If Market Twists Have Stomach Churning, Take These Buffers Merrill Lynch, Prudential Experts Not Optimistic About 1998

Coming amidst the holidays, when many of us are feeling light in the wallet already, the stomach-churning stock market downturns like those last week make you wonder just how much excitement we’re meant to take.

Fortunately, there are a number of ways to calm the nerves and keep your investment portfolio healthy. And it’s time to start organizing your strategy for 1998, anyway.

Long-term forecasts are often wide of the mark, but it’s still prudent to note that many pros expect stocks to be hurt by a slowdown next year in corporate earnings and the overall U.S. economy, partly because of the economic turmoil in Asia.

Most expect inflation to stay low and interest rates to fall, which is usually good for stocks. Nonetheless, most don’t think stocks will repeat the wonderful performances of the last few years, and many predict a deep correction or short bear market.

Richard T. McCabe, chief market analyst for Merrill Lynch, predicts rising stock prices early in 1998, then a correction that could take stocks down as much as 25 percent. Stocks may resume climbing late in 1998 or in 1999, he says.

At Prudential Securities, technical analyst Ralph Acampora last week revised an earlier forecast that the Dow, which closed Friday at 7,679.31, would hit 10,000 by mid-1998. Now he thinks it will trade between 6,000 and 8,600 next year, with the heaviest declines coming in the second half. He predicts that 75 percent of the stocks on the New York Stock Exchange will be 20 percent below current levels a year from now.

For the long-term investor, the simplest way to handle all this is to do nothing. After all, how often have you wished you could travel back in time and buy stocks or stock funds at the prices of yore? Now you’ll get your chance.

That’s not really meant to be smart-alecky. The long-term investor who puts money into the market every week or every month gets more shares for his money when prices are down, fewer shares when prices are up. Over time, this process of “dollar cost averaging” allows you to build a portfolio of stocks bought at below-average prices. That increases your long-term profit.

Obviously, though, in the short run a downturn does reduce the value of the securities you already own. There are several strategies for reducing this risk.

One is to change the balance of your portfolio, reducing the percentage held in stocks and increasing the amount in bonds and cash. Many investors should be doing this anyway because the big stock runups of the last three years have left them “overweight” in stocks.

The risk, of course, is that this causes you to miss some gains if stocks keep rising. But that sacrifice may not be so great.

For example, if stocks rise 15 percent, bonds yield 6 percent and cash pays 3 percent, a portfolio that’s 70 percent stocks, 20 percent bonds and 10 percent cash would gain 12 percent. One that’s 60 percent stocks, 30 percent bonds and 10 percent cash would gain 11.1 percent. Reducing the risk from stocks can thus help you sleep and not cost much if stocks rise instead of fall.

In reducing your stock holdings, the obvious candidates are the losers, since they can produce tax savings by offsetting capital gains and some other income. But the best approach is to review each holding and and ask whether you’d buy it at today’s price. If the answer is “no,” it’s a candidate for a sale.

Taxes shouldn’t dominate the decision but should be considered. Losing investments should be sold by the end of the year so you can take the loss in your 1997 tax return. Moneymakers should be sold after New Year’s so you can postpone the tax until April 1999.

You might consider doing your stock trimming in your 401(k) or IRA accounts. That way, you won’t owe tax on any profits from the sales. (But losses incurred in tax-sheltered accounts don’t bring you tax deductions, so you’re better off selling losers in taxable accounts.)

Other ways to deal with a risky market:

Buy “put” options. These give you the right to sell a block of stock at a set price anytime during a given period - at today’s price for the next six months, for instance. This protects you if the stock’s price drops. Options are available for many individual stocks as well as indexes such as the S&P 500 and the Dow. You can buy an option to protect a block of stock you already own or to bet on movements in stocks you don’t own.

Selling short. Borrow shares of a stock from your broker and sell them at today’s price. If the price falls, you buy shares to replace the borrowed ones and profit on the difference between that purchase price and your earlier sales price. You risk a loss, however, if the price rises and you must replace the borrowed shares with ones that are more expensive.

Invest in real estate investment trusts. These are funds, something like mutual funds, that own real estate. Historically, real estate prices and rents respond to different economic factors than drive stocks. So REITS, and mutual funds that invest in REITS, can go up when stocks go down.

Invest in short-term U.S Treasuries. One-year bills pay about 5.44 percent and two-year bonds pay about 5.61 percent. That’s better than bank savings or money market funds. Treasuries are government-guaranteed, and short-term securities don’t suffer the kind of price declines that hurt long-term bonds when interest rates rise.

Investors who think interest rates will fall next year can buy long-term bonds in hopes that lower rates will drive bond prices up. But if they’re wrong, they will have to sell the bonds at a loss or suffer with their low yields for a long time.

Invest in municipal bonds. You can earn more than 5 percent per year in tax-free income. For an investor in the 28 percent tax bracket that’s like earning 6.9 percent on a taxable bond. As with Treasuries, you risk a loss on a long-term muni if interest rates rise.