On the Level: Presidential Shuffle Ends -- Now What?

With "Indecison 2000" finally over, even if Vice President Al Gore has a hard time accepting the fact, investors should turn their attention to the far larger issue that will dominate our thinking in 2001 -- U.S. economic growth.

Whether you invest in stocks, bonds or currencies, U.S. economic growth will be the key driver of the financial markets next year. You ought to think about this now and get comfortable with some macro view. Yes, I know that no one can forecast the economic future. (I learned that as an aide at the Joint Economic Committee of Congress in the late 1970s.) Nor does it make sense to predict a recession simply because we have not had one since 1991. (The probability of a recession is not dependent on when we last had one.) But you can, and should, estimate whether the economic winds will be blowing in our faces or at our backs.

Growth is undoubtedly slowing, but a recession is by no means clear. All post-World War II recessions have been caused by higher interest rates. Inflation rears its ugly head, and the bond market and the Fed tighten the monetary noose. To be even more precise, in every post-war recession, interest rates were rising going into the slump.

If you look at the yield on the 10-year Treasury note, however, you can see that it has been mainly falling since early this year. That suggests to me that a recession is not in the offing. Unless, of course, you think we are about to suffer a pre-World War II slump -- i.e. a severe global recession bordering on a depression with deflation and double-digit unemployment rates. A slowdown in economic growth bordering on a full stop would not surprise me one bit. A severe recession? Perhaps, but it is no sure thing.

If you agree that we will see a slowdown and may see a recession, then how should you play it?

Since the chances of recession remain less than 50/50, you might not want to load up on bonds right now. They have had a marvelous run in the past six weeks, and yields, which are at their lows for the year, seem already to be discounting a recession next year. That is the word today from financial markets strategist Ray Dalio of Bridgewater Associates based in Westport, Conn. "While our expectations for growth are negative, we recently went moderately short bonds because the bond market has gotten way ahead of the economy's actual rate of slowing," writes Dalio. By his lights, the Treasury market is expecting "the deepest recession since the Great Depression."

If we get a recession -- i.e. at least two consecutive quarters of a shrinking GDP -- you will have time to get into bonds. Dalio has done his history and found, "if we do go into a recession, rates will certainly decline by much more than is discounted because it will take a significant rate decline to end the recession."

He has found that the average interest rate decline required to end a recession was 5.3 percentage points on the T-bill rate, with the lowest decline being a 2.3 percentage-point drop. "In other words," Dalio writes, "It takes hundreds of basis points of cuts to get the economy going again." I'd wait for more signs of recession before buying bonds at current levels. They have already had a run here and are a bit pricey.

The Stock Story

So much for bonds. You probably don't want to hear about stocks, do you? Just kidding.

A U.S. economic slowdown would not be good for most U.S. stocks. It's not simply that earnings growth will slow or losses rise. It's also that so many big-cap stocks do not trade at prices anywhere near their typical recession/bear market lows. Yes, many large-cap stocks have been hit hard this year, but many remain at quite high price-to-earnings ratios. The 12-month trailing P/E on the Nasdaq Composite remains north of 100, which is not cheap by any standard.

What is also worrisome about U.S. stocks in the slowdown scenario? The dollar.

Foreigners, especially Europeans, have been huge buyers of U.S. equities in recent years. Foreign purchases of U.S. equities in the past 12 months through September totaled $173 billion, according to Federal Reserve data. Compare that to the $900 million worth of U.S. stocks they bought in 1994. In a U.S. slowdown, those inflows could become outflows. Even if the outflow did not come close to a run on dollar-denominated assets, it would not be good for the market.

In that kind of move to the door, you should expect that most stocks will get hit, rightly or wrongly. The stocks that would be least hurt include those with steady earnings growth and strong balance sheets. Luckily, you can still find some food and tobacco companies that are already priced for a slowdown.

Europe would be another place to look during a U.S. slowdown. The U.S. would become a less appealing place to invest for foreigners and you might imagine they would repatriate some of their capital. I could see that cash going into European equities. To get ahead of the Euro crowd before they start moving their money home, investors might want to take some kind of position in Europe now. Not only might you avoid some of the decline in U.S. equities, but you may also gain from a strengthening euro. (The currency has been firming of late.)

Dalio notes a second force that may boost European stocks in this scenario. "Because European interest rates have been more driven by currency movements than the other way around [weakness in the euro caused investors to sell European bonds], it is reasonable to expect that strength in the euro will tend to drive European bond yields down, which will be bullish for European stocks."

If you consider taking a trip to Europe, you might want to travel via a value-oriented mutual fund. The best one I know is the Tweedy Browne Global Value fund. (For more on them and their peers see this story .) Managers Chris Browne, Will Browne and John Spears are experienced, successful over the long haul and treat their no-load fund shareholders fairly.

Oh, one more thing. In the event of a U.S. slowdown, keep some cash on hand. At the moment, I'd say at least 10% cash would be prudent. After a painful year like 2000, cash is no longer trash.

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