MONEY stocks

Why You Shouldn’t Reach to Grab New Stocks

150312_ISK_SkepticalInvestor
Taylor Callery

As Shake Shack's recent slide demonstrates, while the IPO boom gives you lots of hot companies to take a flier on, you’ll most likely fall flat.

Do you regret missing out on the stunning debuts of Alibaba ALIBABA GROUP HOLDING LTD BABA 0.49% and Shake Shack SHAKE SHACK INC SHAK 3.38% ? Are you now waiting to hail Uber or snap up Snapchat when they go public, as expected?

Before you jump in, remember that when you pick a stock, you’re already taking a leap of faith—but with a newly public company, you’re taking two leaps. First, do you really know enough about the business? Second, has the market had sufficient time to draw its own conclusions so that you are buying at a fairly rational price?

“Anything that’s been trading for a while has been vetted by a whole host of investors,” says John Barr, a manager with the Needham Funds. Not so at or just after an initial public offering, and that’s why you have to tread carefully.

You’ll pay for the honeymoon

IPOs attract big headlines on day one, but surprises inevitably crop up. From 1970 to 2012, the typical IPO gained just 0.7% in its second six months, after the honeymoon effect had a chance to wear off. That’s five percentage points less than other similar-size stocks, finds Jay Ritter, a finance professor at the University of Florida. The year after that, the average IPO lagged by eight points.

Chinese e-tailer Alibaba, which soared 38% on its first day in September, is getting its dose of reality a bit ahead of schedule. Shares are down 28% lately, after the company surprisingly missed revenue-growth forecasts.

Themes get overdone

It’s easy to be lured by a story. Shake Shack doubled on its first day, thanks to the buzz surrounding high-quality fast-food chains like Chipotle CHIPOTLE MEXICAN GRILL INC. CMG 0.59% . But riding a food trend is hard. A decade ago, overexpansion killed investors’ ravenous appetite for Krispy Kreme doughnuts KRISPY KREME KKD 0.95% , and the company’s shares remain 56% off their peak.

Shake Shack has also entered a crowded battle for foodie dollars: the Habit Restaurants HABIT RESTAURANTS HABT 2.03% , Potbelly POTBELLY CORP COM USD0.01 PBPB 2.75% , and Noodles & Co. NOODLES & CO COM USD0.01 CL'A' NDLS 0% all went public recently, and all more than doubled in the first day. Odds are the market is overoptimistic about most of them. Since 2013, 15 stocks have doubled on day one; only two—both biotech firms—are trading above their first day’s close.

The fact is, unless you gain access to an IPO at a great price at issuance, you can’t view those stocks as buy-and-hold investments. And you should avoid any richly priced new stock altogether.

Shake Shack trades at 650 times its earnings. To justify that valuation, Ritter figures the burger chain must grow from 63 stores to nearly 700, each half as profitable as a Chipotle restaurant. That’s a big leap indeed, given that Shake Shack locations aren’t even a third as profitable at the moment.

This story was originally published in the April issue of MONEY magazine. Subscribe here.

MONEY stocks

Why Shake Shack’s Slide Was No Surprise

150312_INV_ShakeShackDown
Andrew Kelly—Reuters Shake Shack in New York

Wall Street's love affair with upscale burgers has already hit the skids.

On Tuesday, shares of the popular burger joint Shake Shack SHAKE SHACK INC SHAK 3.38% went limp like a soggy french fry, falling as much as 9% in early morning trading Tuesday after the chain’s first financial report as a public company failed to satisfy earnings-hungry investors.

The company — which made a stunning Wall Street debut in late January — reported a net loss of $1.4 million, or 5 cents a share. Some analysts had been expecting a 2-cent-a-share loss.

In announcing the news, Shake Shack CEO Randy Garutti said “we are witnessing a seismic shift in people’s understanding and expectations of food and, for the last decade, Shake Shack has helped lead the change in consumer behavior through our fine casual approach.”

That may be true, but Wall Street’s expectations for earnings remains the same.

What was surprising about Shake Shack’s results?

The fact that the company posted a quarterly loss is no big deal. This is a new chain and investors were not expecting a big profit.

What was surprising was that management did not better prepare analysts for the results.

That’s because normally, newly public companies try to orchestrate their performance as much as possible. Jay Ritter, a finance professor at the University of Florida who specializes in IPOs, noted that in the first six months, newly public companies “neither out or underperform.”

That’s in part because companies work at making sure there are no surprises early on. “When a company goes public, analysts working for the underwriters that took the company public tend to forecast fairly conservative estimates for the first couple of quarters,” Ritter said. Meanwhile, “companies don’t want to disappoint in the first couple of quarters,” so management tends to work hard to make sure that analysts in general know what to expect.

That didn’t happen here.

What wasn’t surprising about Shake Shack’s results.

As MONEY pointed out recently, Shack Shack’s stratospheric rise on its first trading day — the stock more than doubled to $45.90 a share — set the stock up for trouble.

Before the stock dropped, the shares were trading at a price/earnings ratio of around 650. At such a lofty valuation, it’s no wonder investors were willing to punish the stock at the first sign of worse-than-expected news.

But Shake Shack is not alone on this front. In an effort to ride the red-hot “fast casual” dining trend, investors dramatically bid up the recent IPOs of The Habit Restaurants HABIT RESTAURANTS HABT 2.03% , Potbelly POTBELLY CORP COM USD0.01 PBPB 2.75% , and Noodles & Co. NOODLES & CO COM USD0.01 CL'A' NDLS 0% .

All three stocks doubled on the day of their recent IPOs. Yet today, all three are trading well below the closing price at the end of their first day of trading.

For food stock investors, that’s a hard lesson to swallow.

Read next: Why Shake Shack’s Slide Was No Surprise

MONEY stocks

How to Spot the Next Apple

150309_INV_SpotNextApple
David Paul Morris—Bloomberg via Getty Images

The lesson of the last tech bubble isn't just "don't go there." There were smart ways to buy tech in the 1990s, and there are smart ways now.

Tech investors swing for the fences and often ignore price, hoping to get in on “disrupters” that can overturn an industry. Companies don’t need profits to get steep valuations (see Twitter, Tesla, and Box). The mood now resembles that of the first dotcom era, which ended 15 years ago when the bubble burst in March 2000. But the lesson of that episode isn’t just “don’t go there.” There were smart ways to buy tech in the 1990s. Price did matter, combined with two other factors: a catalyst or a financial cushion. The same is true now. Here are three cases to illustrate the point.

Case 1: Apple’s Decisive Turn

Today Apple is the world’s biggest company, worth $683 billion. In 1997, though, Apple was a $3 billion computer maker bleeding market share. It traded at around six times earnings, vs. 20 for the S&P 500.

A cheap stock price wasn’t enough to make it a deal. “In tech, you have to have some semblance of a catalyst, because investors sooner or later demand revenue growth,” says Paul Meeks, a portfolio manager for Saturna Capital. His firm purchased Apple in 1998 at a split-adjusted price of $1.17, which it still owns today at $127.

Saturna couldn’t have seen the iPod or the iPhone coming. Its catalyst was the return of Steve Jobs, which signaled an overhaul of how Apple did business. Jobs immediately negotiated his company’s survival by getting a $150 million investment from rival Microsoft, and then jump-started research and development, which led to 1998’s hit iMac.

Case 2: Cash Saves Dell

In the early ’90s, PC maker Dell made big missteps, including a failed launch of notebook computers. At one point in 1993 the stock had lost two-thirds of its value. Dell still had a decent amount of cash on its balance sheet, though, allowing it to fight another day. That was key for Westwood Holdings’ buy decision in 1993, says chief investment officer Mark Freeman. In 1997, Dell reached Westwood’s target price with gains of about 1,700%.

Case 3: Oracle in 2015

A cheap stock that passes both the catalyst and cushion tests today is the enterprise software giant Oracle ORACLE CORPORATION ORCL -0.81% . Investors fear that new cloud-based services, which allow users to access software online, will eat into Oracle’s business. That’s held the stock at 13 times earnings. But Edward Jones analyst Bill Kreher argues that Oracle’s own cloud push could be a catalyst, allowing the company to cross-sell more to its customers. This will “bolster ongoing maintenance revenues,” he says. Meanwhile, Oracle has $40 billion in cash, a strong defense against would-be disrupters.

Read next: Who will win the battle of the tech titans?

MONEY Apple

5 Things Your Broker Won’t Tell You About Apple Joining the Dow

While the iPhone maker's inclusion in the Dow Jones Industrial Average is long overdue, the change itself doesn't really move the dial.

This morning, the Dow Jones Industrial Average finally got around to adding Apple, which means the most famous benchmark for U.S. stocks will now include the world’s most valuable and influential company.

“As the largest corporation in the world and a leader in technology, Apple is the clear choice for the Dow Jones Industrial Average,” said David Blitzer, managing director and chairman of the Index Committee at S&P Dow Jones Indices.

The official move is expected to take place on March 19, but Apple shares are already jumping on the news. The stock was up more than 1% Friday afternoon, on a day when the Dow itself was down more than 200 points at midday.

Before you get too excited, though, there are several things you ought to know about this move:

1. Apple won’t get a meaningful long-term bounce from being in the Dow.

The Dow may be closely followed, but it’s not a market mover. That’s because while there are hundreds of index funds that track the S&P 500, there are only a handful of index funds that follow the Dow. And those funds and ETFs are tiny in comparison to the more than $5 trillion invested in S&P 500-linked portfolios.

The SPDR S&P 500 ETF, for instance, controls nearly $200 billion in assets, while its sister fund, the SPDR Dow Jones Industrial Average ETF, has only around $12 billion.

2. The Dow has a record of terrible timing when it comes to adding—or deleting—companies from its average.

Consider some of the recent moves:

In February 2008, Bank of America was added to the Dow in the midst of the mortgage crisis and global financial panic, while the tobacco giant Altria was removed. Since being kicked off the list, the defensive-oriented Altria has gained more than 139%, nearly tripling the gains for the S&P 500. Meanwhile Bank of America lost two third of its market value until it was eventually kicked out of the Dow in September 2013.

In April 2004, the insurance giant AIG was added to the Dow just a few years before the company had to be bailed out from collapse by the federal government in the global financial panic. Between then and September 2008, when AIG was removed from the Dow, the stock lost more than 90% of its value.

And then there was the classic case of being late to the party with tech. In November 1999, the Dow finally decided to add Microsoft and Intel after they both experienced astronomical runs throughout the 1990s. Since being included in the Dow, Microsoft shares are down 8% while Intel stock is 12% lower. All the while, the S&P 500 has gained ground:

^SPX Chart

^SPX data by YCharts

All of this confirms a study by University of Pennsylvania finance professor Jeremy Siegel. He looked at the performance of companies that were added to and removed from the Dow between 1957 to 2006, and found that the companies deleted from the Dow tended to outperform the new additions.

3. The Dow is a strange index to begin with.

As MONEY pointed out last year, the Dow is really an antiquated benchmark. Traditional modern indexes are “market-capitalization” weighted. What that means is that the bigger a company is, based on its market value, the greater its influence on the index. That’s why Apple, as the most valuable company in the world, comprises nearly 4% of the S&P 500, versus around 2% for Exxon Mobil, which is the market’s second biggest company.

By contrast, the Dow is a so-called price-weighted index. That means that the higher a company’s share price is—not its overall value, but the arbitrary price of a single share—the greater its sway.

Right now Visa, at around $272 a share, accounts for nearly 10% of the Dow’s movements. However, Visa announced it would split its stock in four, diminishing the value of each share but not the overall company.

Dow officials cited this as a reason for including Apple. They consider Visa a tech stock, since the company works in global payment technology. But because Visa’s meaningless stock split will nonetheless reduce the Dow’s exposure to tech, Dow officials felt the move will “make room for Apple,” Blitzer said.

4. The company that Apple is replacing is vital to Apple’s success.

Don’t think the Dow is trying to make a statement about the importance of the smartphone revolution to the U.S. economy: To make room for Apple, Dow officials kicked out AT&T.

Yet the telecom giant has been a vital cog in the smartphone era, selling data plans, iPhones, Android devices, and other technology. AT&T has already begun marketing smart watches, which is important as Apple is scheduled to unveil its Apple Watch at an event on Monday.

5. Apple doesn’t need the Dow to gain credibility.

Apple is by the far the most valuable company in the world. Just with its savings account (the cash it has on hand) the company could buy three companies that are already in the Dow outright — DuPont, Caterpillar, and the Travelers Group.

What’s more, in the past two years, Apple shares have quadrupled the gains for the Dow. And since the end of 1999, Apple has soared more than 3,000% when the Dow is up barely 50%.

AAPL Chart

AAPL data by YCharts

So you could say that the Dow needs Apple, not the other way around.

MONEY stocks

Nasdaq 5000: Three Reasons “This Time Is Different” Doesn’t Fly

The Nasdaq Marketsite digital monitor wall is seen in New York March 2, 2015. U.S. stocks advanced on Monday, with the Nasdaq moving above the 5,000 mark for the first time in 15 years, helped by technology deals and mixed data that pointed to a slowly accelerating economy.
Shannon Stapleton—Reuters The Nasdaq Marketsite digital monitor wall is seen in New York March 2, 2015. U.S. stocks advanced on Monday, with the Nasdaq moving above the 5,000 mark for the first time in 15 years, helped by technology deals and mixed data that pointed to a slowly accelerating economy.

How sure are you that the Nasdaq isn't partying like it's 1999?

For only the second time ever, the Nasdaq composite index has climbed above the 5,000 mark — 15 years after momentarily accomplishing this feat just before the tech wreck in 2000.

This has led to a chorus of articles about how things are different from a decade and a half ago.

For instance, some have argued that the Nasdaq is not the same tech-heavy index it was in the late 1990s, when tech giants like Microsoft and Cisco Systems dominated the market. Others note that the Nasdaq is a bargain compared to March 10, 2000, when it hit 5048 and the dot.com bubble burst. And still others say there is much less euphoria surrounding the tech economy than in the 1990s.

Really?

Let’s explore these arguments.

1) Yes, tech makes up slightly less of this index than it once did. But the Nasdaq is still extremely tech-centric. In March 2000, technology stocks accounted for half the Nasdaq’s stock market value, and the top holdings consisted of Cisco Systems, Microsoft, Intel, Qualcomm, and Oracle. And today? Tech is 47% of the index, and the top stocks in the index are Apple, Microsoft, Google, Intel, Facebook, Amazon.com, and Cisco. So have things really changed? Not so much.

2) Yes, parts of the Nasdaq are cheaper than they were in the 1990s. For instance, Microsoft, Intel and Cisco all trade at discounts to the S&P 500. But comparing today’s Nasdaq to the Nasdaq of 2000 is sort of like comparing all windy days to Hurricane Sandy. Sure, by comparison things seem calmer.

At a price/earnings ratio of 21.5, today’s Nasdaq looks “reasonably” priced compared to its once-in-a-lifetime P/E of 175 in 2000. But it’s foolish to make relative judgments against such historically extreme cases, says Greg Schultz, a principal with Asset Allocation Advisors. The fact is, at an average P/E of 21.5, the Nasdaq is still considerably more expensive than the Dow Jones industrial average, the S&P 500, European stocks, emerging market stocks, and the list goes on and on.

3) The tech economy has matured. Yes, there are mature technology companies, such as Microsoft, Cisco, and Intel, which all now cash-rich dividend-paying stocks that yield more than the broad market and trade at decent valuations. But giant mainstream computer-based tech giants are no longer the focal point of the tech economy or the Nasdaq.

Last year, Ben Inker, co-head of asset allocation at the investment firm GMO, pointed out that the euphoria had shifted to smaller health-care and biotech names. He was right. Biotech stocks such as Isis Pharmaceuticals (up 538% since 2013; no profits) and drugmaker Incyte (up 422% since 2013; no profits) are now the hottest part of the Nasdaq. Overall, the Nasdaq Biotech index now trades at P/E of around 50.

Meanwhile, many of the Nasdaq’s hottest social and streaming media stocks this year — including Twitter, Netflix — are either profitless or trading at astronomical PE’s.

And as Fortune magazine recently pointed out in its cover story, The Age of Unicorns, tech entrepreneurs and venture capitalists only seem to get excited these days if they can create startups that are instantly valued at $1 billion or more.

So how sure are you that the Nasdaq isn’t partying—at least a little—like it’s 1999?

MONEY

The Most Amazing Thing About Apple? It Still Looks Cheap

Beats headphones are sold along side iPods in an Apple store in New York City.
Andrew Burton—Getty Images Beats headphones are sold along side iPods in an Apple store in New York City.

Despite another blowout quarter, Apple shares are still trading at less than 15 times earnings, which is a bargain for a top-flight tech company.

It’s hard to catch people by surprise when you’re already the center of attention. But with the help of strong holiday sales and another hit iPhone, that’s just what Apple did on Tuesday.

The Cupertino, Calif., gadget maker said sales jumped nearly 30% in its fiscal first quarter to a whopping $75 billion. Wall Street Analysts polled by Fortune had expected an increase of only 20%.

What’s remarkable is that, despite the hype, it’s not hard to make the case that Apple APPLE INC. AAPL -0.82% shares, up about 8% to $118, are reasonably priced. Here’s our investment case:

The heart of the business: More than 90% of Apple’s revenue last quarter came from hardware sales—69% from iPhone sales alone. But if hardware is what Apple sells, it’s not what the company markets. “Apple’s main product is an experience,” tech analyst Neil Cybart told Money magazine last month. “They look at all of their products as taking away the complicated part of technology so the users can feel like they have more control over their lives.”

Apple aims to build a world in which you’ll own Beats by Dr. Dre headphones, wear an Apple Watch, buy coffee with the Apple Pay payments system, and make hands-free phone calls via Apple CarPlay. With all those products interlinked and running on Apple’s iOS software, you’ll rely on the ecosystem for daily tasks, making it a hassle for you to buy your next phone or tablet from anyone other than Apple.

So what’s the risk? Apple has a hit with the iPhone 6 and 6 Plus, in all selling 74 million smartphones last quarter. Indeed, as TIME recently reported, the iPhone 6’s success has cut into Android’s smartphone market share in the U.S. for the first time since September 2013.

But the company isn’t particularly good at ­enticing the owner of one Apple product to purchase another, says Consumer Intelligence Research Partners’ ­Michael Levin.

For instance, only 28% of iPhone owners have an Apple computer, and less than half of them own a tablet, says CIRP. Sales for the iPad have fallen 22% over the past year, acknowledges Apple. But CEO Tim Cook, noting that the company has sold more than 250 million iPads over the past four years, told investors in October that he’s “very bullish on where we can take the iPad over time.”

Why it’s still a value: Apple enjoyed a banner year in 2014. Spurred by sales of the latest iterations of the iPhone and anticipation of the Apple Watch’s release in April, the company’s stock has risen nearly 50% since the start of 2014.

Despite that gain, Apple’s price/earnings ratio, based on projected profits, is just 14. That means the stock trades at an 11% discount to the S&P 500 technology index, even though the company’s earnings are growing 32% faster than the average big tech stock’s.

Apple’s low valuation stems from factors such as investors’ doubts that a company its size can grow as fast as smaller tech firms, along with uncertainty that Apple will keep making products that are both popular and profitable.

That said, Apple is still the best company by far at creating exciting technology that people want to buy. Plus, signs point to an ever-increasing dividend from the stock, which now yields 1.6%; a larger payout can be easily covered by Apple’s $178 billion cash reserves.

This story is adapted from Apple, Amazon, or Google: Who Will Win the Battle of the Tech Titans? in the 2015 Investor’s Guide in the January-Feburary issue of MONEY

MONEY Tech

Microsoft Takes a Step Down the Mobile Path

Microsoft and Nokia sign
Lehtikuva Lehtikuva—Reuters

The onetime technology leader now finds itself struggling to compete in mobile and media markets. With a new operating system set to debut this week, it’s looking to strengthen its chances.

On Wednesday, Microsoft is set to unveil Windows 10, the newest version of its flagship operating system. The time has come, the company says, to introduce a “new Windows…built from the ground up for a mobile-first, cloud-first world.” Most critically, the new products will make it easier for developers to build apps for mobile devices, including Microsoft’s own smartphones.

The news couldn’t come a moment too soon. The onetime technology leader has been struggling to compete in mobile and media markets. Currently, Windows models account for less than 5% of phones in use. So while Microsoft wants to be seen as the fourth member of the current pack of tech titans, alongside Apple, Amazon, and Google, it still has a ways to go.

Mobile weakness notwithstanding, Microsoft remains the world’s largest software producer, with a stock market value of $381 billion (north of Goo­gle’s) and $90 billion in cash on hand. Revenue from selling and licensing products like Windows to companies—about half of Microsoft’s business—grew by an impressive 10% last quarter. Revenue from Xbox, one of the world’s most popular gaming consoles, grew more than 58%. Meanwhile, the company released its latest cellphone to positive reviews. The stock stands at a near 15-year high.

Still Facing Headwinds

A lot is riding on the success of Windows 10. Demand for personal computers has fallen off, thanks to smartphones and tablets. Sales of Microsoft’s own tablets, such as the Surface Pro 3, have picked up recently but lag far behind those of the Kindle Fire and iPad.

The company’s smartphone—$600 at its most expensive—is “too high cost, and it’s too late,” says Mary Mona­han of research company Javelin. A tardy entrance gave Google and Apple valuable lead time and made Windows a less desirable outlet for app developers. “The value of the iPhone is that you get all of these great apps,” says Monahan. “When you buy a Microsoft phone, what do you get?”

The Outlook for Investors

Prospects for Microsoft aren’t ugly, but they’re not great either. While Xbox, with its legions of dedi­cated customers, has proven popular, analysts believe long-term success requires an untethered platform. “The future is more control of your day-to-day life with your phone,” says Monahan.

Windows 10 is part of new chief executive Satya Nadella’s strategy to prioritize investments in mobile, like its 2014 purchase of Nokia’s handset division; Microsoft is likely to use its cash kitty to fund further deals.

Microsoft’s forward price/earnings ratio is near Apple’s, and it has a higher-than-average dividend yield: 2.7%, vs. 1.6% for its information-technology peers. That means investors are paid well to hold the onetime personal computing champion and wait for a turnaround. With the release of Windows 10, that reversal may be one step closer.

Read Next: Who Will Win the Battle of the Tech Titans?

MONEY Economy

The Doom and Gloom of Deflation Hasn’t Reached Our Shores—Yet

Cars fill up at the pumps at a Shell station near downtown Detroit, where the sign shows the price at $1.899 a gallon on Thursday, Jan. 1, 2015
David N. Goodman—AP Cars fill up at the pumps at a Shell station near downtown Detroit, where the sign shows the price at $1.899 a gallon on Thursday, Jan. 1, 2015. AAA Michigan said that the average cost of self-serve unleaded gasoline in the state was $1.97 a gallon, the first time the price has fallen below $2 a gallon since March 2009 and down 9 cents since the beginning of the week.

A new government report shows that prices are clearly falling, mostly due to sinking energy prices. Even so, this could keep the Fed from hiking rates for months.

You might think that falling consumer prices would be met with cheers on Wall Street, especially in the all-important holiday shopping season.

But when a new government report released on Friday showed that consumer prices in December had declined by the largest amount in six years, there was a bit of a gasp on Wall Street.

The Labor Department reported that the Consumer Price Index, perhaps the most widely followed measure of U.S. inflation, sank 0.4% in December, after dropping 0.3% in November.

This data clearly shows there is no inflation in this economy.

Yet it’s still too soon to say if there’s deflation — a quagmire that Europe is currently stuck in, where prices keep falling to the point where consumers postpone purchases, further weakening the economy.

Why?

For starters, over the past 12 months, prices in general have inched up 0.8%. While that’s the lowest yearly rate since 2009, it’s still positive.

More importantly, plummeting gasoline prices were the real culprit that drove CPI down in December and November, notes Michael Montgomery, U.S. economist for I.H.S. In fact, last month’s 9.4% decline in gas prices accounted for the entirety of the 0.4% decline in CPI, he said.

And keep in mind that several key categories of spending did rise in December, including food, electricity, and housing costs.

Overall, so-called core CPI — which strips out volatile energy and food costs — was flat last month and rose 0.1% in November.

This helps explains why Americans regard falling prices as a blessing so far — not a curse.

Consumer confidence, as measured by the University of Michigan’s consumer sentiment index, jumped to a reading of 98.2 this month, the highest point since January 2004.

But economists expect the deflation concerns to linger, as gas prices have sunk even faster this month than in December.

Already, there’s talk that the Federal Reserve might hold off raising interest rates this year because the global slowdown in general and Europe’s deflation specifically are keeping inflation at bay here at home.

This chatter—and concern—will grow if January’s CPI figures show even more falling prices.

MONEY stocks

China’s Boom Is Over — and Here’s What You Can Do About It

Illustration of Chinese dragon as snail
Edel Rodriguez

The powerhouse that seemed ready to propel the global economy for decades is now stuck in a period of slowing growth. Here’s what that means for your portfolio

Every so often an investment theme comes along that seems so big and compelling that you feel it can’t be ignored. This happened in the 1980s with Japanese stocks. It happened again with the Internet boom of the 1990s. You know how those ended.

Today history appears to be repeating itself in China.

Just a decade ago, China was hailed as the engine that would single-handedly drive the global economy for years to come. That seemed plausible, as a billion Chinese attempted something never before accomplished: tran­sitioning from an agrarian to an industrial to a consumer economy, all in a single generation.

Recently, however, this ride to prosperity has hit the skids. A real estate bubble threatens to crimp consumer wealth; over-investment in a wide range of industries is likely to dampen growth; and the transition to a developed economy is stuck in an awkward phase that has trapped other emerging markets.

No wonder Chinese equities—despite a strong rebound last year—are down around half from their 2007 peak.

iSCH1

Like the Japan and dotcom manias before it, China looks like an old story. “Do you have to be in China?” asks Henrik Strabo, head of international investments for Rainier Investment Management in Seattle. “The truth is, no.”

If you’ve bought the China story—and since 2000 hundreds of thousands of U.S. investors have plowed $176 billion into emerging-markets mutual and exchange-traded funds, which have big stakes in China—that’s a pretty bold statement.

In fact, even if you haven’t invested directly in Chinese stocks and simply hold a broad-based international equity fund, China’s Great Slowdown has an impact on how you should think about your portfolio. Here’s what you need to understand about China’s next chapter.

China Has Hit More Than a Speed Bump

After expanding at an annual clip of more than 10% a decade ago, China’s economy has slowed, growing at just over 7% in 2014. That’s expected to fall to 6.5% in the next couple of years, according to economists at UBS. And then it’s “on to 5% and below over the coming decade,” says Jeffrey Kleintop, chief global investment strategist at Charles Schwab.

Why is this worrisome when gross domestic product in the U.S. is expanding at a much slower 3%?

For starters, it represents a steep drop from prior expectations. As recently as three years ago, economists had been forecasting that China would still be growing at roughly an 8% clip by 2016.

The bigger worry is that the slowdown means that China has reached a phase that frustrates many emerging economies on the path to becoming fully “developed,” a stage some economists refer to as the middle-income trap.

On the one hand, a growing number of Chinese are approaching middle-class status, which means wages are on the rise. That sounds good, but rising labor costs chip away at China’s competitive advantage in older, industrial sectors. “You’re seeing more and more manufacturers look at other, cheaper markets like Indonesia, Vietnam, and the Philippines,” says Eric Moffett, manager of the T. Rowe Price Asia Opportunities Fund.

At the same time, the country’s new consumer-centric economy has yet to fully form. About half of China’s urban population is thought to be middle-class by that nation’s standards, but half of Chinese still live in the countryside, and the vast majority of those households are poor. Couple this with the deteriorating housing market—which accounts for the bulk of the wealth for the middle class—and you can see why China isn’t able to buy its way to prosperity just yet.

This in-between stage is when fast-growing economies typically downshift significantly. After prolonged periods of “supercharged” expansion, these economies tend to suffer through years when they regress to a more typical rate of global growth, according to a recent paper by Harvard professors Lawrence Summers and Lant Pritchett.

In some cases, like Brazil, this slowdown prevents the economy from taking that final step to advanced status. Brazil had been expanding 5.2% a year from 1967 to 1980, but that growth slowed to less than 1% annually from 1981 to 2002.

No one is saying China will be stuck in this trap for a generation, like Brazil, but China could be looking at a long-term growth rate closer to 4% to 5% than 8% to 10%.

iSCH2

Your best strategy: Go where the growth is—at home. A few years ago the global economy was ex­pected to expand at an annual pace of 4.2% in 2015, trouncing the U.S.  Today the forecast is down to 3.1%, pretty much the same pace as the U.S. economy, which is expected to keep accelerating through 2017.

In recent years, some market strategists and financial planners have instructed investors to keep as much as 40% to 50% of their stocks in foreign funds. But ­dropping that allocation to 20% to 30% still gives you most of the diversification benefit of owning non-U.S. stocks.

The Losers Aren’t Just in Asia

China’s rise to power lifted the fortunes of its neighboring trade partners too, so it stands to reason that a broad swath of the emerging markets is now at risk. “China is still the beating heart of Asia and the emerging markets,” says Moffett. “If it slows down, all the other countries exporting to and importing from China will see their growth prospects affected.”

The country’s biggest trading partners in the region are Hong Kong, Japan, South Korea, and Taiwan, and all are slowing down. Economists forecast that the growth rates in those four nations will slip below 3% next year.

Beyond Asia, “you have to be careful with the commodity exporters,” says Rainier’s Strabo. China’s slowdown over the past five years is a big reason commodity prices in general and oil specifically have sunk more than 50% since 2011.

China consumes about 40% of the world’s copper and 11% of its oil. As the country’s appetite for commodities wanes, natural resource producers such as Australia, Russia, and Latin America will feel the blow.

Your best strategy: Keep your emerging-markets stake to around 5% of your total portfolio. If your only foreign exposure is a total international equity fund, then you’re probably already there. If, however, you’ve tacked on an emerging-markets “tilt” to your portfolio to try to boost returns, unwind those positions, starting with funds focusing on Asia, Latin America, or Russia.

Here’s another bet that’s now played out: A popular strategy in the global slowdown was to take fliers on Western companies with the biggest exposure to China—companies such as the British spirits maker Diageo (think Johnnie Walker and Guinness) and Yum Brands (KFC and Pizza Hut)—solely because of their China reach. And for a while, that paid off.

Now, though, the stocks of Yum and Diageo have stalled, and major global companies such as Anheuser-Busch InBev and Unilever have reported disappointing results recently in part owing to subpar sales in China as well as in other emerging markets.

Demographic Problems Will Only Make Things Worse

For years, China’s sheer size was seen as a massive competitive advantage. Indeed, China has three times as many workers as the United States has people.

Yet as the country’s older workers have been retiring, China’s working-age population has been quietly shrinking in recent years. Economists say this will most likely lead to labor shortages over the coming years, putting even more pressure on wages to rise.

iSCH3

China’s demographic problem has been exacerbated by the country’s “one-child” policy, which has prevented an estimated 400 million births since 1979. But China isn’t the only emerging market suffering from bad demographic trends.

Birthrates are low throughout East Asia. The ratio of people 15 to 64 to those 65 and older will plummet from about 7 to 1 to 3 to 1 in the next 15 years in Taiwan, South Korea, and Hong Kong, dragging down growth.

Your best strategy: If you’re a growth-focused investor who wants more than that 5% stake in emerging markets, concentrate on developing economies with more youthful populations and more potential to expand. One fund that gives you that—with big holdings in the Philippines, Saudi Arabia, Egypt, and Colombia—is Harding Loevner Frontier Emerging Markets HARDING LOEVNER FRONT EM MKTS INV HLMOX 0.12% . Over the past five years, the fund has gained around 7% a year, more than triple the return of the typical emerging-markets portfolio.

Another option is EGShares ­Beyond BRICs EGA EMERGING GLOBA EGSHARES BEYOND BRICS ETF BBRC 0.51% . Rather than investing in the emerging markets’ old-guard leaders—Brazil, Russia, India, and China—this ETF counts firms from more consumer-driven economies, such as Mexico and Malaysia, among its top holdings.

The Parallels Between China and 1990s Japan are Alarming

For starters, China is facing a real estate crisis similar to Japan’s, says Nariman Behravesh, chief economist at IHS. With easy access to cheap credit, developers have flooded the major cities with excess housing. Floor space per urban resident has grown to 40 square meters, compared with just 35 square meters in Japan and 33 in the U.K.

Not surprisingly, prices in 100 top Chinese cities have been sliding for seven months. Whether China’s property bubble bursts or not, falling home values chip away at household net worth; that, in turn, drags down consumer sen­timent and spending, Behravesh says.

Other unfortunate similarities between the two nations: Excess capacity plagues numerous sectors of China’s economy, ranging from steel to chemicals to an auto industry made up of 96 car­ brands.

Also, Chinese officials face political pressure to focus on short-term growth rather than long-term fixes. This type of thinking has resulted in the rise of so-called zombie companies, much like what Japan saw in the ’90s. “These are companies that aren’t really viable but are being kept alive,” Behravesh says. Yet for the economy to get back on track, inefficiently run businesses have to be allowed to fail, market strategists say.

Your best strategy: Focus on the few major differences between the two countries. Unlike Japan, for instance, China is still a young, emerging economy. Slowdown or not, “the growth of the middle class will continue in China, and that will absorb some of the overhang in the economy, which is something Japan couldn’t count on,” says Michael Kass, manager of Baron Emerging Markets Fund.

What’s more, when Japan’s bubble burst in late 1989, stocks in that country were trading at a frothy price/earnings ratio of around 50. By contrast, Chinese shares trade at a reasonable P/E of around 10.

To be sure, not all Chinese stocks enjoy such low valuations. As competition heats up to supply China’s population with basic goods, valuations on consumer staples companies have nearly doubled over the past four years to a P/E of around 27.

At the same time, the loss of faith in the Chinese story means there are decent values in industries that cater to the established middle and upper-middle class, says Nick Niziolek, co-manager of the Calamos Evolving World Growth Fund. Health care and gaming stocks in particular suffered setbacks last year. And Chinese consumer discretionary stocks are trading at a P/E of just 12, down from 20 five years ago.

You can invest in such businesses through EGShares Emerging Markets Domestic Demand ETF EGA EMERGING GLOBA EGSHARES EMERGING MKTS DOME EMDD 0.39% , which owns shares of companies that cater to local buyers within their home countries, rather than relying on exports. Chinese shares represent about 17% of the fund, led by names such as China Mobile.

That one of the world’s great growth stories is now best viewed as a place to pick up stocks on the cheap might seem a strange twist—until you remember your Japanese and Internet history.

MONEY stocks

Probability That Stocks Will Rise This Year: 90%

barometer
iStock

After a furious rally on Thursday, stocks are now up after the first five trading days of January—a time-tested signal the market could be in store for another positive year.

Maybe this will be a decent year for stocks after all.

After the Dow Jones industrial average lost around 500 points in the first three trading days of the year, it sure looked as if 2015 was getting off to a lousy start. But for the past two days, the Dow posted back-to-back triple digits gains. Yesterday alone, the Dow soared more than 300 points as investors calmed down about troubles in the global economy.

The result: The Dow is up 0.44%, while the Standard & Poor’s 500 index has gained 0.15% so far this year.

^SPX Chart

^SPX data by YCharts

What’s the big deal?

The first five trading days of the year — known as the January Barometer — offer a surprisingly good clue for how stocks are likely to perform for the full year.

Historically, when stocks rise after the first five sessions of a year, equities wind up posting gains for the full year nearly 90% of the time, according to the Stock Trader’s Almanac, which has been tracking this and other market barometers for years.

More recently, the correlation has grown even stronger. In a Fidelity article about the January Barometer published last year, Fidelity technical analyst Jeffrey Todd pointed out that “the January barometer has held true 37 of the 39 times since 1950 when January experienced market gains.”

Even so, isn’t this wishful thinking in 2015?

After all, the global economy seems to have hit the skids, as evidenced by the recent drop in oil prices. In fact, Japan is in recession, Europe is in deflation, and China is decelerating faster than folks expected.

Yet the U.S. remains the one economic force in the world that’s holding its own.

And if softness in the global economy keeps the Federal Reserve from raising interest rates until late this year — or even until 2016, as Charles Evans, president of the Federal Reserve Bank of Chicago, thinks it should — that could be just enough good news to keep Wall Street happy in 2015.

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