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One Eye on the Fed, and the Other on Your Portfolio
Published Sunday, March 12, 2006
By CONRAD DE AENLLE
New York Times

http://www.theledger.com/apps/pbcs.dll/article?AID=/20060312/ZNYT01/603120429/1001/BUSINESS

LIKE a crazed doomsayer who keeps changing the date on his poster foretelling the end of the world, economists have been saying since last summer that the Federal Reserve is about to stop raising interest rates. They will be correct eventually, so how should investors in the stock market prepare for the event?

When interest rates top out, the stock market typically rallies in gratitude that credit conditions will become no worse, investment advisers note. But uncertainty about when the current tightening cycle will end, and concern that a rate peak will also herald slower growth in the economy and corporate earnings, leave much difference of opinion about what portfolio adjustments to make and when to make them.

In times when there is less growth to go around, investors look for businesses that can sustain earnings momentum. The most common places to find them are in stable-growth sectors like health care and consumer staples, or in industries (like some in technology) that are experiencing long-term upward trends that should leave them largely immune from economic swings.

Whatever investors decide to buy, they must also decide when to pull the trigger. Before taking significant steps, some fund managers say that they are waiting for confirmation that the Fed has raised rates for the last time in this cycle. Others have already started their moves, including Walter T. McCormick, head of the value equity management group at Evergreen Investments.

"We're not perfectly clear on when they're going to stop," Mr. McCormick said. "What makes me hesitate in terms of saying the Fed is about to finish is there are signs that the economy is strong. As long as growth is strong, the Fed will have to be vigilant."

Nevertheless, he said, "we know we're getting near the end," and he is already in the midst of his portfolio rearrangement.

By contrast, Henry J. Herrmann, chief executive of Waddell & Reed, the asset management firm, is prepared to wait for concrete indications that the rate cycle has peaked. He said he was putting off making significant adjustments to his holdings.

"We're not, because I don't know when the Fed's going to stop tightening," he said. He agreed, though, with Mr. McCormick that "the economy is stronger than many people think."

The central bank, he said, "is likely to pause, not stop," thereby faking out the markets. "Maybe nine months from now it will be a different story," he said, "but making big portfolio bets on the idea that the Fed's stopping is misplaced."

Fund managers of a more sporting disposition must wager first on whether the Fed will be shown to have raised interest rates by just the right amount or by too much. In the first case, the end of tightening "is potentially a catalyst for the market to start to move considerably higher," said Russ Koesterich, senior portfolio manager at Barclays Global Investors.

The right bet, then, is "to position yourself to take on a little more risk with a rotation back into higher-beta names," or stocks that move in the same direction as the market but with more volatility, he said.

Mr. Koesterich says that such stocks tend to be found in technology industries, especially those like communication equipment that depend on strong corporate buying, and in sectors involved in building industrial machinery and infrastructure. Financial stocks should also benefit, he said, noting that they have been resilient in recent months as investors try to anticipate the final rate increase.

He stressed that the selection of these sectors is based on the assumptions that "we get a soft landing, with core inflation under control and a continuation of the economic expansion," and that the Fed has not made one rate increase too many.

Those are assumptions he is willing to make. "So far," he said, "there aren't really any signs of an imminent collapse of the economy that would suggest that the expansion won't continue in the intermediate term."

Mr. McCormick, at Evergreen, likes several sectors that Mr. Koesterich mentioned, and he is concentrating on larger companies within them. A downshift in economic growth will have a comparatively sharp impact on smaller companies, he said.

"Large-capitalization growth stocks would appear to be relatively attractive," he said. "They will only begin to outperform significantly when the slowdown in growth in the below-large-cap sectors begins to pinch, but then the market will pay more attention to large caps."

Mr. McCormick is paying particular attention to large technology stocks. That is where he has been focusing his post-tightening investments. Two recent additions to Evergreen's portfolios are Cisco Systems and Qualcomm.

Cisco, the big supplier of technology infrastructure, is "beginning to click on an increasing number of cylinders," he said, and Qualcomm offers a chance to benefit from growth in the mobile phone industry, a business in the "sweet spot" of its cycle.

Qualcomm makes a component used in many handsets that eases the signal transfer from one tower to the next when a caller is on the move. The 4 percent royalty that Qualcomm receives on each handset sold with the device makes the stock especially appealing, Mr. McCormick said.

Qualcomm is one of many tech stocks held by Robert E. Turner, manager of the Turner Core Growth fund. He views the semiconductor and telecom equipment industries as particularly good vehicles for profiting from an end to Fed rate increases.

His selections in the first group include Marvell Technology and Broadcom, which he described as his "two biggest overweights," as well as Advanced Micro Devices and Micron Technology. Two that he says he does not hold are Intel and Texas Instruments.

"Semiconductor demand is extremely strong," he said, because of the proliferation of iPods, BlackBerries and other high-tech consumer gear; meanwhile, he said, "tech capacity has not really ramped up much."

The appeal of telecom equipment makers lies in the prospect of more spending by businesses. His holdings in this area include Alcatel, Tellabs, JDS Uniphase and PMC-Sierra.

A THIRD sector he favors is biotechnology. He called Genentech and Genzyme "quintessential growth companies whose earnings should grow, even if the economy slows down."

Rick Drake, co-manager of the ABN Amro Growth fund, likes one biotech stock, Amgen, for its "tremendous product pipeline," but other post-tightening picks are concentrated in financial services and such stable-growth sectors as retailing and health care.

"In the economic environment we're in," Mr. Drake said, "we think investors will look more at consistent-type growth companies" when the Fed stops. He added that "they benefit from a good economy, but they do not need a real strong economy to do well."

Mr. Drake's picks include Fifth Third Bancorp, the Kohl's chain of department stores and St. Jude Medical and Medtronic, makers of medical equipment.

He said he would avoid businesses that depend on continued increases in commodity prices. These have been "driving the economy for the last couple of years," he said. "There's not much money left to be made in the commodity or energy sector."

Mr. Hermann, at Waddell & Reed, would appreciate Mr. Drake's wariness. The conventional view is that the sooner the Fed stops tightening, the better, but Mr. Hermann warned that there was such a thing as too soon. "If the Fed stopped now, people would be surprised and the reaction might be, 'Oh, my goodness, things are weaker than we thought,' " he said. "Probably in that case defensive stocks high-dividend payers, stable, large-cap companies would outperform."