Big Stocks' Gains Mask Disparities

Nation's Business, May, 1999 by Randy Myers

Randy Myers, formerly a writer and editor for Dow Jones & Co., Inc., is a financial writer in Dover, Pa.

For investors, doing the right thing has seldom been less satisfying. While the major stock-market averages again in the first quarter--the Dow Jones industrial average broke through 10,000, posting a total return, with dividends, of 6.6 percent--the average diversified stock fond eked out a modest gain of just 0.9 percent.

In an investment portfolio, diversification is usually considered a good thing. It helps protect a portfolio from sharp downswings that might occur in any one sector of the financial markets.

The problem for the past few years hasn't been sharp downswings. though. but sharp upswings, and almost always in the same narrow sectors of the stock market. Diversified portfolios that don't focus on these sectors have lagged far behind in the performance game.

"The two-tiered market roars on," says Tedd Rosiasky, a portfolio manager for the Mosaic family of mutual funds. "While the indices suggest that everything is great and rosy, the numbers underneath show a different ballgame."

Consider this: Funds that track the Standard & Poor s index of 500 big-company stocks posted a total return of 4.8 percent in the first quarter, according to Lipper Inc., a research firm headquartered in Summit, N.J. But the average small-cap fund, which invests in small-company stocks, lost nearly 6 percent.

"A lot of the smaller and midsized companies haven't been able to consistently meet the earnings expectations that Wall Street has for them," explains Rosinsky. "For that reason, portfolio managers, myself included, don't feel comfortable committing investor monies to them-even though their valuations are a lot more attractive."

Another Hot Sector

There is, of course, one big exception to the preference for big-company stocks right now. Shares of companies whose business model is centered on the Internet are even more prized than large-company issues, regardless of whether they actually earn money.

Science and technology funds, which invest most heavily in these types of companies, earned a whopping 17 percent in the first quarter, putting them up 52.33 percent over the 12-month period ended March 31.

How frothy is the market for Internet stocks? Microsoft Corp. and Intel Corp., arguably the most dominant technology companies in the world, earning billions of dollars each per year, saw their stocks rise 29.2 percent and a fraction of 1 percent, respectively, in the first quarter.

By contrast, At Home Corp., a provider of high-speed Internet access via cable television lines, which lost $144 million last year on sales of $48 million, saw its stock rise 107.4 percent in the first quarter.

According to Lipper, science and technology funds have topped every other stock-fund category in total return for the past three-month, 12-month, two-year, three-year, five-year, 10-year, and 15-year periods.

While no one knows how long the current Internet boom can last, Lipper dryly notes in a public statement that 'This trend [in science and technology fund outperformance] is unlikely to continue forever."

As for the disparity between small-company and large-company stocks, Rosinsky says the relationship between those two sectors of the market isn't likely to change much until inflation creeps hack into the domestic economy.

"I think what's happening now is that a lot of the smaller companies are getting squeezed by a lot of the industry leaders, meaning [the small companies] have no pricing power whatsoever," Rosinsky says. "But the factors that have pushed largecompany stock valuations where they are [low inflation combined with strong economic growth] could actually stay in place for a while yet."

Results From Overseas

Stock-market performance also varied sharply outside the United States during the first quarter. While broad-based international funds earned 1.5 percent and European funds lost 2.6 percent, Japanese funds soared 15.8 percent and Latin American funds jumped 11.6 percent.

The most surprising gain was Latin America's, since the quarter began with Brazil allowing its currency to float against the U.S. dollar, an effective devaluation that confirmed the severity of that country's economic crises. But investors saw a silver lining.

"They will probably have some degree of recession [in Brazil], which will spill over into other South American countries, but that should be followed by an improving economy," says George Evans, manager of the Oppenheimer International Growth fund. "The devaluation is being seen as a catalyst for more economic reform."

The sharp move higher by Japanese funds was also surprising, given that weak economic conditions there haven't changed much, either. The country's unemployment rate is at a postwar high, and domestic consumption is slacking.

Although some analysts are encouraged by early signs of corporate restructurings, Evans is skeptical.

"I don't think Japan is due for a [sustained] turnaround," Evans says. He attributes the gains in the Japanese stock market over the past two quarters largely to fears by some investors that when Japan finally does reverse itself--the stock market there has been in the dumps for a decade-- the biggest gains will come quickly If so, they don't want to be left out.