Stocks: No Time to Panic

The call to "sell in May and go away" reverberated around the investment world two months ago. To have acted on that Wall Street saw would have been neither a blunder nor a blessing. The question now is whether to cry in July while stocks go awry or stand firm in what appears to be a major setback.

How major? It may sound wishy-washy to fob this off as a ride on a roller coaster, but that's what it is: The market is giving back most of the big 5% gain it racked up between the start of May and July 19. Barring an unforeseen shock, we at Kiplinger still expect overall market returns of about 10% for 2007.

Investors are understandably concerned about tighter credit and the potential that such discipline will shut off the takeover activity that helped push the Dow Jones industrials past 14,000. If it wasn't evident as the Dow and other indexes were racing to record highs, it should be clear now that debt is a two-edged sword. Much of the recent merger boom rests on borrowed money. At some point, lenders decide not to lend or demand higher interest rates so they can entice buyers to invest in their bonds and loans.

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As a result, the pace of deal activity slows. This isn't a bad thing. It should contain some of the more-bizarre transactions, such as madcap bidding wars between companies fighting over competitors. For example, Alcoa thought Alcan, a rival aluminum company, was worth $27 billion. Rio Tinto, another metals giant, then came in with -- get this -- $38 billion. A windfall for Alcan shareholders, but is this good business?

This week's stock plunge shows that traders tend to view the actual economy by the trend of activity rather than by the actual levels. The Federal Reserve Board reported earlier in July that the overall delinquency rate on all bank loans and credit cards remains low, although, at 1.74%, it's edging up from last year's bottom of 1.51%. This reading was never less than 2% from 1985 until 2004 -- a period when the bulls pretty much stomped the bears except during the period of the dot-bomb fiasco.

Even the delinquency rate on home mortgages isn't yet historically high. It's 2.01%, compared with 1.57% a year ago, but it was 2.25% at the start of the last recession in the fall of 2001. The delinquency rate has remained manageable despite widespread evidence that lenders have dramatically eased credit-granting standards. But the figures are heading in the wrong direction, as far as Wall Street is concerned. That's why volatility is on the rise, whether the news is good or bad.

It's premature to say the market is taking a summer dip in the River Styx. It wasn't just mortgage worries, lousy home sales and raw emotion that caused both the Dow and Standard & Poor's 500-stock index to drop 2.3% on July 26. ExxonMobil (XOM) picked this day to issue its second-quarter earnings and missed analysts' forecasts by a wide margin, blaming weak natural gas prices. So now Exxon is only up 15% for the year rather than 20%. Carpenter Technology (CRS), a specialty steel company with a stock that has been hotter than a blast furnace, also reported disappointing earnings and got slammed 12%. Carpenter shares are still up 16% for this year and more than 400% over the past five years.

A few key companies actually reported good news on this dark day and were rewarded. Apple (AAPL) rose more than 5% on strong profits and enthusiasm for its new iPhone and its laptops. Bunge (BG), a fertilizer and oilseeds company, rose 5.5% on excellent earnings. And 3M (MMM) announced a good quarter, so its shares moved a little higher. Lenders with notably high credit standards, such as Thornburg Mortgage (TMA), held up okay, while other financial companies that aren't known to be so persnickety got slammed. After the market, Amgen (AMGN), the drug company, reported good earnings and positive news on the product front, so it stands to trade higher in the morning.

What's next?

Citigroup's bullish strategist, Tobias Levkovich, says many conceivable catalysts could lead to a severe market downturn but not much chance that the worst will happen. Wall Street has been wrong before in failing to see the end of bull markets, but if the economy simply stays out of recession, there's no reason that the Dow won't hang around 13,500 to 14,000 by the end of the year. That suggests total returns for the market of about 10% in 2007. And stocks certainly aren't expensive. After the July 26 stumble, the S&P 500 trades at about 16 estimated 2007 profits and 15 times next year’s earnings.

After any powerful charge, you have to brace for backtracking. If you own individual stocks that have climbed sharply -- Carpenter would be an example -- there would be no harm in selling some shares and investing the proceeds in conservative mutual funds or even just putting the money in cash for a while. The same is true with bonds. Junk is out, and higher-quality holdings are in. But there's no reason to dump good stuff wholesale. Most investors saving for a long-term goal, such as retirement, should keep 70% to 75% of assets in a diversified package of stocks and stock funds, 5% in real estate investments, 15% in bonds and 10% in cash, or something similar.

Make sure that at least 15% to 20% of your stock holdings are in international funds. One thing that's changing is the idea that the rest of the world's economies and markets follow the U.S.'s lead. They certainly don't so as much as they used to. In fact, such industrial giants as Caterpillar, General Electric and IBM rely increasingly on foreign sales to rev their growth. The forecasts on that score continue to be encouraging.

Sure, July 26 was a bad day, and this is a bad week. But that's part of the sport of investing.