A Not-So-Bad Year for Some Investors Despite Broad Decline

Measured by most broad indexes, the U.S. stock market was a loser in 2001 for a second consecutive year.

But under the surface, the market was a relatively hospitable place for many investors, depending on how they picked their stocks.

For a second straight year, smaller-company stocks generally were better choices than bigger ones, a trend that continued with the powerful fourth-quarter rally that lifted the market overall from the three-year lows reached after the Sept. 11 terrorist attacks.

Also, “value” stocks generally performed better than “growth” issues, repeating the trend of 2000. But as investors in recent months began to look toward an economic recovery in 2002, growth stocks returned to prominence--boosting hopes that the longest and deepest bear market since 1973-74 had run its course.

Indeed, technology stocks roared back in the fourth quarter, lifting the Nasdaq composite index 30% in the period. Still, the severity of tech shares’ losses earlier in the year left the Nasdaq index down 21.1% for 2001, after a 39.3% plunge in 2000.

The blue-chip Standard & Poor’s 500 index rose 10.3% in the fourth quarter, paring its loss for the year to 13%. The index lost 10.1% in 2000.

Despite the slide in the S&P; index last year, more than 40% of the index’s 500 stocks rose in price, Standard & Poor’s Corp. said.

On the New York Stock Exchange overall, 2,216 issues advanced last year while 1,415 fell, according to Associated Press data. However, the winners’ list on the NYSE is skewed by gains in high-dividend preferred stocks, which tend to perform more in line with bonds (meaning they do well when interest rates fall.)

Still, it may surprise many investors that more stocks rose than fell even on Nasdaq for the year: Winners topped losers by 2,289 to 2,064, according to AP data.

In other words, 2001 could have been a very good year for stock pickers who picked well. A bet on Krispy Kreme Doughnuts a year ago, for example, yielded a 113% gain as the doughnut retailer continued its national expansion. Strong earnings at auto parts retailer AutoZone drove its shares up 152% for the year.

Some investors who played financially troubled companies also wound up with handsome payoffs. Xerox jumped 125% for the year as investors bet the company will avoid collapse.

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For Many Investors, Losers Swamp Winners

But deft stock picking always is tougher than it appears. And the cold reality for most investors with a diversified portfolio of stocks is that the losers in 2001 more than likely swamped the winners.

The average domestic stock mutual fund lost about 12% last year, according to preliminary data from fund tracker Morningstar Inc. It could have been much worse without the fourth-quarter rally that lifted the average fund about 14%.

The central question on Wall Street, of course, is whether the bear market that began in March 2000 has ended. Optimists are in the majority among market professionals, based primarily on their belief that an economic recovery--and a rebound in depressed corporate earnings--is a certainty in 2002.

In a 2002 outlook for clients, investment company Citigroup argues that “policy will beat fear”--references to the interest rate policy of the Federal Reserve and the fiscal policy of the Bush administration, versus the continuing fear of a deeper U.S. recession and the potential for more terrorist attacks.

“In the absence of a major shock, policy stimulus is likely to overcome recessionary forces” in 2002, the company said. That appears to be happening already: A slew of economic indicators over the last month have pointed to recovery.

But many investors understandably remain wary. Despite the strong rally of recent months, the stock market isn’t playing along with the historical script when it comes to Fed interest rate cuts.

The Fed began its campaign to ease credit Jan. 3, when it cut its benchmark short-term interest rate to 6% from 6.5%. The central bank cut that rate 10 more times in 2001, to the current 40-year low of 1.75%.

In 13 previous periods since 1971 when the Fed was aggressively cutting rates, the S&P; 500 index was higher 12 months after the first cut, with one exception (in 1976).

This time, the S&P; still is down 10.5% since the Fed’s first cut of 2001.

Why hasn’t the market responded as usual? Michael Murphy, editor of the California Technology Stock Letter in Half Moon Bay, Calif., believes that “the lag between the business slowdown [which began in 2000] and the consumer slowdown has made this bear market unusually long.”

But that’s also the good news, he contends: “It also has meant that a lot of the bloodletting [in the stock market] was done before the economy actually entered a recession.”

Some analysts, however, warn that the debt-burdened economy may find it much more difficult to turn around in 2002 than the optimists submit.

“This has been an odd recession, so its future may also be unconventional,” said A. Gary Shilling, head of an economic consulting firm that bears his name. The recession will deepen this year as more consumers rein in their spending, he predicts.

If Shilling is right, a rebound in corporate earnings may not happen in 2002, in which case many investors could well sour anew on stocks--especially given that price-to-earnings ratios of many stocks remain above average, even based on the improved profits expected this year.

Still, the market’s trend in 2001 showed that some sectors can shine even when broad stock indexes decline.

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What 2001 Trends Can Mean for 2002

Here’s a look at two of the main themes that were evident in 2001 and what that might portend for 2002:

* Smaller stocks versus bigger stocks. The S&P; index of 600 smaller stocks gained 5.7% last year while blue-chip indexes slumped.

Likewise, the S&P; index of 400 mid-size stocks performed better than blue-chip indexes, losing a modest 1.6%.

The trend of smaller stocks beating blue chips began in 2000, when the S&P; small-stock index rose 11% and the mid-size stock index jumped 16.2%, even as the S&P; 500 fell 10.1%.

Why bet on smaller companies? One argument has been that smaller stocks were unloved for so long in the late 1990s that they became extremely cheap when measured by such yardsticks as price-to-earnings ratios. Brokerage firm Goldman Sachs Group, in a December report to clients, made the case that smaller stocks’ favorable performance should continue in 2002 in part because of “more appealing” valuations than larger stocks show.

Another argument by investors who favor smaller stocks is that the companies can be more nimble than bigger firms in a difficult economy.

Satya Pradhuman, a Merrill Lynch & Co. analyst who focuses on smaller shares, notes that these stocks typically perform much better than the broader market in January--the so-called January effect on Wall Street. If that effect occurs again this month, it could encourage more investors to shift capital from blue chips to smaller names.

* Value stocks versus growth stocks. The “value” label typically is ascribed to stocks that sell for lower-than-average price-to-earnings ratios or that offer higher-than-average dividend yields, or both.

Value shares began to attract more investors in 2000 as the highflying growth sector (led by tech shares) collapsed.

In 2001, value still fared better than growth overall: The average mutual fund that focuses on large value stocks fell about 6% last year, while the average fund that focuses on large growth stocks tumbled 24%, according to preliminary data from Morningstar.

But as hopes for an economic recovery surged in the fourth quarter, growth stocks revived. Now, investors who are betting on a strong economic rebound by mid-year would be smartest to bet on growth shares, particularly technology names, many Wall Street pros say.

Murphy argues that the earnings potential of many tech firms in software and semiconductors could be higher than analysts expect if the economy rebounds, thanks to sharp cost-cutting by the companies and market-share gains as weaker rivals have disappeared.

Other classic growth sectors include health care and retailing.

Meanwhile, classic value sectors include such areas as energy, heavy industry and banking.

But some analysts are telling investors that the best strategy in 2002, and perhaps in any year, is to own shares in both growth and value sectors rather than choose one style only.

Given the uncertainty over the pace of any economic rebound, and the gains in many shares since Sept. 21, “style agnosticism is warranted in 2002,” said market strategist Steve Galbraith at Morgan Stanley in New York. “Portfolios should maintain exposure to both sides of the aisle.”

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How Stocks Fare When the Fed Cuts

(tabular data not included)