Riding out the storm

By , Staff writer of The Christian Science Monitor

Heavy selling doused stocks in the second quarter, but instead of bringing flowers, the showers left many mutual-fund investors midyear with wet-blanket portfolios.

Although most major stock indexes and the funds tied to them emerged from the past three months slightly higher, the gains also brought some disillusionment.

Investors sold the sunniest stocks in the blue-sky market - financial, high-tech, and global, high-growth equities. Hoping for a rebound in world economic growth, they bought cheap "value" stocks in cyclical industries and small companies. The appeal of cyclicals briefly pushed the Dow Jones Industrial Average to a new high.

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A surge in funds that invest in producers of basic materials like metals, chemicals, and forest products reveals how fears about both inflation and a teetering, high-priced market hold investor moods under the drizzle and out of the sun.

Until such anxieties fade, investors will probably embrace funds in safer, low-price cyclical stocks that would weather well an uptick in interest rates, say analysts.

"Prices are moving in anticipation of improving [global economic] fundamentals," says Sam Stovall, sector analyst for Standard & Poor's in New York. But he adds: "I don't think fundamentals have yet borne out the hope."

Most components of the Standard & Poor's 500 Basic Materials sector rose more than 20 percent during the quarter, with paper and forest products stocks, and aluminum equities surging more than 30 percent and 50 percent respectively. (See story, page 15).

Rising waves overseas

Mutual funds that invest in foreign stocks also rode hints of global recovery upward. Funds focused on Asian markets led the pack, followed by emerging market and European funds.

Meanwhile, the high-fliers of the US equity boom jolted downward. Technology funds lagged, with Internet funds trailing the sector (See story, page 15). Funds that invest in financial companies limped forward. In the cellar were funds that hold health care or consumer staples stocks.

The market was especially jumpy last quarter because of uncertainty over interest rates and inflation, with commodities signaling a broad rise in prices.

The threat of a rate hike by the Federal Reserve helped value stocks at the expense of growth stocks.

"There is a lot of shifting back and forth, depending mainly on how interest-rate winds are blowing," says Mr. Stovall.

"The fear of tighter monetary policy may have already started a gradual correction," says Sung Won Sohn, chief economist at Wells Fargo in Minneapolis.

Despite the volatility, some analysts were heartened as money flows broadened from the S&P 500 Index stocks that have led the equity boom this decade into low-price, small-company stocks.

Indeed, last quarter funds tied to three different measures of small company stock performance - the S&P Low Price Stock Index, Russell 2000, and S&P Small Cap Index - were among the top performers. Funds devoted to the S&P 500 lagged.

Still, a rotation from growth to value stocks can also signal weakness.

Such changes "on the scale which began on Wall Street during April have often been harbingers of market corrections," says David Hale, chief economist at Zurich Financial Services in Chicago. In five instances since May 1975, a major move from growth to value presaged corrections in the S&P 500 Index averaging 15 percent, according to Mr. Hale.

Rate hikes may not be over

The historical pattern is already jelling, judging from a popular forecast of interest-rate trends. Rising commodity prices, a tight labor market, strong consumer spending, and slow and steady recovery abroad will probably eventually compel the Fed to raise rates further.

"With America as vigorous as ever, and global healing now increasingly advanced, it is time for the Fed to begin restoring official rates back to pre-crisis levels," says Stephen Roach, chief economist at Morgan Stanley Dean Witter in New York.

Soon after the global financial crisis resurged last August, the Fed staged a significant monetary easing.

But such a view is not universal. It's "nonsense," says Ian Shepherdson, chief US economist at High Frequency Economics in Valhalla, N.Y. He believes more rate hikes are unnecessary.

Still, widespread anxiety over rate trends could be enough to send Wall Street and equity mutual funds tumbling. The market is especially vulnerable because many analysts believe stocks are far too expensive.

"Equities are overvalued," says Mr. Sohn. "Tighter monetary policy should cause a more significant correction later this year."

Ed Yardeni, chief economist at Deutsche Bank in New York, compares expected 12-month earnings to the yield on a 10-year Treasury bond and estimates that the S&P 500 is more than 40 percent beyond its fair value.

This bubble, Mr. Yardeni says, will begin to collapse by the end of the third quarter. "I expect that two rate hikes and increasing ... concerns [about the ability of computer software to avoid major malfunction in the changeover to year 2000] will trigger a sharp decline in stock prices during September and October," he says.

A sharp correction could badly jar the economy, further undermining prospects for equity mutual funds. Sohn estimates a 15 percent fall in stock prices would wipe out $1.5 trillion from the net worth of consumers, the nation's biggest engine for economic growth.

Concerns over interest rates and inflation made the market especially jumpy.

TOP-PERFORMING FUNDS

Second quarter 1999 Total return Phone number WEBS Malaysia 122.0% 800-810-9327 Matthews Korea I 69.7 800-789-2742 Matthews Dragon I 69.6 800-789-2742 Montgomery Emerging Asia R 61.2 800-572-3863 Matthews Pacific Tiger I 60.2 800-789-2742 Van Eck Asia Dynasty A 55.7 800-826-1115 World Funds Third ML Russia 54.4 800-527-9525 Lexington Troika Dialog Russia 53.9 800-526-0056 Guinness Flight Mainland China 53.7 800-915-6565 Liberty-Newport Tiger Cub A 51.1 800-426-3750

One year Total return Phone number Matthews Korea I 278.5% 800-789-2742 Internet Fund 252.6 888-386-3999 Amerindo Technology D 213.3 888-832-4386 Firsthand Technology Innovators 154.2 888-883-3863 Van Wagoner Technology 150.3 800-228-2121 Fidelity Japan Small Companies 143.3 800-544-8888 ProFunds UltraOTC Inv 129.1 888-776-3637 Thurlow Growth 124.0 888-848-7569 Van Wagoner Post-Venture 122.5 800-228-2121 Van Eck Asia Dynasty A 119.2 800-826-1115

Five year (annualized) Total return Phone number Firsthand Technology Value 50.6% 888-883-3863 Rydex OTC Inv 45.5 800-820-0888 Fidelity Select Electronics 44.1 800-544-8888 Fidelity Select Computers 41.3 800-544-8888 Fidelity Select Technology 38.8 800-544-8888 Alger Capital Appreciation B 37.5 800-992-3863 Legg Mason Value Prim 37.4 800-577-8589 First American Technology A 37.2 800-637-2548 Janus Twenty 36.7 800-525-8983 White Oak Growth Stock 36.5 888-462-5386

Source: Lipper Inc. HITNEY DODDS WOODRUFF - STAFF

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