Third-Quarter Review of Investments and Personal Finance : Stock Funds Post Another Big Gain : Average Increase Is 8.9%, Bringing ’95 Rise to 27.3%

Stock mutual funds made it a hat trick with the summer quarter, scoring their third consecutive quarterly gain as Wall Street’s rally broadened significantly.

The average general stock fund rose 8.9% in the three months ended Friday, bringing the year-to-date advance to 27.3%, according to preliminary data from fund tracker Lipper Analytical Services Inc. in New York.

Every category of U.S. equity funds followed by Lipper showed a gain in the third quarter, a testament to the bull market’s power. Of the most popular categories of funds, including growth, growth-and-income and small-company stock funds, the average percentage rise so far this year is remarkably close: between 25% and 29%.

Yet as the millions of fund shareholders watch their invested dollars bloom, concern naturally is growing that the market is getting far ahead of itself.

Indeed, the year-to-date gain in general stock funds is the third-greatest in modern history, measuring from Jan. 1 through Sept. 30.

Only 1967, when the average fund was up 33.1% by this point, and 1987, when the average gain was 28.5% at this stage, were better years, Lipper says.

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But being in the company of those years isn’t much comfort. The Dow Jones industrial average suffered a 12.5% pullback between the end of the third quarter of 1967 and the middle of the first quarter of 1968.

And the fourth quarter of 1987, of course, lives in infamy. The Dow plummeted 23% on Black Monday, Oct. 19, 1987, on the heels of a sudden rise in interest rates and a collapsing U.S. dollar.

“I’m worried because trees don’t grow to the sky,” warns Michael Lipper, head of Lipper Analytical, as he surveys stock funds’ results.

Still, Wall Street veterans note that just because the market is up doesn’t mean it must decline significantly any time soon. In 1991, the average stock fund was up 25% by the end of the third quarter, and it went on to finish that year up 36%--then advance another 9% in 1992 and 12.5% in 1993.

What’s more important than the absolute percentage rise in stocks is the backdrop for that rise: the economic outlook, the interest rate outlook and individual companies’ earnings outlooks.

“I wouldn’t be selling just because I’m sitting on a gain,” says Eric Kobren, editor of the Fidelity Insight newsletter in Wellesley, Mass., which monitors Fidelity funds. “I want to make my decisions based on where I think the market is going from here,” he says. “And right now a lot of things are still going well.”

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Indeed, many bullish fund managers argue that they can still find stocks that are reasonably priced relative to their earnings potential and relative to interest rates. The average blue-chip stock is priced at about 13 times Wall Street analysts’ consensus estimates of 1996 earnings per share.

That isn’t a high price-to-earnings ratio by historical standards; it’s about average. But then, that assumes corporate earnings will meet analysts’ estimates. And the earnings trend, after nearly two years of spectacular increases, is showing definite signs of slowing with the weaker U.S. economy.

That will probably mean that the biggest challenge for fund managers in the fourth quarter and in 1996 will be avoiding disasters--companies that surprise investors with earnings below expectations.

“We’re going over our stocks eight ways to Sunday to be sure that the companies aren’t going to be reporting disappointing earnings,” says George Novello, whose Smith Barney Special Equities fund in New York has rocketed 41% so far this year.

As fund managers cast a more critical eye on companies, any further market advance is likely to be on the backs of a shrinking number of stocks. That will make stock selection key to fund performance. Managers who pick well will score above-average gains, but performance differences among the broad mix of funds could widen dramatically.

Thus, for investors looking to put money to work in a fund now, the first question to ask is whether the manager has proven his or her mettle in tough stock-picking environments, experts say. The rising market tide this year has already lifted all boats; now experienced sailors are needed.

Beyond that, some fund sectors may have an edge if the search for dependable and robust earnings growth dominates Wall Street:

* Small-company stock funds, which rose 11.9% on average in the third quarter, have only in the last few months begun to catch up with their blue-chip brethren after lagging in 1994 and early ’95. If the U.S. dollar continues to strengthen--potentially limiting the overseas earnings gains of multinational companies--more investors may focus on the earnings prospects of domestically oriented smaller companies.

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What’s more, Smith Barney’s Novello notes that the correlation between long-term interest rates and small-company stocks is very strong: When long-term rates fall, small-company stocks often outperform the rest of the market, because lower rates encourage investors to place a higher premium on shares of faster-growing young companies.

Long-term bond yields currently are just above 19-month lows, and some bond market bulls believe there’s room for yields to fall further if inflation remains subdued and the economy grows modestly.

* Science-and-technology stock funds, this year’s market stars, may still have some oomph despite worries that tech shares are in the grip of a dangerous mania. The average tech fund soared 15.2% in the third quarter and is up 46.6% for the year.

Yet the earnings prospects of many technology companies continue to be stellar, some fund managers say. “My [stock-picking] model is not telling me to sell technology,” says Charles Albers, whose Guardian Park Avenue fund in New York is up 32.6% for the year and has been above average in performance long-term, thanks to Albers’ disciplined stock-picking formula.

* Narrow fund sectors such as financial services and health care could continue to lead the broad market because of special circumstances behind earnings growth. In the case of financial services companies such as banks, low interest rates and a swelling merger wave are driving earnings expectations; for health care funds, revived faith in biotechnology’s future is attracting investors.

But for investors who fear that a serious market pullback is looming, the only good offense may be a good defense now, some fund pros say.

Ken Gregory, editor of the No Load Fund Analyst newsletter in Orinda, Calif., favors funds that buy real estate investment trust (REIT) shares. Although the average real estate fund is up just 8.6% year-to-date--one of the weakest fund categories--Gregory notes that REITs’ big dividends could help buffer their shares in any market correction. He also believes that real estate funds’ long-term prospects are excellent, as property values rebound nationwide.

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Equity-income funds, which typically own big-dividend-paying stocks and usually some bonds, could be a good choice for defensive investors as well today. And Michael Lipper suggests that bargain hunters look at still-depressed Japanese stock funds and funds that target shares of emerging-market countries, such as Mexico. International investing, while out of favor currently, remains an important element of any diversified long-term investment plan, pros advise.

For the truly nervous fund owner, however, there may be no substitute for simply taking some money off the table by selling a portion of your highest-flying funds--especially if you now feel over-committed to stocks for the amount of risk you’re willing to accept.

“This could be a time when holding cash starts to have some increased value,” concedes A.C. Moore, money manager at Dunvegan Associates in Santa Barbara.