How to View the Big Picture in Smaller Frames

Everybody who invests has worries about their investments, on some level. But there are worries and then there are WORRIES.

A worry is when your stock mutual fund loses 3.5% of its value in four weeks, which is what the average general U.S. stock fund did through Friday.

A WORRY is when you have your life savings in a stock such as Boston Chicken, the once high-flying owner of the Boston Market restaurant chain. Its shares, which traded for as much as $41.50 in late 1996 when it was considered “the next McDonald’s,� plunged to a record low $2.03 on Friday after its auditors said bankruptcy is a very real possibility.

A worry is when you invested 10% of your mutual fund portfolio in an emerging-markets fund a year ago, and you’ve since lost 20% of that investment as those markets, mainly in Asia, have plummeted.

A WORRY is when that emerging markets fund accounted for 50% of your fund portfolio a year ago instead of 10%.

Last week, world financial markets were riled for the third time in eight months by bona fide WORRIES about the global economy’s future. Watching Asian economies crumble, watching Russia drive interest rates to 150% to protect its currency, watching Mexican stocks lose 2.5% for the week as the peso hit a record low versus the dollar--these are all things that Americans understandably find difficult to connect to their daily lives.

Still, many people can sense that the most important WORRY generated by these events is that the great shift toward global capitalism in the 1990s, which has in no small part fueled the rise in stock prices and long-term decline in interest rates in this country, might be threatened or even reversed. Does anybody want to go back to an era of closed borders, restricted trade and confrontation rather than cooperation among nations and economies?

That’s the big-picture WORRY. But because it’s so big picture, investors can’t very easily relate it to their personal situations--i.e., “buy, sell or hold?�

More important to most investors are a number of concerns that are more immediate, and more easily acted upon. Are they worries or WORRIES? Let’s take a look:

* U.S. interest rates may rise. Until last week, this seemed like a very strong probability in coming months--a big WORRY. A number of Federal Reserve Board governors have warned as much. Many experts have argued that the U.S. economy is too strong for its own good and needs tighter credit to slow demand.

With the latest trouble in Asia and Russia, the Fed seemed likely to stay on hold in the near term. But two events last week hinted that the potential for a rate hike may be fading longer term as well.

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First, the government’s revised report on first-quarter economic growth, issued Thursday, showed a record surge in inventories in the quarter. What does that mean? Simply this: Businesses produced a huge amount of goods, anticipating strong future demand. But many of those goods may still be sitting on warehouse or retail shelves.

Consumer spending has remained healthy, but is it robust enough to absorb all of those goods fast enough to keep businesses from cutting production to clear inventories? Many economists don’t think so.

“Inventory building will almost certainly slow during the balance of the year,� shaving economic growth, said Bruce Steinberg, chief economist at Merrill Lynch & Co.

What’s more, even as consumers continue to spend money at a brisk pace, Steinberg noted that history suggests a slowdown is imminent, given the spectacular jump in spending in the first quarter.

“Whenever domestic demand has grown so rapidly in one quarter, it is almost always followed by a slowdown in the subsequent quarter,� he said.

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Of course, history doesn’t have to repeat. But there was another clue last week that the U.S. economy may indeed be slowing: Long-term bond yields ended the week at new seven-week lows, with the 30-year Treasury bond at 5.80%, down from 5.91% a week earlier.

It’s never a good idea to read too much into short-term market moves. Bonds may be benefiting from a flood of foreign money seeking “safe haven.� But if yields can stay down in coming weeks--or go lower--that could be a major signal that the markets expect the economy to slow enough to preclude a Fed rate increase.

There also could be an investment opportunity here. Bonds have been a dull investment this year. The Vanguard Long-Term Treasury bond fund is up just 3.5% year-to-date. But if Wall Street senses that the economy is slowing, money could pour into bonds.

* U.S. corporate profits are weak. This is unquestionably a WORRY, and it is likely to become a bigger Wall Street concern in coming months, as rising wages, soaring import competition and falling export growth challenge many companies.

Profits, and the promise of more, are what underlie stock prices. But government data in the first-quarter economic growth report showed that overall U.S. corporate profits fell 2.2% in the first quarter after dropping 2.3% in the fourth quarter.

The last time there was a back-to-back decline in corporate earnings was in the last recession, in 1990-1991.

So if earnings are falling, why is the average stock mutual fund, while down 3.5% over the last four weeks, still up 9.3% year-to-date?

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In part, stocks are being held up because interest rates have been relatively benign. But Ned Riley, investment chief at the Private Bank unit of BankBoston, says the next four weeks could be a critical test of investors’ willingness to overlook weak profits.

Companies will soon be warning analysts, and investors, if second-quarter earnings estimates are too high. The louder those warnings get, the greater the threat to stock prices overall.

“The profit side of the equation is still the most negative element� in the outlook for stocks, Riley said.

Is there opportunity here as well? Probably. Amid general disappointment over earnings, those companies that show an ability to sustain strong profit growth will be in even greater demand. Two groups that appear to meet that criteria: drug stocks and retail stocks.

* Smaller stocks are again badly lagging blue chips. This is a worry for investors who have a modest portion of their portfolio in smaller stocks. But it’s a WORRY for investors who have made a big bet on this sector.

The average small-stock mutual fund was up just 5.4% year-to-date through Thursday, according to fund-tracker Lipper Analytical. That compares with a 13.6% rise in funds that track the blue-chip Standard & Poor’s 500 index.

That has been the story since 1994: Except for a few periods of glory, smaller stocks have been dogs relative to bigger stocks. And in times of market turmoil, smaller stocks always sink faster than their bigger brethren.

The argument is made again and again that smaller stocks are bargains, while blue chips are overvalued. That may be true. But looking ahead, it’s tough to imagine how smaller stocks become leaders in the near term.

If interest rates fall because the economy is weakening--giving investors justification to raise the prices they’re willing to pay for stocks even on depressed earnings--blue chips will probably benefit first, because those are the names Wall Street thinks of first.

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What’s more, if foreigners continue to throw money at our market, they will be buying blue chips--again, because those are the names they know.

Finally, even if major companies’ earnings prospects dim, many investors will make two assumptions: that smaller companies’ prospects are dimming as well, and that the bigger companies at least have greater wherewithal in terms of layoffs, restructuring and stock buybacks to get earnings back on track sooner.

The bottom line: If the market continues to slide--and earnings woes are the catalyst--investors who have money they’re eager to put to work may be better off hunting among beaten-down blue chips than among smaller stocks.

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Tom Petruno can be reached by e-mail at [email protected]