Playing to Win

By TOM PETRUNO

Jan. 3, 1999 12 AM PT

Get ready to roll the dice, pick a card and take your chances. A new year is here, bringing new opportunities for investors to win, lose or draw.

Why the board game analogy for something as serious as your personal finances? Because 1998 was a year in which many people learned, or relearned, that investing is indeed a game--of risk and reward.

Even the most informed investing, by definition, amounts to taking a chance. You can choose not to play in this game, of course. But if you aren’t willing to take risks, you will probably have to settle for very little in the way of reward.

Case in point: Given the extreme volatility that struck the U.S. stock market in late summer, amid Russia’s collapse and fears of financial calamity worldwide, investors who had stayed away from stocks for the last few years may finally have felt vindicated.

Keeping everything in a money market fund looked like a fine idea right about then, as the Dow Jones industrial average shed nearly 20%, or 2,000 points, of its value in the course of six weeks, the worst decline since 1990.

But calamity was forestalled, thanks to some fairly fast work by world central banks to ease credit and restore confidence.

And in the fourth quarter, stock markets almost everywhere staged dramatic rebounds--nearly 25% in U.S. blue chips, 27% in Hong Kong, 84% in South Korea, 23% in Argentina, 33% in Italy.

For the year, despite a harrowing journey, the average U.S. stock mutual fund gained 13.7%.

The investor who kept everything in a money market fund, by contrast, earned about 5%. Subtract 1.5 points for inflation and another 1 to 1.5 points for taxes, and there’s very little left of that 5% return.

This is not an argument for putting every dime into the stock market and just rolling with it (although people who truly have a long-term time horizon might argue that they can and should do just that, if they have faith in a growing world economy).

As stories elsewhere in this section today point out, the issue is the mix: What’s the right combination of investments for your particular risk profile?

The simple explanation for global markets’ turmoil last fall is that a lot of people woke up and discovered that they didn’t have the right mix. So they started selling out of the securities that frightened them most.

Another way to look at what transpired is that the world experienced a sudden “margin call”--that is, it wasn’t so much investors deciding to sell as it was leveraged investors’ lenders wanting their money back.

Still, there’s no glossing over the severity of what happened, albeit briefly, in markets last year.

The speed with which people fled the investment game--unwilling to take any risk--left even the normally unflappable Federal Reserve Chairman Alan Greenspan stunned, and he said so.

Could it happen again in 1999? Might this time be worse, and longer-lasting?

Many of the major risks to stock and bond markets, and the world economy, are well-quantified. Japan is in depression, and the fear remains that it, along with the East Asian financial crisis, has already sparked a severe global deflation that will drive the value of real assets lower worldwide in the years ahead.

Crumbled Russia, while not an economic threat to the world, could be a political threat--the kind of out-of-left-field disaster that destroys people’s confidence in the future and thus in higher-risk financial assets. Ditto for the Y2K, or year 2000, computer bug problem.

Meanwhile, Europe is in uncharted waters with the dawn of the euro; President Clinton will go on trial, and there’s no telling what surprises could emanate from the Senate, given all of the other political shockers this year.

Perhaps most important, as U.S. corporate profits dwindle amid slowing world demand, nearly everything now seems to depend on the so-far free-spending American consumer, who is by many measures tapped out, too deep in debt, and staring at far less job security in 1999.

(Which makes one wonder: Will the International Monetary Fund, so generous in bailing out a long list of nations over the last two years, open the community chest to U.S. consumers if need be--or perhaps to investors who lose everything in Internet stocks this year?)

Graham Tanaka, head of Tanaka Capital Management in New York and an investor for nearly 30 years, concedes that a lot of things went wrong last year for markets.

But looking ahead, he chooses to take a different view of the risks. “The Asia-crisis card has been played,” Tanaka says. “The oil-Iraq crisis card has been played; the Clinton scandal card has been played.”

Given the number and magnitude of last year’s crises, he says, one could ask, “How many more could be out there?” And if you can’t shock investors much more than they were shocked last year, he adds, might the bottom line be that markets’ path of least resistance is higher?

“We think Asia could be a very nice surprise in the second half of 1999,” Tanaka says, referring to the potential for recovery there. A world no longer fearing collapse, he says, could be a world in which U.S. blue-chip stocks rise another 10% this year, and smaller stocks gain 15% to 20%, on average.

But what about those supposedly stratospheric valuations on U.S. stocks, even as earnings growth overall slows? Shouldn’t there be a limit to what you pay for a share?

There should be--and, apparently for many people, there was in 1998. Consider: Even as a relative handful of blue-chip stocks lifted the major U.S. share indexes for the year (the Standard & Poor’s 500 jumped 26.7%), the majority of stocks declined for the year.

Fifty-seven percent of New York Stock Exchange issues fell in 1998; on Nasdaq, a whopping 66% of stocks declined.

That could, of course, indicate the start of a long market downturn to which blue chips will soon succumb. But you could turn that around: If most stocks are down, does that mean more buying opportunities for investors who can take a long-term view--especially considering that interest rates on high-quality bonds are offering far less competition for money than in a generation?

Money manager Ron Baron, head of Baron Capital Management in New York, thinks so. When stocks plunged last year, he was busy buying more of his favorites--names like brokerage Charles Schwab, auction house Sotheby’s Holdings and resort operator Vail Resorts.

“I try to figure out what’s going to be a great business long-term, and buy them when the stocks get more attractive--which they always do,” Baron says.

It seems to work: His Baron Asset stock fund (of which I am a shareholder) handily beat the average small-stock fund in the 10 years through last September.

But Baron has no private line to the market gods. He could be dead wrong about his stock ideas. That’s the risk he--and I--are willing to take, for the chance of a decent reward.

In the bond market, Newport Beach-based Pimco Funds’ Bill Gross, who manages one of the world’s biggest bond portfolios, takes a less sanguine view of 1999.

He worries about more economic and market bombs going off in the world--the proverbial “other shoe.” Says Gross: “It’s just not a good environment for risky assets.”

But leaving the investment game is hardly an option for Gross. So he tries to lower his risk by keeping clients’ moneys mostly in higher-quality bonds, mainly government issues.

If the other shoe indeed drops, however, Gross says he will be ready to buy lower-quality bonds, such as junk corporate or emerging-market issues, as their yields presumably soar again as frightened investors flee.

Balancing risk and reward. Taking more risk when the rewards also appear greater. That’s really the way the game is successfully played.

As for trying to predict the future, listen to Barton Biggs, the chief global strategist for brokerage Morgan Stanley Dean Witter, in his year-end letter to clients:

“About next year, if anyone really knew, they wouldn’t tell you.”

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

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A Snapshot of U.S. Markets

Wall Steet’s bears say the U.S. stock market is terribly overpriced. And there’s no question that historically speaking, the average blue-chip stock commands a lofty price relative to underlying earnings--the price-to-earnings, or P/E ratio. Bu that average is being skewed by some very high priced growth stocks that rocketed in 1998. Yet most stocks declined for the year. Is that an omen--or an opportunity, given much lower interest rates?

Blue-Chip P/Es Rise. . .

S&P; 500 P/E, based on most recent 12 months’ operating earnings:

15-year high: 27.2

Current: 26.8

15-year low: 9.1

While Most Stocks Are Down. . .

All NYSE and Nasdaq stocks, 1998 price changes:

Pctg. of issues rising: 36.4%

Pctg. of issues unchanged: 1.2%

Pctg. of issues falling: 62.3%

. . .Even as Bond Yields Tumble

10-year U.S. Treasury note yield at year end: