Beyond the pail: Where to invest in a post-bailout world

by Jonathan Burton, MarketWatch

SAN FRANCISCO (MarketWatch) — Wall Street is bound to get its bailout, in one form or another. The government’s rescue package will be costly to taxpayers, politically controversial — and quite possibly not the last. It will also dramatically change the landscape for U.S. stock investors.

The bailout has a singular task: to grease the locked wheels of the financial system and get credit moving again. What investors need to remember is that even if this plan works, the deep problems plaguing homeowners, consumers and the broader economy won’t magically disappear. The Troubled Asset Relief Plan isn’t called TARP for no reason. It is intended to avert a flood of Depression-era size, but the ground around us will still be soaked.

“Wage growth has been pretty stagnant, the unemployment rate ticks upward, and home prices aren’t doing so great; most people’s homes are worth less than they were two or three years ago, and that makes them feel less wealthy,” said Pat Dorsey, director of equity research at investment research firm Morningstar Inc. “None of these things change with the bailout package.”

Business conditions will be treacherous for some time. Expect credit to loosen but remain tight and the stock market to become even more Darwinian, rewarding high-quality companies that boast reliable earnings, solid cash positions, little debt, and a strong presence in their industry.

“Focus on what you can control and minimize the risk of what you can’t,” Dorsey said. “Companies that are going to benefit have wide economic moats or a strong competitive advantage.”

Where to put your money

To handle these challenges in the months and perhaps years ahead, investors will need a rescue plan of their own. Ironically it also hinges on the Federal Reserve.

With both the Fed and the Treasury pulling out their full arsenal to shore up the banks, the old adage “Don’t fight the Fed” is even more apt today. The Fed is trumpeting that it is on the side of both the economy and investors.

The message is clear: Follow the money. Focus on the areas of the market that stand to benefit from the government’s largesse. Here are some places to look:

1. U.S. stocks; European bonds

After relying on international markets to boost returns for several years, U.S. investors can go home again. U.S. stocks haven’t fallen nearly as much this year as counterparts overseas.

This economic slowdown is global; the U.S. was first to tumble into the mess and likely will be the first out. Meanwhile, Europe is only now beginning to fess up to its own financial problems. Ireland this week became the first European Union member to enter recession, and others may not be far behind.

As a result, Europe’s interest rates are likely to fall to spur economic growth, and the currency will weaken too, undermining U.S. owners of European stocks whose gains were magnified in dollar terms when the euro and the pound were stronger.

“International [stock] investing is probably not a good place to be, probably for the next couple of years,” said Paul Nolte of investment manager Hinsdale Associates.

European bonds are another matter. Declining interest rates favor bond holders, and investors in euro-denominated securities are responding to the shifting winds.

“We are taking interest-rate exposure in Europe,” said Mihir Worah, manager of Pimco Real Return Fund (PRTNX) and sibling PIMCO CommodityRealReturn Stretegy Fund (PCRAX) . “Europe is certainly behind the eight-ball.”

With economic growth slowing around the world, foreign-government bonds in general appeal to Ross Levin, a financial adviser in Edina, Minn. But he’s investing through a mutual fund, Pimco Foreign Bond (U.S. Dollar-Hedged) (PFOAX), which is unaffected by currency swings that could impact returns. “We don’t want the currency risk,” Levin said.

2. Small-caps

Economic troubles abroad and relatively better growth in the U.S. benefit small-cap stocks, which tend to be domestically focused. At a time when Americans are looking inward, trying literally to get their own houses in order, smaller companies have an edge over giant multinationals and exporters.

Moreover, any stabilization in the overall economy from the federal bailout and other stimulus packages will encourage investors to take more risk, which also favors small-caps.

Indeed, small-caps have been a bright spot of the U.S. market. The small-cap Russell 2000 Index (RUT) lost 7% this year through Sept. 25, but its large-cap Standard & Poor’s 500 peer was off 16.4%. The best-performing mutual-fund category in the past three months has been small-cap core funds, up 1.8% according to fund-tracker Lipper Inc.

“The opportunities lie with smaller companies that have the ability to be more nimble,” Nolte said.

Still, at this point he’s mostly thinking ahead rather than actively buying.

“I’ve got my shopping list,” Nolte said. “We’re probably about three to six months away from getting more aggressive.”

3. Financials

The government’s intervention is aimed at resuscitating the financial sector. That won’t be its only rescue action. Look for the Fed to cut interest rates before year-end, and taxpayers may get another round of rebate checks to encourage spending.

All of which should be good for financial services. “You will see bank stocks and financial stocks rally,” said William Rutherford, a Portland, Ore. investment adviser. “There’s plenty of money on the sidelines, and that will be one of the first places investors look.”

That said, plenty of investors find the financial sector toxic. Rutherford did too until recently, when he bought shares of deposit-taking giants J.P. Morgan Chase Co. (JPM), Wells Fargo Co. (WFC), Bank of America Corp. (BAC) and Northern Trust Corp. (NTRS)

“Don’t fight the Fed,” Rutherford cautioned. “I wouldn’t be shorting financials right now.”

4. Consumer goods

What’s good for Wall Street banks is good for Main Street consumers. Put simply, easier credit keeps businesses afloat and workers employed. See related story on bailout’s effect on consumers.

Consumer companies — particularly those with mostly U.S. operations — are strong defensive plays now and will share in an economic recovery. Mutual funds dedicated to the consumer-staples sector, for example, rose 3.9% in the past three months.

“They’re not rockets, but they can be depended upon,” Rutherford said. His clients’ portfolios include shares of Church & Dwight Co. (CHD), Monsanto Co. (MON) and Hroger Co. (KR).

Morningstar’s Dorsey also has high regard for brand-name retailers with substantial market share. He points to Wal-Mart Stores Inc. (WMT, Home Depot Inc. (HD), Lowe’s (LOW) and Bed Bath & Beyond Inc. (BBBY).

“Home Depot and Lowe’s own the home-improvement business,” he said. “Whenever consumer spending comes back, those are the companies that are going to benefit. You’re not going to make as much in Home Depot or Wal-Mart, but your downside risk is a lot lower.”

5. Health care

The health-care sector typically holds up in a slowing economy, and this time is no different; the average health-care fund added 3% in the past three months.

Another catalyst for health-care investing is that the credit crunch may have quashed the political clouds overhanging the industry. Any federal health-care reforms are likely to be less grand in scale, Dorsey said.

“The political fears of health-care reform have been way overblown,” he added. “Health care is as attractive as it ever was.”

You can mitigate the risk of the health-care sector by investing in companies with diverse product lines, Dorsey said. He recommended Johnson & Johnson (JNJ) and Merck & Co. (MRK). He’s also a fan of managed-care provider WellPoint Inc. (WLP).

And as shelter from the unpredictability of financially strapped, economically sensitive sectors, Dorsey said there’s nothing like health care to protect your portfolio.

“Health care avoids the whole mess,” Dorsey said. “Demographics are what they are; the world moves on.”

Jonathan Burton is an assistant personal finance editor for MarketWatch, based in San Francisco.