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."

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