Investors Feeling Bad . . . and That Just May Be Good

Investors head into the fourth quarter today with hefty year-to-date paper profits on their U.S. stock and bond investments--and, from many indications, an uneasy feeling that those profits won’t last.

But that paranoia may be the markets’ best friend, some Wall Streeters point out. The greater the worry out there, the less likely it is that we’re seeing a market peak. This is basic contrarianism, but it often works well as a forecasting tool.

Stock and bond investments alike generally beat money market accounts once again in the third quarter ended Thursday, as long-term interest rates fell while the economy struggled ahead.

The Standard & Poor’s index of 500 major stocks rose 1.9% in the quarter and is up 5.3% for the year, not counting dividends. While that may seem like a small return, it’s far better than the 2% you’d have earned year-to-date in a money market fund.

For many bond investors, the third quarter also was generous: The average bond mutual fund, for example, is up about 8.7% for the year, more than 2 percentage points of which was tacked on last quarter, according to fund tracker Lipper Analytical Services in Summit, N.J.

Yet investors appear increasingly reluctant to believe that Wall Street’s party can be sustained. Surveys of professional and individual investors over the last three weeks have shown a marked drop in bullishness. A poll by Investors Intelligence of New Rochelle, N.Y., for example, shows the percentage of investment newsletter writers who are bullish on stocks slid from 43.3% three weeks ago to 39.7% last week. The rest are short-term or long-term bearish.

Two other third-quarter trends also point to high caution among investors:

- Value stocks continue to lead the market. Among big-name stocks, those that sport low price-to-earnings ratios and high dividend yields--so-called value issues--were the quarter’s best performers. They include many banks, utilities, insurance companies and energy firms.

Their gains were fueled partly by the ongoing slide in interest rates, which has driven more investors to search for high dividends. But many of these stocks also are viewed as a “defensive” way to play the market--in other words, if stock prices in general were to take a big hit, the value issues should drop least. So investors see them as a low-risk haven in a high-priced market.

Through Monday, the value stocks in the Russell 1000 index of major stocks were up 4.25% in the third quarter, while the index’s “growth” stocks gained just 1.77% as a group.

- Small stocks’ rise is viewed with disbelief. Small-company stocks were the market’s undisputed stars in the third quarter. The Russell 2000 index, made up exclusively of smaller-company issues, rocketed 8.4% in the quarter and is up 14.5% year to date.

In contrast, the Dow industrials eked out a 1.1% third-quarter gain and are up 7.7% for the year.

Yet individuals, who normally chase performance (buying whatever’s hot), have so far ignored smaller stocks’ third-quarter fireworks. Many mutual fund companies say their cash inflows from individuals into small-company stock funds were shockingly small in September.

Fidelity Investments, for example, said purchases of its most aggressive stock funds (which usually focus on smaller names) actually decreased in September from August, despite new highs for the Nasdaq small-stock market.

Robert Leo, director of mutual funds for Smith Barney Shearson in New York, agrees that small-stock funds are a tough sell today, even though that is where the greatest gains are being made. “What it says is that people coming into mutual funds are being conservative,” he says.

Is there good reason to fear the market at these heights? Certainly, stock price-to-earnings ratios overall are historically high. And October, of course, has an exaggerated reputation for being a lousy month in which to own stocks. (Remember 1987 and 1989, not to mention 1929.)

But look around, say the bulls. Corporate takeovers are booming again, and that shows that businesses see value in other businesses, even at these prices. What’s more, despite the economy’s sputtering growth, corporate earnings gains overall have been impressive this year, and that should continue, thanks to cost cutting, interest savings and export sales to the Third World.

If the fourth quarter, as expected, brings more of what markets have enjoyed all year--continued low interest rates and an economy that grows in spite of itself--investors’ caution about stocks may once again be misplaced.

The best stocks to buy now? Bargain hunters may want to look among industrial issues that stagnated in September on economic worries, some experts say. The market will come back to these stocks at the first suggestion of faster growth. And given the disbelief surrounding small stocks in general, their rally may have much further to run--especially if the companies’ third-quarter earnings come in as good or better than expected.

Stock Group Trends

Here are the biggest winners and losers among 87 stock industry groups in the third quarter, through Wednesday. WINNERS:

3rd-qtr. Group change Hotels/motels +33.3% Semiconduc. +22.9 Home builders +19.5 Misc. transp. +18.3 Major banks +16.1 Broadcasters +15.7 Housewares +13.1 Manuf. homes +12.6 S&Ls; +11.4 Life insurers +10.8

*LOSERS:

3rd-qtr. Group change Clothing mfg. -16.1% Elec. instrum. -15.2 Shoemakers -14.3 Med. supplies -12.9 Computer sys. -12.6 Gold miners -12.0 Misc. metals -10.6 Box/bag mfg. -9.4 Oil/gas drilling -9.1 Drugs -9.1

Source: Smith Barney Shearson, using S&P; indexes