Weighing the Opportunities


Goodbye to the bear, and hello to . . . what, exactly?

The second-quarter turnaround on Wall Street raised hopes that the worst stock market decline in at least 13 years has run its course.

But even if the bear rests in peace, what will follow it is far from clear. Another roaring bull market? A long period of weak returns? Or, after a short-term advance, a new bear phase?

Hanging an investment strategy for the next few years on a single scenario would be the neat, clean thing to do. It also could turn out to be extremely dangerous, financial advisors warn: If things don't play out as you've bet, your portfolio results could range from mediocre to disastrous.

With the crash in technology stocks, many people learned the hard way over the last year about skewing their investment portfolio too heavily toward one sector or one scenario.

But a risk now is that gunshy investors will opt to be overly conservative, underestimating the potential for many types of stocks to do well in this decade, even if previous leaders continue to struggle.

The second-quarter rally was a case in point: Though broad-based, it was led by small and mid-size stocks, while the big-stock leaders of the late-1990s performed about half as well, on average.

The blue-chip Standard & Poor's 500 index gained 5.9% in the quarter ended Friday, rebounding from a two-year low set April 4.

The mid-cap S&P; 400 index, by contrast, surged 13.2% in the period.

Strong gains in mutual funds that target small and mid-size stocks helped lift the average domestic stock fund's quarterly total return to 8.5%, according to fund tracker Morningstar Inc. Even so, the average fund still was down 5.8% for the first half--a reminder that the bear market's losses could take quite a while to recoup.

The stock market's comeback seems to be owed in large part to the Federal Reserve's deep cuts in short-term interest rates in the first half: six strong doses of medicine for the wobbly economy.

Though the market all but ignored the Fed in the first quarter, by the end of the second quarter investors were far more confident that the economy will in fact avoid a full-fledged recession.

Now the issue is the shape of any economic rebound--whether it resembles a "V," meaning strong growth soon resumes; a "U," meaning business activity just plods along for a while, gradually turning higher; or an "L," meaning stagnation lingers for a long period.

The rebound's shape could determine what happens with corporate profits, on which stock prices are based in the long run.

The most popular view on Wall Street today is for a U-shaped recovery. High corporate and consumer debt loads, plus overexpansion in the tech sector in recent years, could restrain spending for a sustained period, many economists argue. At the same time, the Fed's aggressive credit-easing will support a gradual recovery, they say.

"I expect slow growth and a sluggish turnaround," said Jay Mueller, economist at Strong Capital Management in Milwaukee. "Things should be back on track by the latter half of next year. But by 'back on track' I don't mean we're likely to see five years in a row averaging 28% returns in the stock market as we did in the late 1990s."

He expects equity returns over the next five years to look much more like the historical norm--averaging closer to 10%.

But in a U pattern, "It would be much harder to pick winners and losers" in the market, Mueller said. "Some sectors will do well. But the sweet spots will be hard to predict."

They already have been: The rally of the last three months has been led by an eclectic bunch, including software stocks, entertainment issues and steel shares.

If Mueller is wrong and the economy rebounds far faster than expected, it's conceivable that stock prices could be much stronger across the board in the second half of this year and in 2002.

On the other hand, if the surprise is that the U.S. economy is entering a long stretch of stagnation, stocks overall could be lousy investments. Instead, conservative bonds could become the best place to invest.

The uncertainty, financial advisors say, argues more than ever for portfolio diversification--a concept many investors began to appreciate a year ago.

Said Russel Kinnel, Morningstar's chief mutual fund analyst: "Even if you're right about calling the economy, translating that into actual investments is never easy."

As an example, he noted that "the conventional wisdom is that in a recession 'cyclical' stocks get killed." Yet in the current economic slowdown, many cyclical industrial companies have fared much better than in the past--thanks in part to investments they made in cost-saving technology in recent years.

And Russ Koesterich, analyst at Instinet Research in New York, notes that individual stock sectors tend to recover at their own pace.

"People talk about Vs and Us and Ls as if it's one big picture, but it's not," he said.

Consumer-cyclical industries such as autos and retailing may benefit in this year's second half, buoyed by lower interest rates and the federal income tax rebate, he said.

"The consumer part of the economy could be a U, while technology might end up stuck in an L," Koesterich said.

Even within sectors, there will be major differences, he said.

Tech and telecom companies in areas such as fiber optics that still have overcapacity problems could try investors' patience through 2002, he said. Meanwhile, tech service companies that perform tasks such as payroll and data processing, with steadier revenue streams, might hold up better.

All of this suggests that the next few years could be a true "stock-picker's" market--one in which portfolio managers are rewarded for paying attention to the fundamentals and finding companies that will do well in whatever economic environment develops.

For stock mutual fund investors, that means the goal must be to invest with managers who pick well.

Some analysts say a good starting point for investors who are evaluating their portfolios today is to focus on the major shifts in the market over the last year, asking whether they are likely to continue and whether one's portfolio is structured to take advantage of those shifts.

Here are some of the key trends that have emerged over the last year:

* The return of "value" investing. More investors have begun to pay attention to stock valuations again, after the Internet stock bubble--and the idea of paying stratospheric price-to-earnings ratios for "growth" companies--ruined countless portfolios in 2000.

Jonas Ferris, editor of Maxfunds.com, a Web site that covers the fund industry, thinks value-oriented funds could continue to outperform growth funds this year, even though growth funds did somewhat better in the second-quarter rebound.

In any case, value stocks and funds have proved in the last year that they provide needed ballast for a portfolio, he said.

"Just don't expect double-digit returns forever in value like we saw in the last year," he said, calling that "an anomaly from underpricing compared to the overpricing of growth."

Ferris' value-fund picks include T. Rowe Price Capital Appreciation and Dodge & Cox Stock. T. Rowe's Capital Appreciation is a balanced, or "hybrid," fund, as defined by Morningstar: Manager Richard Howard uses stocks, bonds and convertibles to build a risk-averse portfolio.

Dodge & Cox Stock is a team-managed fund that sticks with value blue chips and keeps expenses low.

Kinnel's value picks include Longleaf Partners, Weitz Value, American Funds' Washington Mutual and Selected American.

* A comeback for "growth-at-a-reasonable-price," or "GARP," investing. Rather than shy away from growth stocks, some portfolio managers say the key is simply to make sure you're paying a fair price for true growth stocks.

Value and so-called deep-value investors, by contrast, usually demand bargain-basement prices and are more willing to buy stocks with a cloudy profit outlook.

Kinnel's GARP picks include Marsico Focus and Marsico Growth & Income. Tom Marsico, who manages both large-cap funds, is known for picking beaten-down names along with classic growth stocks.

Kinnel also admires Howard Ward, manager of Gabelli Growth. Ward sticks to a disciplined style, picking blue-chip stocks with decent earnings growth--and selling them if they rise to his price target, Kinnel said.

* The revival of small-cap and mid-cap stocks. Smaller stocks historically do well after cycles of interest rate easing by the Fed, Koesterich said. That bodes well for a continuation of market leadership by small-cap and mid-cap stock funds over the next six months at least, he said.

Paul Merriman, editor of the FundAdvice.com newsletter, said many investors remain overweighted in large-cap growth stocks, even after more than a year of under-performance.

"Whenever small-cap and value do well, it tends to last a while, perhaps three to five years," he said. "So this cycle could go on."

Ferris argues that small- and mid-cap stocks generally still look attractive based on valuations and earnings projections, relative to blue chips.

Funds he likes include some of the leaders of the spring rally, including Wasatch Small Cap Growth and Turner Small Cap Value.

The funds take different approaches: Wasatch Small Cap leans toward modestly sized growth stocks with rapidly rising sales and earnings, whereas the Turner fund favors micro-cap stocks--the smallest of the small--selling at perceived bargain prices.

Ferris also likes CGM Focus, a concentrated small-cap "blend" fund run by Kenneth Heebner that makes hefty bets, sometimes on mid-size and large stocks. Blend funds hold a mix of growth and value stocks--a good way to cover both bases in one portfolio.

However much these sectors may be shining now, analysts also warn investors not to make the mistake others made by dramatically overweighting tech stocks in their portfolios when that sector was on top in 1999 and early 2000.

It's possible smaller stocks will stay in favor for years. It's also possible that big-name companies will restore their earnings growth much faster than most analysts expect after the current economic slowdown. So maintaining a portfolio that ignores big-cap stocks altogether could be costly.

Likewise, with foreign stock market returns for U.S. investors hammered this year in part by the strong dollar, there's a temptation to ignore foreign markets. But if the dollar should weaken, foreign funds could resurge.

The better strategy, many advisors say, is to realize that great opportunities in markets could be as numerous as poor performers in coming years--and to admit that it's more prudent to spread your bets around and hope you hit some winners than to bet everything on one or two ideas.


The Market Revives

After four consecutive quarterly losses the blue-chip S&P; 500 index rebounded in the second quarter, as investors bet on a turnaround for the economy.

S&P; 500, total return each quarter:

Q2 2001: +5.9%

Source: Bloomberg News

Rally Leaders: An Eclectic Mix

The stock sectors that have led the market's rebound over the last three months have been a diverse bunch--a big change from the tech-dominated market of the late 1990s. Here are the sectors within the blue-chip Standard & Poor's 500 index that have gained the most from the index's two-year low reached April 4, through Tuesday.

Source: Bloomberg News

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