Giants Are Astir on Wall Street

By Tom Petruno

Oct. 1, 2006 12 AM PT

Times Staff Writer

There were a lot better places to invest during the last seven years than in the stocks of the largest U.S. companies.

But lo and behold, the giants are stirring again. The Dow Jones industrial average had Wall Street’s attention last week as the blue-chip index briefly traded above its record close of 11,722.98 set in January 2000.

The Dow rose as high as 11,741.99 on Friday, then faded. It ended the day at 11,679.07, down 39.38 points for the session.

That was disappointing for market bulls, but it didn’t diminish the Dow’s strong showing in the third quarter overall.

As investors snapped up blue-chip issues such as Pfizer Inc., McDonald’s Corp. and AT&T; Inc., the Dow rose 4.7% in the quarter, bringing its year-to-date price gain to 9%.

That beats what most other major U.S. stock indexes have achieved this year. In particular, the Dow has turned the tables on the small and mid-size stock indexes that had trounced blue-chips for most of this decade.

A Standard & Poor’s index of 600 small-company stocks is up 6% year to date; an S&P; index of mid-size stocks is up 2.2%.

If the Dow can keep its lead, it would be the first time in this bull market (which will enter its fifth year Oct. 10) that it beat its major rivals over a full calendar year.

The revival of the blue chips is more than a little relevant to millions of American investors because large-company shares tend to be the bedrock of people’s individual-stock and mutual fund holdings. That makes sense: If stocks are a way to own a piece of the economy, the shares of the biggest businesses in the economy should be the core of an equity portfolio.

But that core has been a huge disappointment in this decade.

Although a new high on the Dow would be a milestone for Wall Street, it also would be a reminder that an investor who bought the index at the 2000 peak is just now breaking even in terms of price.

Add in dividends and the Dow stocks have produced a paltry average return of about 2.1% a year since Dec. 31, 1999. The total return on the broader blue-chip index, the S&P; 500, is worse -- about zero.

By contrast, the S&P; small-stock index has produced a return of about 10.6% a year in this decade. The S&P; mid-size index is up 9.2% a year.

Foreign stocks also have been far better performers than U.S. big-name stocks. The Fidelity Diversified International equity fund has gained about 7% a year.

It’s true that technology stocks have fared far worse than the Dow since the tech bubble burst in 2000. Then again, everybody knew (or should have known) that tech was inherently risky.

But nearly seven years for blue chips to get back to even? Few on Wall Street believed that was a reasonable forecast once the market started going down in 2000 -- or once it began to turn up in late 2002.

Things were downright embarrassing for the Dow in 2004 and 2005. While the average New York Stock Exchange issue rose 12.6% in ’04 and 7% in ‘05, the Dow’s returns were 3.2% and a negative 0.6%, respectively.

The premier U.S. stock index in recent years has been held back by problems specific to some of its 30 member stocks. Drug giants Pfizer and Merck & Co. were beset by generic competition. General Motors Corp. seemed to be on a path to insolvency. Financial service titans Citigroup Inc. and American International Group Inc. were hounded by scandals.

As many investors saw it, however, there was a more basic problem with blue-chip stocks: They were simply too expensive relative to underlying earnings.

The price-to-earnings ratio of the S&P; 500, was a lofty 28.4 at the end of 1999, according to Standard & Poor’s data.

As earnings have boomed over the last three years while the stocks have struggled, the P/E has dropped sharply, to about 15.6 based on estimated 2006 operating earnings per share, S&P; calculates.

That is the lowest P/E since the mid-1990s.

Michael Holland, head of New York money management firm Holland & Co., has been pounding the table for blue chips for the last few years. The stocks, he says, are bargains.

“The risk-reward trade-off for the blue chips makes them the best things to put money in now,” Holland said.

The stocks certainly were cheap enough for some investors in recent months. The S&P; 500, like the Dow, had a strong third quarter, rising 5.2% and lifting its year-to-date gain to 7%.

The fear factor gave an assist to big-name U.S. stocks in the summer after global markets dived from mid-May to mid-June on concerns about then-rising interest rates.

The plunge, although short-lived, was a reminder of how quickly sentiment can turn against smaller stocks and foreign issues, many of which fell sharply.

That steered some nervous investors toward the perceived safety of blue chips. The Dow lost a relatively modest 8% in the spring sell-off and quickly climbed back.

More recently the major debate on Wall Street has been whether the slowing U.S. economy is headed for a soft or hard landing.

A hard landing, or recession, may not spare blue-chip companies from financial pain, Holland concedes. Still, he said, if markets trip in the next few months over fears of a U.S. recession, “my guess is that you’re going to lose a lot less in General Electric than in emerging markets and other things.”

But investors who believe that the economy is in a sustained slowdown, and that corporate earnings growth will slow significantly as well -- or turn negative -- have to decide whether even reduced P/Es make blue chips worth the risk, said Kevin Caron, investment strategist at brokerage Ryan, Beck & Co. in Florham Park, N.J.

He figures the S&P; might end the year at 1,350, which would be a mere 1% gain from Friday’s closing level. Caron believes there’s a 50% chance of a recession in 2007.

“Is it worth it?” he asked of the market now.

For investors whose economic forecast is more upbeat, however, the message from blue chips in the last few months may just be that their time has come, once again, after spending most of this decade in the doghouse.

No market sector stays out of favor forever. And many on Wall Street have for some time been predicting a return to blue chips.

A quarterly survey of money managers by Russell Investment Group has found for two years running that most managers believed that blue-chip growth stocks were undervalued and had better potential than any other major stock sector.

The blue-chip resurgence in the third quarter could be a head fake. Or it may be that more investors who have touted the appeal of the stocks are, finally, actually voting with their dollars.

tom.petruno@latimes.com

(BEGIN TEXT OF INFOBOX)

Catch-up time?

U.S. blue-chip stocks have badly lagged behind other major market sectors this decade.

Average annualized total return (including dividends), Dec. 31, 1999, through Sept. 22

Bloomberg REIT* index: +21.1%

XAU gold stock index: +11.3%

S&P; small stock index: +10.6%

Dow utility index: +10.2%

S&P; mid-size stock index: +9.2%

Fidelity Emerging Markets fund: +9.0%

Fidelity Diversified International fund: +7.0%