2002: BREAKOUT --OR BUST?

Just as the thought of staying in the stock market was becoming almost too much to bear for some investors, the fourth quarter arrived.

The rally that has lifted share prices since September has fanned hopes that the worst market decline in more than 25 years finally is over.

But the damage that has been done may take a long time to repair. Start with this harsh reality: With the market’s slump since March 2000, even investors who’ve been in stocks for three years may have only losses to show for their efforts, as measured by average returns in key mutual fund categories.

The average large-stock “growth” fund, for example, rebounded 14.8% in the fourth quarter, according to fund tracker Morningstar Inc. Yet the annualized return for that category is a negative 3.2% over the three years ended Dec. 31.

It’s as if investors have traveled a long and tortuous road and wound up back where they started, or even behind their starting point.

As 2002 dawns, however, the bulls are running again on Wall Street. The Standard & Poor’s 500 index rose 2.1% in the first three trading days of the new year, padding its 10.3% price gain in the fourth quarter. Market optimists see share prices decisively breaking out to higher ground this year, assuming the U.S. economy is growing again after last year’s recession and the Federal Reserve leaves short-term interest rates at 40-year lows well into 2002.

But if the last few years have taught investors one lesson, it’s to be suspicious of glowing consensus forecasts. After all, Wall Street analysts almost uniformly believed Internet stocks were worth their sky-high prices early in 2000. And as recently as last summer, many of the most respected fund managers still considered now-bankrupt energy trading giant Enron Corp. to be a premier investment.

What’s more, not one of the market strategists at the biggest U.S. brokerages foresaw the extent of last year’s stock plunge, which left the S&P; 500 index down 11.8% for the year (including dividends), the worst calendar-year loss since 1974.

Yet as share prices rebound nearly across the board, many of those same strategists are projecting double-digit gains for equity investors in 2002.

The favored sector of the late 1990s--technology--has led the rally since September, with the average tech-stock mutual fund up 36.8% in the fourth quarter, according to Morningstar. But the rally was broader than just tech: All but two of the 28 stock fund categories tracked by Morningstar rose in the quarter.

Still, the average tech fund lost 38.3% for the year. The average domestic stock fund slumped 10.9%, which, as in the case of the S&P; 500 index, was the biggest calendar-year drop since 1974. In 2000 the average domestic stock fund fell 1.9%.

One strategist who is wary of the market’s recent comeback is Tobias Levkovich at Salomon Smith Barney in New York. It is “somewhat disconcerting to see markets ... bounce back with the volatility and magnitude we’ve seen in the past 10 weeks, because it suggests that the investment community is still seeking the same kind of returns it once took for granted,” he said.

Virtually every mutual fund manager now professes to be paying close attention to stock valuations--in other words, none of them wants to run the risk of overpaying for stocks relative to earnings potential. But so far, that hasn’t stopped many investors from riding the market’s new momentum, even as price-to-earnings ratios rocket again.

The average blue-chip stock is priced at more than 20 times analysts’ consensus estimate of 2002 earnings per share. Even if that P/E is “fair,” it still raises the question of whether a continuing rally this year could quickly make many stocks overvalued again.

Technology remains a worry for many fund managers.

“I think the economy has bottomed and it’s possible we’re already in recovery mode, but certain parts of the market have already anticipated that, perhaps overdoing it,” said Brian Berghuis, manager of the T. Rowe Price Mid-Cap Growth fund.

“I’m not overenthusiastic about technology, where excesses in supply still need to be worked off and the valuations of some of these companies remain high,” he said.

Berghuis said his fund, which lost 1% last year but has averaged gains of 9.6% in the last three years, remains underweighted in tech and communications. He noted that, historically, the leaders of one bull market don’t normally lead the next one. Berghuis said he believes the health-care sector--and the biotechnology industry in particular--could be a key growth area in the next bull move.

For 2002, uncertainty over the strength of an economic recovery and corporate earnings, along with the risk of new terrorist attacks or other unforeseen global political traumas, mean that forecasting the market’s near-term course may be as difficult as ever.

It could be a new bull market, as some predict. Or stocks could be stuck in a trading range--a cycle of rallies and sell-offs that leaves prices overall no higher a year from now.

In a trading-range market, nimbleness and patience could be the keys to success. “The patient investor, in our view, can outpace [market indexes] by keeping some purchasing power in reserve, waiting for an opportunity to buy into good companies at more attractive valuations,” said Thomas McManus, strategist at Banc of America Securities in New York.

The worst-case scenario would be that the market bust that began in 2000 still hasn’t run its course. If major market indexes lose ground this year, it would mark the first period of three straight calendar year losses since 1939-41.

Given the risks, financial advisors say the best strategy remains the same one that would have limited the damage to most investors’ portfolios over the last three years: Stay well-diversified.

Indeed, even as technology stocks collapsed in 2000 and 2001, many other market sectors posted gains or suffered only minor losses.

For the last two years, mutual funds that target small and mid-size stocks have held up better than funds that own big-name stocks, as investors have broadened their search for promising business ideas.

Also, “value”-oriented funds held up better than “growth”-oriented funds in 2000 and 2001. Value funds tend to favor stocks that sell for below-average price-to-earnings ratios or offer some kind of relative value lure, such as a high dividend yield.

The average small-stock value fund rose 17.4% last year, according to Morningstar. The average real estate stock fund (usually considered a value sector) rose 9.3%.

The year’s standout was a category that was all but abandoned by most investors in the late ‘90s: precious metals funds, which generally own shares of gold- and silver-mining firms. That sector rose 20.2% for the year.

Diversification in some foreign stock sectors also would have helped U.S. investors. The average emerging-markets stock fund fell 3.6% for the year, one-third the loss of the average U.S. stock fund.

But major foreign markets in Europe and Asia fared worse than the U.S. market, pulling the average foreign stock fund down 21.8% for the year. The dollar’s strength deepened overseas losses.

The fourth-quarter leader board, not surprisingly, was dominated by tech funds and de facto tech funds, including a trio of manager Garrett Van Wagoner’s roller-coaster products, Van Wagoner Emerging Growth, Van Wagoner Post Venture and Van Wagoner Technology, each of which rocketed more than 80% in the period--but still finished the year with huge losses.

But for the year as a whole, fund managers who held value stocks or whose portfolios mixed stocks and bonds fared best.

Leaders among large-stock funds included Thompson Plumb Growth, a “blend” fund (owning value and growth stocks) that rose 19.1% in 2001; Dodge & Cox Stock, a value-oriented fund that gained 9.3%; and Citizens Value, a socially screened value fund that climbed 13.4%.

In the mid-size-stock area, the year’s standouts included TCW Galileo Value Opportunities, which rose 33.7%; Merrill Lynch Mid Cap Value, which gained 25.5%; Oppenheimer Main St. Opportunity, a blend fund that climbed 16.1%; and Needham Growth and Liberty Acorn Twenty, growth funds that gained 12.1% and 8%, respectively.

Small-stock-fund winners for the year included Franklin MicroCap Value, up 41.3%; Aegis Value, up 42.7%; and Wasatch Small Cap Growth, up 24.2%.

Among the nation’s most widely held stock funds, the $80-billion Fidelity Magellan lost 11.7% in 2001, earning a moral victory over its biggest rival, the $87-billion Vanguard 500 Index fund, which dropped 12%, in line with the S&P; 500 index it tracks.

Meanwhile, solid stock-picking in the value area helped two fund managers extend their record winning streaks, although neither performance was especially pretty: Van Kampen Equity Income’s James Gilligan lost 2.2% for the year, beating the average domestic hybrid fund for the 11th year in a row (“hybrid,” or balanced, funds hold a mix of stocks and bonds) and Legg Mason Value Trust’s William Miller lost 9.3%, beating the S&P; 500 index for the 11th straight year.

In the long run, of course, it’s the best stock pickers who produce the best results for their investors. If the market continues to be a difficult place overall, investors will find it much easier to separate the mutual fund industry’s best stock pickers from those who were just along for the ride in the late 1990s.