Clearly, there are some weird goings-on in this market, and it appears to be an equal-opportunity crusher. Here’s a brief guide to the risks and steps to take to protect yourself.
Know thy portfolio: You’re not as diversified as you think you are. Many fund investors figured that out for the first time when their supposedly broad-based portfolios tanked and then rebounded with the Nasdaq over the last couple of weeks. The Standard & Poor’s 500 Index is approaching a 40 percent technology weighting (as are the index funds which track it). Almost one of every two dollars in a mid-cap growth fund is in a tech stock, and lots of funds go way beyond that, says Morningstar, Inc. Even the biggest, most widely held and supposedly diversified funds are heavy into tech, too: Fidelity’s Magellan and Contrafund each have almost 25 percent in tech stocks; the firm’s Blue Chip Growth Fund is 35 percent in those New Economy stocks, too. American Century Ultra and Putnam Voyager are each 39 percent tech-heavy.
Put it all together, and you can have a personal portfolio that is dangerously high in overpriced technology stocks. It may even be overweighted in individual companies, since there are specific stocks that every portfolio manager owns (Cisco Systems, anyone?). To determine just how tech-heavy you are, you really have to open the semiannual reports and read what your fund manager is buying. Or you can go to Morningstar.com, type all of your stock and fund names into the firm’s free “portfolio X-ray” analyzer, and see how your portfolio’s sector weightings compare to those of the S&P 500.
Don’t give up on tech altogether, cautions Merrill Lynch chief U.S. strategist Cheryl Rowan. It’s the only place she expects to see earnings grow by 35 percent a year or better going forward. But if you’re too tech-heavy, consolidate funds that have similar holdings and buy a new one for ballast. Some decent funds that are keeping tech to a minimum are American Century Equity Income, Clipper and Artisan Small Cap Value.
Profits matter: Internet-stock touts sold the notion that these shares were too different to be assessed by normal price- earnings measures and could be assessed by the traffic on the site: eyeballs, clicks and the like. Perhaps that worked for venture capitalists but not for stock investors, who lost their shirts when everyone woke up and realized that earnings matter after all. It’s commonly accepted that the firms that will hold their own in this market are those that make money and are expected to make more. But that’s never easy to measure with new firms, high-tech or not.
Analysts are depending more heavily than ever on price-to-earnings growth (PEG), a way of comparing stocks of companies that might be selling at radically different price-earnings ratios in part because they are growing at different rates. It is derived by dividing the long-term expected profit-growth rate into the current PE ratio, which is itself derived by dividing one year’s per-share earnings by the company’s share price. Pretty technical, but done right, it will tell you how much growth potential you’re buying with every dollar of share price; a PEG of one or less is considered a reasonably priced stock. If a company is really doubling its earnings every year, for example, it might actually be worth 100 times current earnings.
But there are risks. PEG ratios are only as good as the long-term earnings-growth estimates upon which they are based. A pie-in-the-sky outlook could make a lousy stock look cheap. Avoid that risk by backing up PEG plays with other data, suggests Ted Murphy, a quantitative analyst who runs marketplayer.com, one of the more thorough stock-screening sites on the Web. Look at how much cash a company is creating relative to the money that’s been invested in it; traditional value analysis would put that figure at 25 or more. If you’re mining for new ideas, seek shares of firms that already have shown solid earnings growth in the past and have enough market capitalization, say $5 billion or more, to ride out rough times.
Protracted declines: You think every sell-off is a buying opportunity. Yeah, that’s what everyone thought back in ‘29, too. Here’s what The New York Times said back then, two days before the Big Sell-Off: “The repeated demonstrations which the market has given of its ability to ‘come back’ with renewed strength after a sharp reaction has engendered a spirit of indifference to all the old-time warnings.” So, for posterity’s sake, here are some old-time warnings. Even with the immediacy of today’s market reactions, there could come a sell-off that isn’t retraced within days or even months, or even years. The money that you need within the next five years should not be in the market. The money that you won’t need for 10 should. If you want to really take advantage of the drops without becoming a market-obsessed (and money-losing) day trader, use the quaint technique of dollar-cost averaging. Pick a really diversified fund, such as a total market index fund, and invest a like amount every month, regardless of market activity. You’ll buy more shares when the prices are low, fewer when they are high, and develop an immunity to the daily drama. Bull or bear, it will all be good news to you.
Helpful HintsDiversify:
Analyze: Choose stocks that are priced right relative to their earnings and earnings growth. You can hunt for good fits at Marketplayer.com.
Stay Calm: Ride out market swings by dollar cost averaging. Invest steadily, think long term and ignore the little lurches.
