The Uncertain Bull

By Daniel Kadlec

After nearly seven fitful years, the Dow Jones industrial average hit a new high last week. Long-term blue-chip-stock investors who bought in January 2000, when the Dow peaked at 11,723, were even at last. Time to break out the bubbly? Maybe. Then again, maybe not.

The funny thing about bull markets is that by the time you're seeing new highs, often the ride is all but over. Last spring the Dow flirted with a record but collapsed into a dismaying summer swoon. Will the autumn surge be another false positive? Consider the odds: over the past 100 years, half of all sustained market rallies (measured by the Standard & Poor's 500) ended without reaching their reigning all-time high or dried up shortly thereafter, according to the Leuthold Group.

Investors may be sensing a trap. Daily stock trades at Charles Schwab fell 9% in August. That month investors poured money into stocks globally but withdrew $4 billion more than they put into U.S.-focused mutual funds. The figures for September were expected to show only modest improvement.

That's hardly the kind of fireworks you expect amid record-high stocks and other bits of good news--energy prices easing, inflation ebbing. True, the economy is slowing, but profits are still growing, and long-term interest rates have begun to fall. Meanwhile, history suggests that the longer and steeper a market bust, the longer and more robust the recovery. And the 2000-02 decline was one for the ages: the S&P 500 fell 49%, vs. the bear-market median decline of 34%.

Yet Tim Hayes, chief investment strategist at Ned Davis, doubts we'll see much follow-through this time. "The valuation excesses we saw during the bubble still have not fully corrected," he warns. Today's price-to-earnings multiple of 17 suggests that the market is far from cheap. "Usually, you have to get well below the average [which is 16] before you can turn it around," says Hayes.

This bull market is now entering its fifth year--outlasting the typical bull. And there are some clear trouble spots developing. One is the weak housing market, which is shutting down the easy money from home-equity borrowing. Another is higher rates, which have begun to hit home owners where it really hurts. Some $2 trillion worth of adjustable-rate mortgages is scheduled to reset at a steeper rate by the end of 2008, estimates Moody's Economy.com A recession next year is not out of the question.

How do you deal with such crosscurrents? First consider carrying a little more cash. With short rates above 5%, money-market funds and other cash instruments offer a decent, low-risk return. And you'll have money to invest should the market fall and offer better opportunities.

Stay with stocks. But consider moving money out of small-cap stocks (those with market values under $1.5 billion) and into large-cap stocks, such as those found in the Dow and the S&P 500. Large caps, which are better able to handle today's higher rates, have been outpacing small caps for months, after lagging for years.

It's time to lighten up on energy, basic materials and other economy- sensitive stocks, says Liz Ann Sonders, chief investment strategist at Schwab. She is shifting into slowdown stalwarts like health care and consumer staples. But she is also heavy in technology shares, which she believes have fallen so far as to be bargains in any economic climate.

It's not much fun turning defensive just as the Dow is soaring. But it has worked before and probably will again.