By Jonathan Burton
SAN FRANCISCO — Stocks could use a shot of Botox right now to smooth those deep lines and wrinkles. But change isn't always pretty. New forces control the global markets and many U.S. investors are wondering how that affects them.
The simple answer is: In unfamiliar and unexpected ways. Large-capitalization stocks are outperforming small-cap stocks and growth stocks are crushing value names. Technology, industrials and energy have held up better than financials and real estate. The trillion-dollar question heading into the new year is whether people cut back on spending and the U.S. economy slips into recession.
In a transition period like this, market volatility is a given. Winning investment strategies for the next few years will be markedly different from those which dominated in the recent past.
Volatility also gives forward-thinking investors a chance to ride long-term investment waves.
"Recession is still very much in the cards," says Komal Sri-Kumar, chief global strategist at mutual-fund giant TCW. "At this stage, what you should be doing is looking beyond the recession at the economic recovery that is likely to follow."
Here are 10 ways to position your portfolio in the coming year and beyond:
1. Buy U.S. Treasury bonds
Don't fight the Fed. The U.S. central bank has lowered short-term interest rates twice since August and while policymakers could pause in December, future cuts are likely. It's the best hope of keeping housing, banking and consumer spending from deteriorating further and sparking the first consumer-led recession in a generation.
"This easing cycle still has plenty of legs," Merrill Lynch & Co. economist David Rosenberg wrote in a recent research note to clients. He sees the Fed funds lending rate headed toward 3 percent in 2008 from 4.5 percent today, and perhaps as low as 2 percent before the Fed is done and the economy recovers.
No surprise, then, that Treasury bonds are rallying. Bond prices rise when declining interest rates push down yields, and U.S. government debt, which can be purchased directly from the Treasury, is the safest you can own.
"Consider allocating more into the 10-year Treasury," says Bernard Baumohl, managing director at forecasting firm The Economic Outlook Group. "If the economy is slowing we're going to see a lot of people moving out of the stock market and into Treasurys, which translates to higher demand, higher prices and lower yields."
2. Embrace large-capitalization U.S. stocks
Large-cap stocks are leading the U.S. market in a big way — for good reason. Outside of financials and housing, corporate balance sheets tend to be solid, so borrowing is minimal, and many shares are priced attractively to expected earnings growth.
Plus, large-cap companies are likely to have international sales that benefit from the weak dollar. Earnings in euros, for example, are worth more in dollars. Rosenberg, the Merrill Lynch economist, told clients in a report to pay close attention to companies' foreign sales — extra padding in a slowdown. Even if the greenback strengthens against major world currencies, as some strategists predict, U.S. exporters should still see healthy profits.
Blame pessimism on past experience. The last time Americans faced a combination of declining home prices, tighter credit conditions, high energy prices, a weak dollar and a cloudy jobs picture — in 1991 — a consumer-led recession followed.
The discouraging "R" word is often heard nowadays, but its roots were evident more than a year ago when MarketWatch published a report on how to recession-proof your portfolio. See full story.
Even if the slowdown doesn't become a full-blown recession, shaken consumers will save more and spend less. The best-performing market sectors in that environment, according to Bank of America strategist Tom McManus, include technology, energy, consumer staples, and health care.
Ten stocks on his list to buy: Abbott Laboratories; Emerson; Entergy Corp.; Fannie Mae; Freddie Mac; Johnson & Johnson; MetLife Inc.; PepsiCo Inc.; Procter & Gamble Co. and Yum! Brands Inc.
3. Rotate to growth stocks over value
An old Wall Street adage holds that when corporate profits are abundant and even lesser firms are thriving, investors price earnings growth like water. When growth is scarce, the market prices it like diamonds.
Today, diamonds are your best friend. But many investors will likely find that years of outperformance from small-cap and value-oriented stocks have left them underexposed to growth stocks, particularly large-cap growth, which hold the best prospects.
"Twelve months out I would guess that it's the growth side of the equation that will do better than value, and large-cap stocks that outperform smaller-cap stocks," says Sam Stovall, chief investment strategist at Standard & Poor's.
Growth companies on his list include International Business Machines, Jacobs Engineering Group Inc. and Fluor Corp.
4. Emphasize companies with rising dividends
Companies that boost dividends regardless of economic or market conditions telegraph financial strength and stability. Add earnings growth, and you've got a winning combination.
"Big, broad diversified companies tend to be multinational, with good free cash flow and rising dividends," says Bob Doll, global chief investment officer of equities at investment manager BlackRock Inc. "That's the area of the marketplace that's going to do well."
For the muscle to power ahead when times are tough, Doll suggests global leaders such as ExxonMobil Corp., Chevron Corp., IBM and American International Group Inc.
5. Focus on developed international markets
It used to be that when the U.S. sneezed the rest of the world caught cold. Today, the opposite seems true.
"The U.S. economy is slowing dramatically at the same time the rest of the world is clipping along," says Ernie Ankrim, chief investment strategist for index provider Russell Investments. "Make sure you have enough non-U.S. exposure."
Many experts are convinced that developed markets will outperform. "France is our No. 1 favorite out of 36 economies," says Audrey Kaplan, manager of Federated InterContinental Fund.
Two recommendations: oil titan Total SA and communications giant France Telecom .
Other attractive European markets include Germany and Italy, Kaplan says. She taps Germany's BASF, Daimler AG and Deutsche Bank AG, and Italy's Luxxotica Group.
In Asia, two of Kaplan's picks are South Korean steelmaker Posco and Taiwan Semiconductor Manufacturing Ltd.
6. Overweight technology stocks
The shift to traditional growth stocks has overwhelmingly favored the technology sector, especially large caps. Many big tech outfits boast a wide and global revenue stream - about 56 percent of U.S. tech-company sales on average are international — and customers are expected to upgrade systems.
"The slower the economy gets, the more corporations are going to look for ways to improve productivity," says Charles Rotblut, senior market analyst at investment researcher Zacks.com. "That means more investment in software, servers, computers, BlackBerrys."
Many strategists are particularly bullish on semiconductor companies. Analysts at Zacks point to Intel Corp., SanDisk Corp., National Semiconductor Corp. and Micron Technology Inc.
Stovall at S&P broadens the lineup to include Microsoft Corp., Apple Inc., Hewlett-Packard Co., Oracle Corp., Seagate Technology and Citrix.
7. Play defense in consumer staples, health care
Consumers are getting clocked, but even in the worst economic times, people still buy food, drinks, household products and medicines. That favors consumer-staples and health-care companies.
In consumer staples, Bank of America's McManus taps Coca-Cola Co., Constellation Brands Inc., Pepsi and Procter & Gamble. At Standard & Poor's, Stovall flags Colgate-Palmolive Co. and CVS Caremark Corp.
Among health-care companies, McManus lists Wyeth and Medtronic Inc., along with Abbott Labs and Johnson & Johnson. Federated's Kaplan adds AstraZeneca Plc and GlaxoSmithKline Plc.
8. Keep exposure to industrials
Exports and a weak dollar are the drivers of this cyclical group, but many strategists see ongoing strength from manufacturing companies with international operations.
The best performers, analysts say, will include military contractors and suppliers. These companies are riding a rising tide of global arms spending, which strategists say is likely to march forward regardless of which party wins the White House in 2008.
At Zacks, Rotblut looks for double-digit earnings growth from General Dynamics Corp., while BlackRock's Doll taps Lockheed Martin Corp. (LMT:Lockheed Martin Corporation, Honeywell International Inc. and Raytheon Co.
9. Stick with the energy sector
Oil and other energy stocks have been powering the market for several years now, so questioning the sector's leadership makes sense. Moreover, energy stocks tend to lose steam in recessionary periods and when the Fed lowers interest rates.
Yet energy companies mesh with growth strategies and, like technology firms, mostly operate on a global stage. So while analysts increasingly are neutral or even downbeat on the sector, oil-services firms and oil drillers remain in favor.
Zacks strategist Rotblut points to companies such as National Oilwell Varco Inc. BlackRock's Doll adds diversified giants such as Occidental Petroleum Corp., along with ExxonMobil and Chevron.
10. Scoop up bargains in financials
When do you catch a falling knife?
Banks, brokerages and insurers are getting slammed, and many analysts see the worst yet to come. No one knows how much damage these companies will suffer from subprime-related losses.
It's probably too early to wade into the financial services sector, but not too early to imagine a rebound.
"The financial sector, which I would underweight today, might well be a nice overweight position in the first quarter of 2008," says TCW strategist Sri-Kumar, echoing a controversial sector call from veteran Legg Mason fund manager Bill Miller.
Banks and brokerages have strong incentive to fully account for losses before Dec. 31 and start next year clean, Sri-Kumar adds.
Moreover, Sri-Kumar points out, newly appointed heads of troubled financial giants — think Citigroup Inc. and Merrill Lynch — have a personal motivation for their companies to swallow this bitter medicine sooner than later.
That way, he says, "they're not responsible for the bad numbers, and a year from now are going to look very good by comparison."
Jonathan Burton is MarketWatch's investments editor, based in San Francisco.