Editor's Note

07/26/2007 12:00 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

July 26, 2007

For the first time in a while, I'm concerned about the health of the market-at least in the short run.

We're in the midst of earnings season, when positive surprises were supposed to propel stocks higher, but it's a decidedly mixed bag.

Companies like Dupont, Caterpillar, even Google have come up short of analysts' estimates, taking the market down with them. And although companies are likely to beat analysts' low expectations in general, this is when the market should be surging.

Instead, it's struggling. The Dow Jones Industrial Average, which had a huge rally two weeks ago (gaining almost 300 points in one day), huffed and puffed its way to 14,000 last Thursday before suffering a 150-point loss to end the week and a 200-point decline on Tuesday. Subsequent "rebounds" have been unconvincing, accompanied by poor breadth and weak volume.

The Standard & Poor's 500, which also moved into record territory last Thursday, has fallen through its 1535-1540 support level and on Thursday morning dipped below 1500.

Meanwhile, the bearish background noise has been rising, mostly on fears about the dollar, the spillover effects of subprime housing debt, and rising energy prices

When the market first sold off in March and then again in June, I wrote that we might not get the textbook 10% correction the pundits were expecting. Stocks went on to hit new highs both times.

But now we're entering the dog days of summer. Traders and money managers are hitting the beach. When earnings season ends, there will be little except the occasional economic data release to push stocks higher. And everybody who isn't catching rays in the Hamptons or Hilton Head or wherever will be moaning and groaning about all the market's "problems."

I can't predict the markets' short-term moves; nobody can. But this is as good a time as any for a real correction, and investors should be prepared to weather it-and profit when it's over.

I don't think we're looking at the end of the bull market, though. Global economic growth should approach 5% this year, according to the International Monetary Fund. That's nearly twice the projected growth for US gross domestic product (GDP) and part of what the IMF called "one of the longest sustained periods of growth after the Second World War." And few corners of the globe are untouched by this boom.

This extraordinary growth has allowed the rest of the world to take the burden off the overstretched US consumer. But although US GDP growth is modest, unemployment remains at only 4.5%, and household net worth stood at a whopping $56.2 trillion at the end of the first quarter, according to the Federal Reserve.

The big question now is how bad the subprime housing mess is going to get. Fed chairman Ben Bernanke recently pegged the ultimate cost at $100 billion. That sounds like a lot of money, but remember: we have a $13-trillion economy and the collapse of the savings & loans back in the 1990s cost taxpayers and shareholders about $150 billion. (In today's dollars that would be a lot more.)

This time you and I may not have to foot the bill. So far the losses have been contained, although major financial institutions have started setting aside reserves to cover future deficits. No one knows how far it's going to spread, because so many secretive hedge funds have taken all kinds of leveraged positions on both sides of these funky securities.

My best guess is the slicing and dicing of these securities into so many pieces sold to so many investors will work as it is intended to. Because risk has been spread so widely, I think we'll avoid the kind of systemic threat the collapse of Long Term Capital Management posed in 1998. But it is a risk, no doubt about it.

Over the last few weeks we've seen a so-called "repricing" of risk, especially for private equity deals. The ever-so-brief "golden age" of private equity, as Henry Kravis himself dubbed it this past spring, may already have passed. Investors are shying away from the riskiest credits, and dicey deals are not getting done.

But most others will. Borrowers may have to pay a little more, which means private equity investors may have to settle for a mere 17% or 18% a year rather than the 20%+ annual returns they've taken for granted. Somewhat tighter credit really isn't the end of the world.

But it's a clear signal to individual investors to lighten up on the riskiest assets, as we've recommended here since March and again a month ago and begin to move your assets into lower-risk, steadier growing assets.

That will mean not only unloading real estate investment trusts (REITs), junk bonds and emerging-market bond funds, but also start shifting your equity portfolios from the big winners of the last few years-small- and mid-cap stocks, value stocks and emerging markets-into what I believe will do well over the next few years-blue-chip growth and developed-market stocks.

As risk rises and growth slows, leadership already has shifted to reliable, well-capitalized companies that can grow steadily in any kind of economy. (This year the Dow is up more than 10% while the small-cap Russell 2000 has risen only 1%.)

And these big US multinationals do more and more of their business overseas, benefiting from the strong global economy and the weak US dollar. If we are going through a correction, they should withstand it better and come out stronger on the other side.

It's amazing to watch sentiment turn on a dime. When stocks are rising, it seems as if nothing will ever go wrong again. When they're falling, it's the end of the world.

The truth, of course, is somewhere in between, and investors need to keep from being swayed by either extreme. Remember Kipling's famous words: "If you can keep your head when all about you are losing theirs." It's good advice-especially now.

Comments? Please email us at TopProsTopPicks@InterShow.com.

Howard R. Gold is editor-in-chief of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow.

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