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After three years of underestimating the economy's strength, in 1998 investors stopped gambling on a slow-growth scenario. Instead of purchasing shares of companies with steady and dependable profits, many investors turned to fast-growth companies in the technology and retail sectors, groups that generally do well in a fast-growing economy. Despite the risks that accompany high valuations, there are compelling reasons to include stable-growth stocks in a portfolio. These stocks have outperformed the market over long periods; they deliver better returns than any other type of stock during an economic slowdown; and since they're companies worth holding on to, a portfolio of stable-growth stocks typically requires little trading activity, a distinct advantage for taxable accounts. To see just how much the market covets these stocks, look at two institutional indices of stable-growth companies. In early February, a Merrill Lynch portfolio of more than three dozen stable-growth stocks traded at 36 times earnings and about 11 times book value, or net worth. Morgan Stanley's index of 30 consumer-oriented stocks was valued at 30 times earnings and 6 times book.




What makes this group of stocks so interesting at this point in time is that they perform especially well when the economy is slowing. An economic downturn was precisely what many investors were betting on from 1995 through 1997. Consequently, Kim's portfolio of stable-growth companies rose 44 percent in 1995, 26 percent in 1996, and 42 percent in 1997, outpacing the S&P 500 in all three years. The U.S. economy may not have to nosedive for stable-growth stocks to come back in vogue. A slight change in investors' perception could do the trick. The economy grew 3.8 percent in 1997 and 4.1 percent last year. Most Wall Street economists expect about 2.5 percent growth this year. Though this is a reasonable level by historical standards, it could be enough of a change to alarm investors. Chicago Fed president Michael Moskow refers to this possibility as the Sammy Sosa syndrome. "For years, Sammy Sosa hit 30 to 40 home runs, a good performance," Moskow said in a speech this January. "Last year, he hit 66-an extraordinary performance. If he hits 40 this year, some will say he had a bad year. It's a case of unrealistically high expectations." Despite the risks that accompany high valuations, there are compelling reasons to include stable-growth stocks in a portfolio. These stocks have outperformed the market over long periods; they deliver better returns than any other type of stock during an economic slowdown; and since they're companies worth holding on to, a portfolio of stable-growth stocks typically requires little trading activity, a distinct advantage for taxable accounts. ick your poison: Internet bubbles o r currency devaluations. An economy that's growing too fast or headed for a sudden downturn. Though the bulls are still stampeding, the market is increasingly volatile. It's enough to turn even daring investors into more conservative ones, forsaking Wall Street's exotic fare for a diet of more consistently dependable stocks, venerable companies like Walgreen, the Deerfield, Illinois-based purveyor of food and drugs.

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If you and your spouse have $98,000 a year in combined income, you may think that you're in the 31 percent federal tax bracket. The reality is more complex: you pay a 31 percent federal income tax only on the last $1,100 you earn. In fact, your marginal tax rate is 31 percent, but most of your income is taxed at 15 percent or 28 percent. What's my marginal tax rate? Steve Kim, an equity-derivatives analyst at Merrill Lynch, has closely studied the past performance of stable-growth stocks. Kim compared the returns of the 500 largest-capitalization companies with a portfolio of stocks with the lowest volatility in earnings in the food, drugs, and tobacco industries. His research showed that the stable-growth stocks outgained the 500 large caps by 2.25 percent a year from January 1970 to February 1996, with only slightly more risk. After three years of underestimating the economy's strength, in 1998 investors stopped gambling on a slow-growth scenario. Instead of purchasing shares of companies with steady and dependable profits, many investors turned to fast-growth companies in the technology and retail sectors, groups that generally do well in a fast-growing economy. For a married couple filing jointly in 1996, the 28 percent federal rate kicked in for amounts over $40,100; the 31 percent tax rate applied to amounts over $96,900; the 36 percent rate applied to amounts over $147,700; and 39.6 percent was levied on amounts over $263,750. (Federal tax brackets are adjusted at the end of each year for inflation.) Throughout the history of capitalism employment generation has been powered by rapid growth in Industry. The reason is that ever since 1820, from when adequate data became available, productivity in industry has grown at three times the pace of productivity in the services sector. As a result one has needed three additional workers in the services sector to clear away and sell the product of one additional worker in industry. Why the turnaround in investor attitude? Low unemployment, minimal inflation, solid wage growth, and a friendly stock market all combined last year to fuel consumer spending. Whether that trend will continue is a hotly debated point; indeed, many economists now view the consumer as a wild card. If the stock market fails to shower investors with double-digit gains, Americans might make fewer trips to the mall, dampening economic growth. Smart Questions to Ask Your Financial Advisers

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On the other hand, if your marginal tax rate is low, investing in tax-exempt municipal bonds doesn't really make sense for you. If your marginal tax rate is 31 percent, earning 5 percent interest tax-free is like earning 7.25 percent in a taxable investment. If your marginal rate is only 15 percent, a tax-free 5 percent is worth only as much to you as 5.88 percent in a taxable investment. You might earn more in Treasuries, which are free of state and local taxes-and safer than municipal bonds. This is important information for any investor-even someone who never ventures into the stock market. Smart Questions to Ask Your Financial Advisers

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Despite the risks that accompany high valuations, there are compelling reasons to include stable-growth stocks in a portfolio. These stocks have outperformed the market over long periods; they deliver better returns than any other type of stock during an economic slowdown; and since they're companies worth holding on to, a portfolio of stable-growth stocks typically requires little trading activity, a distinct advantage for taxable accounts. What makes this group of stocks so interesting at this point in time is that they perform especially well when the economy is slowing. An economic downturn was precisely what many investors were betting on from 1995 through 1997. Consequently, Kim's portfolio of stable-growth companies rose 44 percent in 1995, 26 percent in 1996, and 42 percent in 1997, outpacing the S&P 500 in all three years. Steve Kim, an equity-derivatives analyst at Merrill Lynch, has closely studied the past performance of stable-growth stocks. Kim compared the returns of the 500 largest-capitalization companies with a portfolio of stocks with the lowest volatility in earnings in the food, drugs, and tobacco industries. His research showed that the stable-growth stocks outgained the 500 large caps by 2.25 percent a year from January 1970 to February 1996, with only slightly more risk.

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