe haven from stocks but carry their own risks. They represent a bet on stable or falling interest rates, a great hedge against recession.

If your tolerance for risk is higher, try one of the concentrated mutual funds that I assess in my column near the end of this magazine, in Personal Time. Or invest in the small stocks of the Russell 2000, preferably through an index fund or an actively managed small-stock fund. These small stocks have been beaten down more than their larger brethren, despite having comparable earnings.

If you weren't prepared for last week's stock drop--you had too much money in stocks and now find that your new-car money is gone--don't despair. The worst is probably over. Still, you don't want to risk the grocery money too. You're way ahead if you've been in the market more than a year, so just sell down to your comfort level. But don't overdo it and try to time a further drop. You'll only end up selling at the bottom and cursing the market all the way back up.