Editor's Note

03/01/2007 12:00 am EST

Focus:

Howard Gold

Founder & President, GoldenEgg Investing

Thurs., Mar. 1

We've lived through the ups and downs of the last few days. We've read all about the return of risk, wondered whether we're in a correction or a bear market and tried to gauge where the bottom might be. We've heard pundits (some of whom have appeared on this site) tell us to sit tight and not panic, but instead wait for buying opportunities.

So, what now?

I'd like to step back and look at the Big Picture, because this week's selloff may be the beginning of a new fundamental shift in the markets.

As the US economy slows (the Commerce Department revised fourth-quarter GDP growth down to 2.2% from 3.5%) and appetites for risk shrink, asset classes that prospered for years may well play second fiddle. Growth may trump value, large may surpass small, developed markets may top emerging economies, and real estate and high-yield bonds may lag again.
 
This decade has seen huge changes.  The Bush tax cuts and the Fed's sharp reduction of interest rates under Alan Greenspan sparked a recovery and bull market that continue today, even as the Fed has raised rates again. China, India, and other developing countries have emerged as legitimate economic powers.

This helped unleash a tide of liquidity. Hedge funds, with over $1 trillion in assets, use advanced finance theory and sophisticated computer modeling to pounce on new opportunities immediately. Private equity funds, which have tens of billions of dollars in their coffers, take over public companies and use financial engineering to pump out more profits for their investors and themselves.

All this extra money sloshing around has helped shrink risk premiums dramatically and boost returns for asset classes like high-yield bonds. "High-yield bonds have gotten to pricing at ridiculous levels," fixed-income expert Richard Lehmann said at the recent World Money Show in Orlando, "The risk that you're taking is not commensurate with the yields that you're going to get."

The same is true for emerging-market stocks, as I wrote here last week (see "Sell China, Buy American," March 22). In the five years ending last September 30, the MSCI Emerging Markets index racked up a 28.8% annualized gain, twice that of the MSCI EAFE international developed market index and four times what the Standard & Poor's 500 did. 

But with faster growth comes more volatility-and higher risk. Last May, the prospect of a Fed rate increase caused some emerging stock markets to lose a quarter of their value within weeks. That proved to be a false alarm as investors piled back in. This time, I think it's for real: Once the global correction is complete, emerging markets may struggle.

Commercial real estate, too, continues on a tear, even as residential has cooled. The FTSE NAREIT US real estate index posted total returns of 24.32% annually in the five years ended January. But as real estate's value has soared, the "capitalization rate," which measures landlords' return on commercial property, has shrunk to its lowest level in years. As in high-yield bonds, investors simply aren't being paid to take the extra risk of ownership.

Finally, US stocks. For the last few years, small and mid-cap stocks have trounced their blue-chip brethren. The Russell 2000 Small-Cap index is up by an annual 11.39% over the last five years, while the Midcap index has risen 10.4%. Large caps have gained only 6.24%.

But look behind the numbers and you'll find that most of that gain in all sizes has come from value stocks: The Russell 2000 Value index is up 15.37% annually during that time, the Midcap Value index has risen 15.88%, and even the Russell 1000 (large-cap) Value index was up 10.86%. Growth stocks have trailed badly..

Value stocks (especially smaller value stocks) tend to shine when the economy is improving. And once they've had a big move, well, they're just not so valuable anymore. According to Birinyi Associates, mid-cap and small-cap value stocks have higher P/Es than growth stocks in those categories. That's not supposed to happen, and it suggests yet another part of the market where investors aren't paying appropriate prices for what they're buying.

As economic growth tapers off, I believe they'll move toward steady growers that are less tied to the economic cycle and are rock-solid financially. And I believe last year's winners will become this year's losers, and vice-versa.

So here's what I'd do now in a widely diversified portfolio (the only kind you should have). As I said last week, I'd take some profits in emerging-markets stocks and reduce my exposure there. I'd also cut down my holdings in REITs and high-yield bonds, maybe even put all my high-yield assets into a general bond fund. (If default rates rise, the result won't be pretty.) I'd also start moving away from value stocks, especially small- and mid-cap value.

What should you buy? Depending on your tax bracket, I'd buy some two-year CDs (you can still lock in 5%-plus yields) and, as I recommended last week, put more money into  large-cap US growth vehicles like the iShares S&P 500 Growth index ETF (IVW) and either the Vanguard Growth ETF (VUG) or the Vanguard Growth index mutual fund (VIGRX), which track the same benchmark. These stocks pay good dividends, too.

This selloff could end next week, and we could be off to the races again. Asset classes can outperform for much longer than we expect them to, and sometimes it takes a long time for the worm to turn. That's why I think investors shouldn't panic, but should use rallies and other signs of strength to systematically take profits from yesterday's opportunities and start looking for tomorrow's.

Howard R. Gold is editor-in-chief of MoneyShow.com. The views in his commentary are his own and do not necessarily represent those of InterShow.

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