INVESTORS BRACE FOR A GRIZZLY BEAR MARKET THAT MAY TURN OUT TO BE JUST A CUB

► As January goes, so goes the year, according to a Wall Street aphorism. It’s hardly surprising, then, that January’s 5.9% fall in stock prices—the worst such drop for the Dow in 12 years — has led to a flood of bear market predictions.

There are plenty of trends to worry about. “Corporate profits crashed in 1989,“ says H. Erich Heinemann, chief economist for Ladenburg Thalmann, “and layoffs are on the way.” As the economy deteriorates, Heinemann expects a correction that could send the Dow down as much as 15% to below 2300.

Maybe so. But then again, maybe not. Share prices have been hurt recently by the collapse of the junk bond market, which has made takeovers harder, and by the recent half-point hike in interest rates. But the uptick was caused by rising rates overseas, not by inflation in the U.S. Once junk and rates stabilize, it’s possible that stocks could start recovering.

While blue chips made their 2810 high in the first week of January, smaller companies have been performing badly for the past four months (see the chart on page 62). In fact, analysts say that some stocks are down so much they’re not likely to fall a lot further.

Defensive investors should now be looking for depressed issues that have strong balance sheets, prospects for steady profit growth and attractive yields. Even if they go a bit lower, such shares could prove to be excellent buys over the next three years. Here are some choices:

STOCKS THAT OUTPACE DEBT-HEAVY RIVALS

“if the ’80s was the decade of deal stocks, the ’90s will be the decade of quality stocks,” predicts Bob Chesek, manager of Phoenix Growth Fund. Nowhere do such stocks stand out more clearly than in industries populated by giant companies left deep in hock by deals. Here are five financially sturdy companies that analysts say could profit from the woes of their overleveraged rivals:

► Philip Morris. As RJR Nabisco’s junk bonds have been hammered — down 20 points in two days in January — competitor Philip Morris (1989 revenues: $44.8 billion) has been gobbling up the market for cigarettes, with its share rising to 40% from 37.5% over the past year.

► Great A&P. Cash-hungry leveraged chains, such as Supermarkets General and Kroger, have raised prices at the expense of sales. But because $11.2 billion A&P carries only a moderate debt of S571 million, analysts project that its earnings can grow 18% a year through 1994.

► McDonald’s. Fast-food chains weakened by debt have been bruised by price wars, but $6.1 billion McDonald’s has stayed out of the fray. Further, the company’s balance sheet is stronger than its 49% debt-to-capital ratio suggests. McDonald’s carries its real estate on the books at 30% less than the market value of $9.5 billion, explains Edward M. Kerschner, chief investment strategist at Paine Webber. (For a contrary view on Philip Morris and McDonald’s, see page 171.)

► Sara Lee. More than 30%’of its $ I1.7 billion in revenues comes from personal product lines, including Hanes underwear and L’eggs hosiery. Rival Fruit of the Loom has been hampered by chairman William Farley’s fruitless efforts to complete the $3 billion acquisition of West Point-Pepperell.

► Melville. This $7.5 billion retailer is well positioned to capitalize on the collapse of the Campeau empire, which has defaulted on $7.5 billion of debt. Chris Linden, manager of FPA Perennial Fund, thinks that Melville’s Marshalls discount clothing stores will negotiate attractive prices for merchandise from wholesalers seeking assured payments.

BARGAIN HUNTING FOR BLUE-CHIP YIELDS

► Among the victims of investors’ recession fears are cyclical companies, whose profits are highly sensitive to the economy. Now several analysts think that some of the issues are attractive. “Their prices already reflect the worst-case economic scenario,” says analyst David Katz of Value Matrix Management in New York City. “So they offer limited downside risk and substantial upside potential.”

Several money managers and analysts currently recommend five such stocks that yield more than 4%. All trade on the New York Stock Exchange at prices less than six times the amount of cash they generate each year. (For cyclicals, cashflow ratios are often a better measure than P/Es of whether a stock is cheap.) Here are the experts’ favorites:

► Ameritech, the midwestern regional telephone company, whose share price fell 15% this year after state regulators ordered Illinois Bel! to cut rates by 2.8%. Kenneth Hackel, president of Systematic Financial Management in Fort Lee, N.J., thinks investors have overreacted and that Ameritech, with revenues of $10.8 billion, will still earn enough to raise its dividend — the fourth hike in four years.

► Ford, which David Katz of Value Matrix regards as a steal at its current price of only 2.5 times cash flow. “Ford (revenues of $97 billion! is in much better shape to weather a downturn in the U.S. than GM or Chrysler, because Ford has strong European operations and a very profitable finance subsidiary,” he says.

► Imperial Chemical Industries, which Katz favors because of the $21.4 billion British-based company’s attractive pharmaceutical business. “Because the chemical business is not having a robust year, the stock has fallen to a price that does not reflect the improved profits I expect from drugs,” he says.

► K Mart, which is selling near the low end of its 52-week price range because investors fear that consumers will cut spending. Even with an economic slowdown, though. Katz thinks the $33 billion mass merchandiser can get back on its historical annual earnings-growth track of 10% within two years.

► Union Camp, which has reported flat profits from sales of $2.7 billion in the past year because it spent more than $500 million to buy cost-saving papermaking equipment. Once the modernization program is completed in 1991, Hackel thinks that cash flow will improve and that the dividend may be raised.

For Market Update, turn to page 62.

SMALL INVESTORS GO FOR INCOME AS RATES TURN UP

The sharp jump in interest rates in January and early February sent small investors scrambling into high-yield stock funds, municipal bond funds and money funds.

For the month, the Money Small Investor Index fell $770, to $41,201. Stocks lost $828, and bonds, $83. Short-term assets such as CDs and money funds added $ 116, while gold gained $30.

Investors poured money into stock funds of all kinds during the first two weeks of 1990 — $51 million at the Financial Programs fund group, for example, 65% more than the total for all of December. But then, as stock prices fell, investors became more selective, strongly favoring only two types of equity funds:

• Growth and income funds, which cushion market downdrafts with high-yielding issues.
• International funds, which give small investors a way to cash in on reform in Eastern Europe.

An estimated $1 billion went into tax-exempt bonds and mutual funds in January, up more than 35% from December. Because the spread between taxable yields on Treasury bonds and tax-free yields on municipals has narrowed — munis pay 90% as much as Treasuries — tax-exempts are now especially attractive for investors in the 28% tax bracket or above.

The most popular place for new money was money-market funds, the only investment certain to benefit from rising interest rates. More than $15 billion poured into money funds in January; investors withdrew upwards of $8 billion in December.