How you can help clients profit from it.

With manufacturing expansion reaching a 20-year high in December and new jobless claims falling to a three-year low Christmas week, little doubt remains that the U.S. economy is in recovery mode, at least for the moment. Certain market trends typically materialize in an upcycle, economic history tells us, and some of them have already transpired in this turn of the wheel. For instance, the initial beneficiaries of past recoveries-technology and other risky assets such as small-cap stocks and high-yield bonds-performed handsomely in 2003.

Yet every rebound is unique, observes Paul Greenwood, U.S. equity director at Russell Investment Group, the money managers formerly known as Frank Russell Company. "History seldom repeats itself exactly," Greenwood says. Examining past tendencies can be useful. Just don't expect a detailed re-enactment. Record-low interest rates mean, among other things, that banks face a much different backdrop today than in the early 1990s recovery, when they fared well with high-margin double-digit money rates.

A peculiarity that could limit upside to this recovery is all-time high debt. Household debt (including mortgages) is now more than twice disposable personal income, a ratio that climbed quickly during the heady 1999-2000 era and continued through the recession, according to Sam Burns, an analyst at Ned Davis Research, institutional stock market researchers in Venice, Fla. "Normally in a recession, people stop spending and pay off their debts. But in this cycle, there wasn't any big retrenchment. People just kept spending. There may not be as much pent-up demand or room to increase borrowing as in previous recoveries," Burns says.

Nevertheless, early estimates of 2003 holiday season shopping suggest a healthy surge from the prior year's annual results. Looking ahead, greenbacks will soon ease their way into pocketbooks. This spring's tax refunds are expected to be 25% larger than in the past. Ca-ching, ca-ching, cash registers could sing.

A full-fledged recovery requires capital spending by businesses. Several years of aggressive cost cutting have left Corporate America lean, mean and with computers ready to take on Y2K. Higher profits, potentially abetted by the offshore demand for U.S. products that grows with a declining dollar, could encourage spending on new equipment, ventures and employees, and there are companies that stand to benefit from that.

Belief in a recovery is belief in equities. But the redheaded stepchild of a healthy economy is higher interest rates. In good times, saucer-eyed businesses smell opportunity left and right, so the demand for capital grows. Also pushing the cost of money higher is the specter of inflation, an eventual by-product of economic vigor. Fixed-income allocations, therefore, must assume a defensive posture. "In this environment, clients should rebalance to their minimum fixed-income exposure and maximum equity exposure," says Bill Tedford, director of fixed-income strategy at Stephens Capital Management in Little Rock, Ark. But whether many investors who saw their portfolios vaporized in the 2000-2002 bear market, by some measures the worst in 70 years, will follow suit remains to be seen.

To maintain portfolio income, consider placing the incremental equity allocation in high-dividend, high-quality stocks, advises Dave D'Amico, a managing director at David L. Babson & Co. Inc., asset managers in Cambridge, Mass. He says, "There may be more risk in (long-term) bonds than in a select number of high-dividend stocks" such as BP PLC, the London-based successor to BP-Amoco whose ADR sports a 3% yield. Victims of bear market trauma who have been clinging to cash should be encouraged to average back into equities, D'Amico says.

As advisors reposition portfolios for recovery, use caution with vehicles that are new in the marketplace. It's impossible to know how securities with short histories will perform in a recovery scenario, especially if they rely on derivatives or complex contractual arrangements that leave you scratching your head (remember Enron's smoke-and-mirrors business model?) Losses in unusual investments all too frequently trigger customer complaints.

The Opportunities In Stocks

By now, the easy money has been made in the stock sectors that initially profit from economic rejuvenation, says Jeff Schwartz, manager of Safeco Growth Opportunities Fund. Schwartz and other pros were unloading technology and most small-caps when interviewed late last year. Remaining plays include little companies with big cash positions, says Philip Tasho, co-founder of TAMRO Capital Partners and manager of two ABN AMRO funds. Because small public outfits have the least access to capital markets, many knowingly conserved cash during the last downturn. "We're discovering that a lot of small technology companies are selling at very depressed valuations when you consider the inordinate amount of cash on their balance sheets," Tasho says.

The real territories to mine, however, are mid- and large-cap stocks. After the initial phase of a recovery in which risky, low-quality assets outperform, "you start to see broader market participation," says Morningstar Managing Director Don Phillips. In 2003, many companies with sound fundamentals showed poor movement relative to the overall market trend. Tasho says, "We think a great way of playing the recovery is to look for high-quality companies that have sat out this market uplift so far."

Take Microsoft, for example. Tasho purchased it near the $25 mark, a price that he says does not anticipate any surge in replacement of old PCs. "Microsoft has about 60% of the desktop market, their financials are pristine, they're using restricted stock (as an employee benefit) instead of options to enhance transparency, and they're spending a lot on R&D to come up with new products," Tasho says.

Telecom operators that generated free cash flow in the latest recession are emerging as very strong competitors in this upcycle, says Bernard Horn, manager of Polaris Global Value Fund. He touts Verizon Communications despite others' fears that hard-wired land lines could become obsolete. "It costs considerably more to make a mobile call than a fixed-line call. Businesses are not going to just give all their employees mobile phones," Horn says. Verizon's wireless network is good, he points out, and the company is upgrading its fixed-line network "to make that more efficient and competitive for the enterprise customer. Verizon is going for the triple play," Horn says, "where they (provide) your fixed-line business, your wireless business and potentially your broadband business."

Media stocks could get hot in a robust recovery. "As firms become more profitable, they begin spending to improve the top line, and the way they do that is through advertising," says D'Amico. "We think '04 could turn into a strong advertising environment." D'Amico's favorites are New York Times Company and Clear Channel Communications, which operates outdoor billboards and over one thousand radio stations. D'Amico also cites Viacom-owner of CBS, MTV, VH1 and other outlets-calling it "a very high-quality media and entertainment company." (Microsoft is in media, by the way. The former software monopoly owns about 7.5% of cable-television giant Comcast, Morningstar reports.)

Healthcare is another space to watch. As unemployment drops in a recovery, the rolls of insureds swell, and more people can afford health services. Polaris's Horn has been actively acquiring insurers and HMOs such as PacifiCare, Oxford Health Plans and Anthem Inc. In fact, Horn touted Anthem some time ago in the past, predicting that the growing collection of demutualized Blue Cross/Blue Shield plans could become the largest healthcare provider in the country. Recently Anthem announced plans to merge with WellPoint, another biggie. "That would clearly put them in the top ranks," Horn says.

Demand for the energy that literally fuels a booming economy can boost energy shares, says Tasho, who has been adding to positions. "The surprise could be that if there is a recovery globally, we'll see increased demand for natural resources. Their prices could stay higher than people realize." Consolidation has left the energy industry with favorable operating leverage going forward, he adds. In large-cap, Tasho covets BP. "We love what they're doing with their investments in Russia." A small-cap pick is National Oil Well, a parts-supplier that could benefit from increased drilling and exploration.

Energy also appeals to Bill Fries, a managing director and portfolio manager at Thornburg Investment Management Co. in Santa Fe, N.M., whose holdings include Marathon Oil and Amerada Hess. Fries, a favorite of many advisors, was recently named Morningstar's international manager of the year. In Thornburg International Value Fund, Fries owns CNOOC Ltd. (NYSE: CEO), the dominant producer of crude oil and natural gas offshore China. "CNOOC does things on a joint venture basis with the major oil companies, and that reduces the execution risk you might normally associate with an emerging market company," Fries says.

Railroads may not be as sexy in the computer age as when they linked ocean to ocean in 1869, but they still thrive when trade improves. "Autos move by rail. Merchandise goes by rail," Fries says. Imports and exports travel by train between the heartland and the coasts, too. Fries owns Union-Pacific, the nation's largest railroad concern.

To play the voracious consumer, Fries suggests electronics retailer (and turnaround situation) Circuit City Stores. The company recently sold its bankcard portfolio and now holds about $4 per share in cash, Fries said with the stock hovering around $10. He also likes Circuit City's stock price-to-sales ratio of 0.22. It's less than one-third of sector-leader Best Buy's 0.72. "You don't find disparities like that very often," Fries says. "Circuit City doesn't have to be as good as Best Buy to be a good stock."

Defending Fixed-Income Positions

If you haven't already, you should be taking steps to mitigate the damage an uptick in interest rates could wreak.

For clients with sufficient assets, it may help to own individual debt securities, rather than bond funds, says certified financial planner Marilyn Dimitroff, president of Capelli Financial Services in Bloomfield Hills, Mich. An individual bond that drops in market value can be held until maturity, at which time it returns the investor's principal (barring issuer bankruptcy). But pooled investments lack a repayment date, making permanent capital erosion a distinct possibility.

Another ploy is to minimize U.S. government debt, says advisor Michael Boone of M.W. Boone and Associates in Bellevue, Wash. Treasuries are a pure interest-rate play, while the credit risk of corporate and municipal instruments reduces their sensitivity to rate changes.

However "the best insurance against rising rates is to bring in (shorten) the duration of the portfolio," says Bob Doll, president and chief investment officer of Merrill Lynch Investment Managers in Princeton, N.J. "We're generally a half year-and in some cases, a full year-below our benchmark," Doll says. At Stephens Capital Management, Tedford is keeping duration at 2.2 years, slightly above his permitted floor of 2.0 years and well below the current 3.4-year duration of his benchmark, the Lehman Brothers Intermediate Government Index.

Some advisors are using so-called inverse bond funds to hedge portfolios. These short the long T-bond (or create an equivalent economic position) at the market close each day in an attempt to capture change in the opposite direction. Rydex Juno Fund is among those that seek a one-to-one inverse move. Others are levered, such as the relatively new Rising Rates Opportunity ProFund, which aims for a 125% change opposite of price movement in the most recently issued long bond. Watch out for high expense ratios with this breed of fund, warns Eric Jacobson, a senior analyst at Morningstar.

Advisors with clients concerned about inflation must consider the latest options. U.S. Treasury inflation-protected securities (TIPS) are no longer the only game in town. Last year, Incapital LLC of Chicago began underwriting corporate-backed Inflation-Protected InterNotes. IPIs are unsecured (albeit investment grade) debt securities that sidestep the phantom tax problem which plagues TIPS and frequently lands them in tax-deferred accounts-not exactly at hand for investors seeking income. IPIs pay inflation-adjusted interest monthly while maintaining a constant principal value, whereas TIPS grow your principal for inflation, causing tax on the paper gain. However, issuance of IPIs has been limited since introduction.

Nervous nellies who demand Treasury-strength inflation instruments have a new choice in the Lehman TIPS Bond Fund, a Barclay's iShare exchange-traded fund introduced in December (under the clever ticker TIP). Its intention is tracking the Lehman Brothers U.S. Treasury Inflation Notes Index. With 20 basis points of expense, the new ETF is 0.02% cheaper than Vanguard's popular TIPS fund, although you also have to consider brokerage commissions with ETFs. Yet there is something to be gained from professional TIPS management-as long as you don't overpay for it-says Morningstar's Jacobson. "The TIPS market is small in terms of the number of (outstanding) issues, but it's a relatively inefficient market. The decisions that managers make can be important," Jacobson says.

Another way to profit in a potentially inflationary environment is to capitalize on changes in commodity prices. Funds such as PIMCO Commodity Real Return Strategy and Oppenheimer Real Asset attempt to mimic commodity indexes. Both enjoy "pretty good negative correlation" with the bond market, Boone says his research indicates.

While a rebounding economy unquestionably presents opportunities and challenges, it's important not to forget what the bear market taught: Diversification cushions total portfolio return. Yet some clients with short memories want to party like it's 1999, according to Dimitroff. "There are still people who are saying, 'Diversification is just going to slow us down,'" she says.

Don Phillips adds, "The mistake is not to come away with any valuable lessons from the last few years." Indeed, helping clients invest appropriately is the best way to profit, recovery or no.