Recession? Where to put your money now

Gloom in the markets means great opportunities, if you've got courage and patience.

By Shawn Tully, editor at large

(Fortune Magazine) -- Here we go again. Day after day, Americans are being bombarded by a relentless drumbeat of unsettling economic news. The Dow regularly swings by hundreds of points in a single session as it gyrates near bear-market territory. Oil prices keep bubbling toward $100 a barrel. The dollar is crumbling, and a rogue trader in Paris is blamed for triggering a synchronized selloff heard round the world. We're constantly warned that an ugly recession is looming, if not already here. It's all enough to cause a panic attack.

Don't let the doomsday headlines and the careening markets scare you. Take a sip of Chardonnay - or a shot of bourbon - and remember your history. We've been through this kind of wrenching volatility many times before: during the meltdown in October 1987, the S&L crisis of the early 1990s, the Asian Contagion of 1997 and 1998, and most recently, the tech bubble of 2000. These plunges are both predictable - because they're part of the bumpy ride that holding stocks is all about - and unpredictable, because you never know when they'll strike. In fact, stocks offer big returns in the long term precisely because their performance zigzags wildly at times like these. "Investors should be grateful for bear markets, because without them stocks would offer bondlike returns," says Larry Swedroe, a financial advisor with Buckingham Asset Management in St. Louis. So while it's tough to see anything good about this rocky market while watching your 401(k) shrink - the S&P 500 index is off 13% from its high in October, and the Nasdaq has shed 18% - remember that big selloffs present rare and essential buying opportunities, and the current one is no exception.

Still, investors need to temper their courage with caution by picking investments that are genuinely cheap, not just less expensive than they were a year ago. This isn't a shopper's paradise like the early 1980s, when every type of stock seemed to be a screaming buy. But for the first time in years we're seeing lots of genuine bargains, chiefly in beaten-down sectors that have already gone through the equivalent of a steep recession. It's a great time to grab big-dividend-paying bank and pharma stocks, for example. Meanwhile, keep plenty of cash so you can pounce when still-overpriced issues - hint, the tech sector is full of them - spiral downward. It's going to happen: That's why bear markets are a gift to nimble investors.

This story will help you make smart decisions to profit from today's turbulence. We'll guide you through the market noise and Wall Street chatter so that you'll make the right moves at the right times. We'll start by looking at current conditions; then we'll get down to specific stocks, bonds, and funds to buy now.

Wall Street wisdom says that the biggest danger to the markets is the R-word: recession (generally defined as two quarters of falling gross domestic product, but "officially" determined after the fact by the National Bureau of Economic Research). However, the predictions of a deep downturn are highly exaggerated, in part because Washington is rushing to revive the flagging economy. GDP increased 0.6% in the fourth quarter (on first estimate), after a powerful 4.9% surge in the third quarter - so no contraction yet. Exports are booming, growing at an annual rate of 13%, thanks to the weak dollar. The employment picture is surprisingly resilient. Jobless claims, a reliable harbinger of recession, have averaged about 325,000 for the past four weeks, far below the danger point. "We haven't seen the 25% increase in jobless claims we had before the last two recessions," says Michael Darda, chief economist with MKM Partners, an equity trading and research firm. "We're not getting a recession signal."

The forces weighing down the economy are soft consumer spending and plummeting housing prices, along with far more expensive credit that's slowing everything from auto purchases to the creation of new businesses. Those factors are a serious drag on demand. But they pose their gravest threat in the first two quarters of 2008. If we're going to get a recession, it will most likely happen amid this turmoil, in the first half of this year.

But any slump is likely to be short and mild, mainly because Washington is on the case. Since mid-September, Federal Reserve chairman Ben Bernanke has reduced the target for the Fed funds rate by 2.25 percentage points, with the biggest move, a sudden 75-basis-point cut, coming on Jan. 22. On Jan. 30, the Fed cut another half-point, bringing the target to 3%. It usually takes six to nine months for a Fed rate cut to bolster consumer and business spending. By midyear the flood of liquidity will be channeled into new loans for companies and consumers. A resurgence in easy credit - stoking the appetite for everything from big-screen TVs to capital equipment - will be practically irresistible. Consumer spending will get another boost from the roughly $150 billion economic stimulus plan Congress is poised to approve. Checks that could range from $1,000 to well over $2,000 are likely to start going out to families this summer. The easy money doesn't stop there. The Fed has practically promised even more rate cuts. The markets are predicting that the Fed funds rate will be 2% to 2.5% by year-end. With that kind of aggressive stimulus, look for growth to jump back to the 3% to 3.5% range in the second half of the year. Says Brian Wesbury, chief economist at First Trust Advisors: "You simply don't get recessions when the Fed funds rate is at 3% or below, and the Fed is in a strongly expansionary mode."

Those low rates, though, are creating the conditions for a bigger crisis down the road. "The real challenge will be inflation," warns Darda, "not the near-term economic worries that the financial press is harping on." After fretting over surging prices early last year, the Fed is now ignoring them in its all-out campaign to revive the economy. But the threat isn't going away. In 2007 the consumer price index rose 4.1%, the biggest jump in 17 years. The combination of high oil, food, and metals prices, along with low interest rates and growing global demand, is a classic recipe for inflation. "Much higher inflation is practically inevitable," says Carnegie Mellon economist Allan Meltzer. Eventually the market will wake up to the problem, and so will the Fed. "The real danger is in 2009 and 2010," says Meltzer. "The Fed will be forced to raise rates substantially to kill off inflation, possibly causing a recession."

While the economic outlook is highly uncertain, one key fact is not: Stocks are still expensive. Wall Street analysts never tire of telling investors that equities are cheap. They cite the current price/earnings ratios, which indeed appear reasonable. The problem is that corporate earnings are coming off not just a cyclical peak but a historic pinnacle, which makes P/E ratios look artificially low. Until late 2006, average earnings for the stocks in the S&P 500 had jumped by at least 10% over the previous year for 18 consecutive quarters, a feat never before achieved. (Profit margins rose to well above their historical average as well.) Yale economist Robert Shiller has developed a formula that smooths out earnings to remove the cyclical spikes. It shows that stock prices now stand at a lofty 24.5 times earnings - well below the towering 27.5 posted in March but still leagues ahead of the long-term average of around 15.

Now we're ready to get down to business. As an investor, you face two challenges in today's tumultuous market: First, you have to choose bargain stocks while recognizing that the overall averages are still extremely pricey and have plenty of room to fall. Second, you must assemble a portfolio that will protect you from the claws of inflation, while keeping plenty of funds in cash so you can grab the beaten-down buys when they appear. We offer our advice with a big proviso: If you already have a sound, highly diversified portfolio spread across a wide variety of U.S. and foreign large-cap, value, and small-company stocks, you're already positioned to withstand and even profit from market shocks. In that case, we recommend that you do nothing. Simply stay with your plan. But if you're about to start building a portfolio, or if you've just received a big bonus or inheritance, or if you're stuck in high-cost funds guaranteed to sap a huge part of your future gains, even if you're regularly adding to your 401(k), Fortune can guide you to both profit and protection of your money in turbulent times.

Watch those fees

One thing is true in good markets and bad: Investors who pay big fees will fare far worse than those who exclusively buy ultra-cheap funds. Vanguard founder John Bogle, the leading apostle of low-cost investing, estimates that the average actively managed mutual fund absorbs an astounding 2.5 percentage points in expenses (the total of sales charges, management fees, and trading costs) - vs. one- or two-tenths of a point for most index funds and exchange-traded funds. Research shows that index funds perform just as well as actively managed mutual funds before fees, and that after fees, it's no contest. "All the studies show that expenses are the most powerful indicator of a fund's performance," says Russell Kinnell, director of research at Morningstar.

Index funds and ETFs come in all varieties, covering large and small stocks, growth and value styles, foreign and domestic, and everything in between. The most popular are those that cover the whole range of large-cap U.S. stocks, including Vanguard 500 Index (VFINX) and Fidelity Spartan 500 (FSMKX). ETFs are similar to index funds, except that they trade on exchanges like stocks. The Rydex Russell Top 50 (XLG) is a Morningstar favorite that holds the 50 largest U.S. stocks. It's a bit pricier, with annual expenses of 0.2%, but still a bargain.

Dividends can cushion the blow

The big selloff is creating a rare opportunity: a chance to buy big-dividend-paying companies at yields we haven't seen in years. Dividend stocks offer fatter yields when their prices fall - and that's precisely what has happened in sectors as diverse as financial services, pharmaceuticals, and tobacco.

There are lots of reasons to love dividends. They're taxed at only 15% at the federal level, at least until 2010. Unlike the fixed interest payments on bonds, they generally grow with earnings. So yield stocks are a great hedge in America's jittery new world of sharply rising prices, and the ability to pay a consistent dividend signals that the company is healthy. "It shows that management believes the prospects are good," says Lowell Miller of Miller/Howard Investments, a money management firm. (Of course, an unusually high yield can be a warning sign: Citigroup's yield jumped into double digits shortly before the beleaguered bank cut its payout.) For investors, the crucial task is to find solid players that are unloved but boast strong, predictable earnings. Those companies will keep dispensing - and increasing - dividends. If you want growing income for life, now is the time to pounce.

Where do you go hunting for yield? One place to start is pharma. Today Bristol-Myers Squibb (BMY, Fortune 500) and Pfizer (PFE, Fortune 500) yield over 5%, and GlaxoSmithKline (GSK) isn't far behind at 4.5%. A second category is utilities. Here, prices are far stronger, but yields remain attractive: Consolidated Edison (ED, Fortune 500) for example, pays over 5%, and its earnings are solid as granite. A number of big utilities that specialize in energy distribution offer attractive yields, and they're protected from the bumpy economy by regulated rates of returns. Pepco Holdings (POM, Fortune 500), AGL Resources (ATG), and WGL Holdings (WGL) are all paying around 4.3%. A smart strategy is diversifying via ETFs and index funds. Vanguard's SPDR S&P Dividend ETF (SDY) spreads the risk among 52 stocks that have increased their payouts steadily. Current yield: 3.5%.

Buy battered shares, if you dare

If you have a strong stomach for risk, read on. In this section we'll talk about the two most reviled, bloodied sectors in the current carnage - banks and homebuilders. The argument for buying them selectively is compelling, for this reason: They pass the test of being genuinely cheap. When it comes to banks and homebuilders, the market's expectations are extremely low, hence easy to beat. Let's look first at banks. The best buys aren't the Wall Street giants, which depend heavily on highly erratic profits from trading, but the big, diversified players that sell lots of retail products, from credit cards to checking accounts. They've suffered from write-downs too, but the worst is behind them, and the Fed's rate cuts will boost their profit margins on loans. Four excellent picks are Bank of America (BAC, Fortune 500), Wachovia (WB, Fortune 500), Wells Fargo (WFC, Fortune 500), and US Bancorp (USB, Fortune 500). BofA and Wachovia earnings have been dented by bad subprime debt but are still extremely strong. Both stocks are trading at less than 12 times the past 12 months' earnings and boast dividend yields of better than 6%. Wells and US Bancorp skirted most credit problems, yet Wells pays a dividend of almost 4%, and US Bancorp yields over 5%.

True daredevils may want to consider the homebuilders. Keep in mind, stocks usually rebound not when news in a stricken sector gets better, but well before. So it's a good time to start building stakes in the battered builders, a bit at a time, via dollar-cost averaging. Despite all the chaos in real estate, Americans aren't going to stop buying homes in the future, and the future is what counts. We recommend two. The first is Toll Brothers (TOL, Fortune 500) which has lost 60% of its value since 2005. Toll specializes in high-end homes, so it stands to reap excellent margins when markets recover. Our second pick: NVR (NVR, Fortune 500), which is known for innovative, mass-production building techniques and carries relatively little debt.

Look abroad

Want to improve your returns without increasing your risk? One answer is tilting your portfolio heavily toward international stocks. As always with a sound portfolio, the benefits will materialize over a number of years. But the time to start is now. In the past two years foreign stocks have wildly outperformed U.S. equities. European stocks soared at a 23% annual rate in 2006 and 2007, while emerging markets jumped 35% a year. In 2008, however, both markets have suffered sharp corrections, as have equities worldwide. The EAFE index of big-cap stocks worldwide now looks like a bargain: Its P/E stands at under 14, far below multiples in the U.S.

Not all foreign stocks deliver diversification. Players like Sony (SNE) or Unilever (UL) are fully global - they simply mimic the performance of other international colossi like Coca-Cola and IBM. "To get diversification, you need to go to the less liquid part of the market, to small-cap stocks," says Dan Wheeler of Dimensional Fund Advisors, a pioneer in index funds. Why do small caps work best? Because far more of their sales are concentrated in local markets. And since those markets offer very different dynamics from the U.S., they often thrive when America is swooning. The benefits? According to a study by Rex Sinquefield, DFA's co-founder, investing heavily in stocks that track local markets and in value shares yields investors an extra two points of return, without increasing volatility.

With that in mind, we suggest devoting 35% of your equity stake to foreign shares, with about two-thirds going into small-cap and value stocks, via funds like Vanguard International Explorer (VINEX). Divide the rest of your stake between a broad large-cap ETF like iShares' MSCI EAFE Index (EFA) and an emerging-markets entry like iShares MSCI Emerging Markets (EEM). DFA offers a variety of strong choices, available through financial advisors.

Beware of bonds

The problem with most bonds is that they're not paying enough to compensate investors for today's inflation, let alone the surging prices that haunt our future. Right now ten-year Treasuries are yielding just 3.6%, because in these rocky times, many investors are willing to sacrifice returns for short-term safety. As Wharton economist Jeremy Siegel puts it, "There is no value for investors in most bonds."

Indeed, for your fixed-income portfolio, only two choices make sense: municipal bonds and Treasury Inflation-Protected securities, widely known as TIPs. Now is an ideal time to buy munis. Bonds issued by state and local authorities in New York and California pay around 3.3% and are exempt from federal taxes (and local levies if you live in those states). That's the equivalent of a pretax return of almost 5%, far above the yield on Treasuries. For a diversified blend of munis, an excellent choice is Vanguard Intermediate-Term Tax-Exempt (VWITX), which boasts a yield of 3.4% and fees of just 15 basis points.

With increased inflation almost a sure thing, TIPs are an essential. They are the only investment guaranteed to keep pace with inflation. The face value of each TIP is adjusted every six months to reflect the change in the CPI. You can buy TIPs online the same way you buy Treasuries, with no fees. Simply log in to treasurydirect.gov. And Fidelity, T. Rowe Price, and Vanguard, among others, offer TIPs funds.

Finally, let's deal with cash. The best place to park it is in CDs. Even though the Fed is chipping away at short-term rates, the yields on CDs are holding up amazingly well. The reason is that banks are competing ferociously for funds, especially now that longer-term lending rates are rising. The key is to stay in maturities of six months or less - and shop around. Corus of Chicago, for example, is paying 4.1% on a six-month CD. That term is just about right. If rates rise, you can quickly move your cash into CDs or bonds that yield more.

Winning in these treacherous times is as much about psychology as following the rules. It takes guts to be daring when markets are melting down. But that's the quality that makes great investors. As Warren Buffett says, "Be fearful when others are greedy and greedy when others are fearful." Now's a time when greed, Buffett-style, is good. Just make sure your greed is highly selective.

Reporter associates Katie Benner and Eugenia Levenson contributed to this article.