Future stocks

The Baltimore Sun

In major stock market sell-offs, investors often can look at what held up during the storm and figure what sectors will be the leaders as the stock market recovers in the future.

Frequently, times of upheaval are turning points in the market. What worked leading up to a market peak turns out to be yesterday's news. And new stocks emerge from the downturn to be the market's winners going forward.

But this time may be different. Some areas that have held up relatively well may prove not to be the leaders when the market rebounds. And experts warn against simply buying beaten-down shares, saying they may not be bargains at all.

Some strategists say that reading the tea leaves this time around is more confusing than some other periods of stress because hedge funds, with more than $1 trillion in assets, have become major drivers of the markets.

In particular, funds that use computer-driven models to select investments have been hardest hit the last few weeks. They make up an estimated $241 billion of the global hedge fund business.

Rather than selling stocks in which they have lost confidence, many hedge fund managers have been forced to sell both strong and weak holdings because their lenders aren't supplying them with money, and investors are fleeing the funds and demanding money back.

"We are witnessing the world's greatest margin call ever," said Ed Yardeni, chief investment strategist of Yardeni Research.

Hedge funds often do most of their investing with borrowed money, known as leverage. Consequently, when investors are bailing out of hedge funds, the fund managers have little access to cash. They have had to sell what is expedient to raise cash, and that has meant selling some of their strongest stocks.

Analysts say that has blurred market analysis, with virtually every type of stock sinking after the July 19 peak. Not surprisingly, home construction, which is at the center of the housing recession, became the biggest loser, dropping 21 percent over the next four weeks, based on the Dow Jones home construction index, although it has recovered some ground since.

But a range of stocks, including precious metals, energy, technology, insurance, retailing and utilities, dropped more than 8 percent before rebounding a bit. Health care, which generally is seen as a defensive sector because people need medical care regardless of the economy or market conditions, behaved true to form in market shocks. It held up well, falling less than 5 percent.

Financial stocks and stocks that depend on consumers rather than business spending have been the weakest stocks of the year. Besides plunging during the shock of the last few weeks, they are the only two sectors that are in losing territory from the start of the year.

Now, analysts are trying to figure out what has been pummeled primarily because of hedge-fund selling and short-term fear, and what might remain in a slump in the future.

They are warning investors about jumping quickly into stocks based on the assumption that the Federal Reserve will save the day. And they want investors to be cautious about trying to identify bargains in knee-jerk fashion simply because a sector has been hard hit recently.

"Consumers love a sale, especially when they get two for the price of one," said Standard & Poor's chief investment strategist Sam Stovall. "Investors are the same way. Wall Street tends to get very excited whenever the Federal Reserve begins a new rate-cutting program."

Still, Stovall said, S&P;'s Investment Policy Committee recommends investors "take a cautious approach to the market in the coming weeks and advises against assuming that the Fed's rate cut signals an 'all clear.' "

There is a growing realization that the problems that led to the market's swoon may not be short-lived or as easy to resolve as pundits urging investors to go bargain hunting.

During the last few years, lenders increasingly let down their guard, providing loans to homebuyers and businesses without the ability to repay them.

As homeowners and companies loaded down with debt struggle to keep up with payments, the economy is expected to feel the pressure. And with lenders tightening up lending standards, both consumers and businesses will likely have to hold back on some spending, a serious drag on the economy.

In such an environment, Merrill Lynch economist David Rosenberg said, even Federal Reserve interest rate cuts might not easily generate growth.

Private lenders are cautious. The result: The interest rates of fixed-rate mortgages have climbed to about 6.6 percent, and rates on so-called jumbo loans, or mortgages over $417,000, have risen significantly.

"That's not good news for anyone living in California, where the median price of a home is $595,000," Rosenberg said. "That is what we call a form of credit crunch; this is the end result of heightened risk aversion by both lenders and borrowers."

Against that backdrop, he said, the Fed could be "pushing on a string" as it tries to bolster the economy. He warns investors not to expect the economy to make a quick move out of troubled waters.

"There has never been an asset and credit bubble that managed to unwind in an orderly fashion, and what the historical record shows is that the Fed spends the first half of the rate-cutting cycle running backward on the treadmill," he said. "It's not until the second half of the easing cycle that the clouds really begin to part."

Consequently, rather than feeling compelled to go bargain hunting in financial stocks, Merrill Lynch strategist Richard Bernstein is telling investors that commercial banks, consumer finance companies and diversified financial companies are "value traps" or "minefields."

There could still be major surprises ahead in the financial sector. With questions remaining about the value of mortgage-related securities, "nobody seems to know the quality of the assets on financial-sector balance sheets, how big the potential losses are, and who exactly is sitting on those losses," Rosenberg said.

"Until market participants are told the answer to these questions, market volatility and weakness will be the order of the day."

Bernstein also says to pay attention to the excesses of the recent past and to avoid "capital-intensive sectors," which could have trouble borrowing money at attractive rates amid a credit crunch.

"Energy and materials are two very capital-intensive sectors," he said. "Housing and real estate are clearly capital intensive. More insidious are some of the emerging market stories."

Bernstein said the unique aspects of this cycle "were unbridled credit creation, liquidity and speculation." That led, he noted, to speculation in stocks, lower-quality debt (or bonds), currencies, commodities, emerging-market debt and stocks, private equity, real estate and hedge funds. So, he said, investors must be cautious about seeing buying opportunities based simply on downturns.

During the past 30 days, materials have been the worst-performing sector in the Standard & Poor's 500, and financials have been second from the bottom.

Bernstein said "emerging-market stories are just beginning to unravel," with the MSCI emerging-market index down about 12 percent last month.

While all sectors have declined recently, Merrill Lynch strategist Brian Belski said the market has rotated toward growth and away from commodities.

He is suggesting that investors downgrade financial stocks because they will remain under pressure and add to technology stocks, which could gain as investors seek expanding earnings at a time of slower growth.

Gail MarksJarvis writes for Tribune Media Services.

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