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Long-term investment outlook spells trouble

Published Aug. 24, 2005

This trend isn't your friend.

I claim no ability to forecast the market's short-term direction. But I think it is worth paying attention to longer-term trends.

On that score, one phenomenon stands out: The long decline in interest rates is almost certainly over. I am not sure what that means for 2005. But it will have a huge impact in the decade ahead.

ALL FALL DOWN: When the Dow Jones Industrial Average plunged nearly 23 percent on Oct. 19, 1987, many observers saw it as a watershed event. It wasn't.

Instead, the 1987 crash turned out to be a mere blip in an extraordinary two-decade run that carried the Dow industrials from 776.92 in mid 1982 to 11,722.98 in early 2000. That, of course, was when stocks crashed again. This time, however, it really was a financial watershed.

Think about how things changed in early 2000. During the final years of the bull market, overconfident investors recklessly gunned for capital gains, first betting on the big blue-chip stocks in the Standard & Poor's 500 stock index and then, in the bull market's final hurrah, turning to technology stocks with no profits and scant sales.

But in the years since, there has been a complete about-face, with increasingly skeptical investors favoring real assets over paper assets, hunting for income rather than capital gains, and smiling on anything that wasn't the S&P 500.

That has meant healthy gains for, among other things, property prices, gold stocks, smaller companies, real estate investment trusts, foreign stocks, dividend-paying companies, high-yield junk bonds and inflation-indexed Treasury bonds. In fact, if you consider the market to be the S&P 500, then picking market-beating stocks and stock funds has been a cinch in recent years _ including the market bounce-back years of 2003 and 2004 _ because so many investments have outpaced the S&P.

RATE ADVENTURE: Why has the market's mood changed so much during the past five years? Stocks may have been brought down by a combination of economic weakness, tighter monetary policy, absurd valuations, accounting scandals and Sept. 11, 2001.

But to understand why the great bull market isn't coming back, you need to look at interest rates. As inflation waned through the 1980s and 1990s, the yield on the benchmark 10-year Treasury note fell from almost 16 percent in September 1981 to 3.1 percent in June 2003.

That long interest rate decline didn't just shove bond prices higher. It also made the principal investment alternative _ stocks _ appear increasingly attractive, helping to propel shares to the ridiculous valuations we saw in early 2000.

But the joys of subsiding inflation and falling interest rates are apparently over. With the 10-year note at 4.3 percent, there isn't a whole lot of room for interest rates to fall further.

Maybe rates will muddle along at current levels. Maybe they will rise, as inflation revives, the federal government budget deficit balloons and foreign bondholders demand higher yields to compensate for a falling dollar. Either way, there are four key implications for investors.

+ Stocks and bonds probably will generate only modest returns. Without the fuel of falling interest rates, bond investors can't expect to earn anything more than their yield.

Meanwhile, with the S&P 500 still at a lofty 21 times trailing 12-month reported earnings, price/earnings multiples are more likely to fall than to rise. That means stock investors will have to rely on earnings growth to drive share prices higher.

As always, diversifying your stocks beyond the S&P 500 makes a ton of sense. But I am more excited about foreign markets than about smaller U.S. companies or REITs.

It goes back to those longer-term trends. Not only do valuations among foreign stocks seem more compelling, but also the dollar has been declining for just three years. By contrast, small stocks have outperformed the S&P 500 for the past six years and REITs for five years. Both trends may have almost run their course.

+ It is hard to get excited about short-term bonds, which pay about 3 percent, or inflation-indexed Treasurys, which yield some 2 percentage points above inflation. Still, they may be the best bet for the bond portion of your portfolio.

Yields elsewhere in the bond market aren't much better, and at least short-term bonds and inflation-indexed bonds won't get crushed if inflation and interest rates head higher.

+ Faced with the risk of rising rates, this is a good time to lock in your borrowing costs. If you have an adjustable-rate mortgage, consider swapping into a fixed-rate loan. If you have large balances on your credit cards or your home-equity line of credit, consider substituting a fixed-rate second mortgage.

True, that might initially increase your borrowing costs. But in return, you will get protection against rising interest rates.

+ If mortgage rates edge up, property prices are likely to stagnate. But if the climb in rates is accompanied by renewed inflation, today's heavily indebted homeowners may luck out.

That higher inflation will reduce the real value of their mortgage debt and it could buoy home prices.