Pacesetters Expected to Keep Up the Pace

As this year’s second quarter got underway, the Federal Reserve Board was raising short-term interest rates, clouding the general outlook for stocks. Financial stocks in particular--always sensitive to changes in lending costs--were expected to suffer.

So much for forecasts.

Thanks to a slowdown in consumer spending and continued low inflation, longer-term interest rates have fallen since March, despite the Fed’s rate boost.

And financial stocks--those of banks, investment firms and insurers--rallied nicely in the quarter to remain one of the market’s best-performing sectors for the first half of 1997.

Brokerage stocks rallied too (as the accompanying chart shows), dovetailing with the stock market’s relentless march to record highs. Stocks of drug makers and other health-care companies also continued to lead the pack. Computer, semiconductor and other technology issues also stood out, rebounding from a lackluster first quarter.

Some observers don’t see a big shift for the next six months.

“I don’t think there’s a major reversal or change of leadership [among stock groups] coming in the second half,” said Eric Miller, chief investment officer of Donaldson, Lufkin & Jenrette Securities.

That’s why he still likes the financial services and drug groups, along with the oil services sector, all of which have done well so far this year.

“You usually don’t have a major change in leadership until you have a major [market] correction or a recession,” Miller said. “So I don’t think you’ll get a pop in autos or appliances or a lot of the other consumer cyclical stocks.”

Nonetheless, analysts are growing wary of how long the ideal economic conditions that are keeping the Fed in neutral will last. There’s concern that the economy will begin overheating in the second half of the year, prompting at least one more tightening of credit by the central bank before 1998.

“We keep pinching ourselves; this seems too good to be true,” U.S. investment strategist Jeffrey Applegate of Lehman Bros. wrote recently. For now, he said, the Fed’s “monetary policy remains masterfully run.”

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If the economy can continue its solid, low-inflation expansion, financial stocks should continue gaining, analysts said. They typically thrive when rates aren’t going up and aren’t increasing their cost of funds. That’s why financials remain populous on Lehman’s list of recommended shares.

Among its picks: banking giants Citicorp (ticker symbol: CCI) and Chase Manhattan Corp. (CMB); Pasadena-based Countrywide Credit Industries Inc. (CCR); and the newly merged investment giant Morgan Stanley, Dean Witter, Discover & Co. (MWD).

Brokerage firms are also getting a lift from speculation that major banks will be buying more investment houses. NationsBank Corp. (NB) confirmed Monday that it will buy privately held Montgomery Securities for $1.2 billion in cash and stock.

But even in that sector investors must be careful. Another regional investment house, Hambrecht & Quist (HQ) took a tumble after analyst Dean Eberling of Smith Barney Inc. downgraded his outlook for the stock.

Lehman’s list is also heavy on capital goods stocks, representing companies that make the hard goods that are in demand when the economy is hitting on all cylinders. They include airplane colossus Boeing Co. (BA), General Electric Co. (GE) and industrial controls maker Honeywell Inc. (HON).

Indeed, U.S. markets strategist Douglas Cliggott of J.P. Morgan Securities Inc. noted that he had expected U.S. manufacturing to decelerate late this year “and grow very slowly in 1998,” and therefore had urged investors to pare their holdings of industrial stocks.

“We have been wrong!” Cliggott conceded in a recent report, noting that the paper, lumber, copper, aluminum, machinery, steel, heavy trucks and specialty chemical sectors all outperformed the Standard & Poor’s 500 index between mid-May and mid-June.

Now “it may not be until well into 1998 before a slowdown in manufacturing activity is clearly visible,” he said. Despite weaker U.S. consumer spending, many manufacturers are benefiting from strong exports.

Hence, Morgan is touting such industrial stocks as farm and construction equipment maker Case Corp. (CSE) and chemicals giant DuPont Co. (DD).

Ongoing demand for computer power and faster computer and telecommunications networks is also driving technology ahead, though the sector remains among Wall Street’s most volatile.

Merrill Lynch & Co. is particularly hot on shares of computer services firms, because “we see no signs that competition is eroding profitability or that end-market demand is slowing.” The pact at which the firms are signing new contracts is “still quite strong,” the firm said in its latest report to individual investors.

Merrill’s favorites include El Segundo-based Computer Sciences Corp. (CSC), which operates large-scale data processing for its clients; Fiserv Inc. (FISV), a leading check-processing provider; and First Data Corp. (FDC), a major player in credit card processing.

In the high-flying drug sector--the American Stock Exchange’s pharmaceutical index has jumped 34.8% so far this year, compared with the 19.5% gain of the S&P; 500--investors should focus on the big-name, large-capitalization issues such as Merck & Co. (MRK) and Pfizer Inc. (PFE), according to research firm Value Line Investment Survey.

The large players have strong and steady earnings records and can count on widespread demand because they have a multitude of drugs to sell, unlike smaller pharmaceuticals that can be hurt if only one or two products run into trouble, Value Line noted.

Value Line also likes to rank sectors by their “timeliness” in terms of being ready for a move up. And an unlikely group tops its list: alternative-energy and coal companies, because of surging overseas demand for power and consolidation in the coal business. Its picks there include AES Corp. (AES) and Zeigler Coal Holding Co. (ZEI).

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For investors with a contrarian bent, Wall Street’s outlook for the market’s laggards isn’t changing much, either.

The gold- and silver-mining sector is still neglected, owing simply to the slump in the precious metals’ prices. Gold, for instance, dropped 6% in the second quarter alone to a recent $335.30 per troy ounce on the New York Mercantile Exchange.

The electric utility and natural gas sectors are also expected to stay troubled for the rest of 1997, because deregulation sweeping through those industries is making it hard for Wall Street and individual investors to evaluate the companies’ earnings prospects.

Finally, one of last year’s best sectors--real estate investment trusts, or REITs--suddenly went very cold in the first half of 1997. For instance, the Chicago Board Options Exchange’s index of 24 major REITs--which had posted a sizzling total return of 29% last year--eked out a total return of only 1.9% in the first six months of ’97.

(REITs should be measured by more than simple price appreciation because they pass along nearly all of their profits to stockholders in the form of dividends. Thus, total return--price gains plus dividends--is a better gauge of REIT performance.)

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What went wrong for REITs? The earlier prospect of rising long-term interest rates dampened interest in REITs (even though rates eventually reversed), and the trusts issued a lot of additional shares in the period, which diluted per-share earnings and stock prices, said analyst Craig Silvers of Sutro & Co. in Los Angeles.

“But in the second half of the year, we expect REITs will perform well, because all the data coming through shows there’s no reason for the Fed to raise rates and that will give investors comfort,” he said. Two of his favorites: Price REIT Inc. (RET), which focuses on shopping centers, and the apartment-oriented REIT Essex Property Trust Inc. (ESS).

Of course, the Fed could wind up doing the opposite of what Silvers and others expect--confounding yet another forecast.

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Times staff writer James F. Peltz can be reached at james.peltz@latimes.com

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The Indexes Weigh In

Indexes tracking health-care, financial and high-technology issues showed the greatest gains during the first half of 1997, while gold and utility indexes fared badly. Here’s the ranking of some major domestic indexes followed by Bloomberg News:

GAINERS

(Index: % change Jan. 1 to June 30)

Amex Pharmaceutical: +34.8%

(15 drug-related stocks)

Lehman Select Technology: 33.9

(23 diversified technology stocks)

S&P; Health Care: 30.9

(31 diversified health-care issues)

Bloomberg Wall Street: 28.0

(20 investment/brokerage stocks)

Philadelphia Semiconductor: 27.2

(16 chip-related stocks)

S&P; Midcap Transportation: 24.9

(12 mid-size transportation stocks)

Morgan Stanley Multinational: 24.2

(50 stocks of multinationals)

Bloomberg Broadcasting & Cable: 23.1

(68 broadcasting/cable stocks)

S&P; Financials: 22.6

(163 banking/financial issues)

Amex Computer Technology: 22.4

(26 stocks of computer makers)

S&P; 500: +19.5

LOSERS

(Index: % change Jan. 1 to June 30)

S&P; Communications Services: -20.5%

(5 small telecommunications stocks)

CBOE Gold Index: -13.9

(10 gold-mining stocks)

Amex Natural Gas: -7.7

(15 natural gas issues)

S&P; Small Energy: -4.3

(25 small energy stocks)

CBOE Gaming: -3.0

(15 gaming/hotel stocks)

Dow Jones Utilities: -2.5

(15 utility stocks)

Amex Networking: -1.7

(15 computer-networking stocks

CBOE Real Estate Investment Trust: -1.2

(24 REIT issues)

Amex Biotechnology: -1.2

(15 biotechnology stocks)

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Abbreviations:

Amex: American Stock Exchange

CBOE: Chicago Board Options Exchange

S&P;: Standard & Poor’s

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Source: Bloomberg News