Lessons Learned: The upsides of the downturn

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By GENE KELLY/Personal Finance

 “A bird doesn’t sing because it has an answer; it sings because it has a song.” — Quoted by Maya AngelouAll investments are a vote of confidence in the future. My last column touched on a similar idea: You plant crocus bulbs four inches deep in autumn, in anticipation they will root, store energy and reward you with blossoms when the soil warms early in spring.

In the midst of the Wall Street tempest, it is difficult to think about your portfolio in this context. Yet, unless you’ll need a large chunk of your savings next week, next month or next year, agonizing over recent financial statements is not a proactive approach to life.

My inclination, when a storm threatens, is to find shelter and think brave thoughts. When everyone is passing around pessimism, take a deep breath and hold on.

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Most of us are feeling less “rich” than last week, last month and especially one year ago. If you’re primarily invested in stocks, it’s been unnerving to watch them shrink in value.

However, my strategy has been to buy on the way down, either by putting new money each month into mutual funds or by reinvesting dividends. History teaches us that even during the Great Depression those who held on to stocks, rather than fleeing to cash or Treasury bills, achieved the best long-term investment results.

While waiting for an eventual equity market rebound, you might consider some ideas that represent the upside of the downturn.

n Blue-chip blues: Big stocks will bounce back.  The large companies that dominate the Standard & Poor’s 500 index and the 30-stock Dow Jones Industrial Average are so beaten up that their share prices relative to earnings (P/E ratios) have rarely been lower, says Jeremy Siegel, well-known business school professor at the Wharton School, University of Pennsylvania. The price/earnings ratio is a key measure of stock valuations.

In fact, equities haven’t been this cheap, based on price-to-earnings, since August, 1981, just before market sentiment shifted from negativity to optimism, which triggered a multi-year bull market.

As a result, you would take much less risk buying U.S. large-caps now — priced at 21 times earnings, or less — than if you had bought them at 29 times earnings in 1998, before the tech-stock bubble started losing a massive amount of hot air.

n Looking for yield and principal protection: Even those searching for safe-harbor investments have encountered the perfect financial storm: Interest rates paid by banks or credit unions on CDS and savings accounts have drooped. Out-of-favor companies have trimmed their stock dividends. Investors’ flight to safety has forced Treasury yields down to extremely low levels.

When credit markets froze up, municipalities postponed bond offerings. But the current upheaval in the tax-exempt muni bond market has largely been a liquidity crisis, not a credit-quality crisis. In other words, muni bonds aren’t defaulting.

Recent dislocations in the credit market have produced an odd situation: Many muni bonds now yield more than Treasurys of similar duration. This almost never happens. Since municipal bonds are tax exempt, they usually yield less than comparable Treasurys or taxable bonds.

The bond bottom line: You can find munis yielding 5 percent to 6 percent. For online research, there’s a comprehensive list of available bonds at municipalbonds.com. The Morningstar.com bond calculator can be used to determine a bond’s tax-equivalent yield. Be skeptical of too-good-to-be-real yields.

n Expect a much lower capital-gains tax bill on battered funds: Even when the stock market plummets, you can be hit with an unexpected tax bill if a mutual fund you own makes a substantial year-end capital-gains distributions.

This year, the news about these payouts is mostly good: Based on preliminary 2008 estimates, the number of funds making payouts, as well as the dollar amounts, are expected to be much less than a year ago, when distributions were a record $415 billion.

Payouts generally are taxable for shareholders of taxable accounts. Distributions within a 401(k) or similar tax-sheltered retirement account are reinvested to buy additional shares.

Here’s a red flag for investors who are tempted to get back into the market: Contact the fund or look on its website to see if the portfolio manager is planning a taxable capital-gains payout, the estimated amount, and the distribution dates. Stepping into a stock fund before the qualifying dates could leave you with a hefty tax bill — one that can be sidestepped.

If you have a Lessons Learned topic to suggest, you can call Gene Kelly at 421-2861, write to him at 2611 Bretigne Circle, Lincoln 68512, or e-mail him at  EKELLY1@neb.rr.com