Stocks’ Slide Shows Value of a Good Defense

Stock mutual fund investors suffered a scare in the second quarter, as worries about rising interest rates and higher inflation triggered a global market sell-off in May and early June.

Was it a mere blip -- or a warning to fund investors to rework their portfolios for a dicier environment?

Some analysts say investors should take the hint. “It’s a decent time to play defense,” said Russ Kinnel, director of fund research at investment firm Morningstar Inc. in Chicago.

That doesn’t mean bailing out of all higher-risk investments, he said. But it does mean looking closely at your mix of stock funds to make sure you aren’t too heavily invested in any one sector -- and that you have enough diversification so that weakness in some funds could be offset by strength in others.

The average domestic stock fund slid 3.4% in the three months ended June 30, after four straight quarters of gains, according to Morningstar.

For the first half of the year, however, most stock fund categories still were solidly in the black, thanks to global equity markets’ sharp rally in the first quarter. The average domestic fund was up 3.1% for the half. The average foreign stock fund was up 8.3% after losing 1.7% in the second quarter.

In the giddy first quarter, U.S. investors seemed highly confident in the “Goldilocks” scenario for the economy: The expectation was that nearly two years of credit-tightening by the Federal Reserve would slow the economy enough to allow the Fed to stop raising interest rates, but not enough to threaten recession.

But the central bank threw investors a curve early in May, when Fed officials sounded fresh warnings about rising inflation pressures. Instead of pausing at their May 10 meeting, policymakers raised their key short-term rate for the 16th time since mid-2004 -- then followed that with a 17th increase, from 5% to 5.25%, at their June 29 gathering.

Amid growing fears that rising interest rates could lead to an economic accident, some investors decided to cut back on stock market sectors that have historically been considered above average in risk.

For the quarter overall:

* Small and mid-size stocks generally fared worse than large-company issues. The average fund that owns small-capitalization “growth” stocks dropped 7% in the three months, according to Morningstar. By contrast, the average large-capitalization growth stock fund lost 4.8%.

All figures are for total return, meaning principal change plus any dividend or interest income.

* Growth stocks -- typically shares of companies whose earnings are expected to grow faster than the market average -- fell more than “value” stocks. Value issues tend to be slower-growing companies, but the prices of their stocks often are lower, relative to earnings, to reflect that.

The average fund that owns mid-size growth stocks lost 5.6% in the quarter, compared with a 1.4% drop for mid-size-value funds.

* Emerging-market stock funds, which own shares of companies in fast-growing economies of the developing world, slid 5% in the quarter, on average.

* Technology stock funds were the quarter’s worst performers among major sectors. They lost 9.7%, on average, hurt by worries about the economy and by a widening investigation by federal regulators into tech companies’ stock-option accounting practices.

For tech, the second-quarter decline added insult to injury: The sector remains one of the worst-performing of all fund groups over the last five years.

The big question on Wall Street is whether the weak performance of sectors such as emerging markets and small stocks in the quarter was the start of a trend, or just some needed profit taking after the heady gains of recent years.

Emerging-market stock funds have trounced U.S. funds over the last five years. The average emerging-market fund has gained 20.2% a year in that period, compared with 3.9% for the average U.S. fund.

Measured by Standard & Poor’s indexes, smaller U.S. stocks have beaten big-name issues every year since 2000. Although bigger stocks fared better in the second quarter, they’re still trailing year to date.

Bill Nygren believes that big-name U.S. stocks are in the process of taking the lead from their smaller brethren.

He’s got a vested interest in saying so: His Chicago-based Oakmark Select fund is heavily invested in such U.S. blue chips as Time Warner Inc., Intel Corp. and Bristol-Myers Squibb Co. The fund slipped 0.8% in the second quarter, holding its ground better than most equity funds.

Nygren expects investors to gain a new appreciation for large-company stocks if the economy slows and earnings growth becomes tougher for companies in general.

Many U.S. stocks are priced right around the same level relative to underlying earnings per share -- about 15 to 16 times estimated 2006 earnings, Nygren said. That suggests “there’s no premium for large-cap stocks versus small- and mid-cap stocks,” he said.

“If everything is priced homogeneously, then our job is to find the better businesses,” he said. He believes that the better businesses are the bigger names -- particularly, he said, in an environment in which the economic risks arguably are rising, which means it could be easier for smaller companies to stumble.

Marc Reinganum, a portfolio manager at OppenheimerFunds in New York, agrees with Nygren on the relative appeal of bigger stocks.

The Oppenheimer Main Street Opportunity fund can invest across the entire spectrum of stocks -- large, mid-size and small. Its managers judge the attraction of stocks using a model that includes price-to-earnings ratios and the economic backdrop, Reinganum said.

When the fund began in 2000, the majority of its assets were invested in smaller names because that’s where the bargains were, he said. Now, 87% of the fund’s $3.5 billion in assets are in large-capitalization shares, Reinganum said. “Our model is saying it’s large over small.”

Some veteran investors say the same market shift is underway overseas.

Matt Dennis, co-manager of the AIM International Growth stock fund in Houston, said that as interest rates rise worldwide, the logical shift by investors should be toward higher-quality companies and away from riskier names. “I think that’s where the opportunities really lie,” he said.

If the U.S. economy is slowing, Dennis said, another logical shift would be for global investors to focus on foreign companies whose growth is more dependent on business and consumer demand on their home turf.

European financial services companies such as UBS and Anglo Irish Bank fit that bill, Dennis said.

Whether the quarter’s market shifts have staying power is yet to be seen, of course. Many pros have been predicting for at least two years that big-name stocks would move to the forefront. They could still be too early.

If nothing else, many investment advisors say, the enduring lesson of the second quarter will probably be that market volatility is returning to more normal levels, after three years of relative calm in equity markets.

“Be prepared for some serious turbulence,” Kinnel said. “I think that’s pretty much a given in the next few years.”

*

(BEGIN TEXT OF INFOBOX)

The Bull Stumbles

Sell-off leaders

The average domestic stock mutual fund sank 3.4% in the second quarter, the first quarterly decline since the first period of 2005.

These stock fund sectors led the market’s decline in the second quarter.

Healthcare: -6.7%

Technology: -6.8

Japan: -6.8

Small-cap growth: -7.0

Communications: -9.7

Source: Morningstar Inc.