Where The Bear Lurks

Thousands of stocks were ailing before this correction

Only a year ago, Matritech Inc. was a darling of Wall Street--a classic "momentum stock." The Newton (Mass.) company is developing new methods of diagnosing cancer, and over four months early last year, enthusiastic investors drove up Matritech's share price by 300%. "The stock was taking off like a rocket," says Matritech's chief executive, Stephen D. Chubb. But in recent months, the momentum has gone into reverse. Despite generally favorable news and buy recommendations from analysts, institutions have begun to drift away. Matritech shares that traded at $18 last May now change hands at about $5.

There are a lot of Matritechs out there--companies whose stocks were ailing long before a Federal Reserve rate hike sent the entire market into a swoon at the end of March. Until the recent sell-off, continuing strength in the blue chips diverted attention from what was happening in smaller, less followed stocks: For thousands of them, a correction had been under way for quite some time. "The market has simply not been as strong as the indexes have looked," notes Michael Metz, investment strategist at Oppenheimer & Co.

BIGGEST RISK. But this is not necessarily bad news. Some market observers believe that this "hidden bear market" may have already set the stage for a rebound--particularly among the segments of the issues that have taken the worst drubbing. Indeed, some analysts figure that bargain-hunting investors may have a field day in small-cap stocks--but only after the smoke clears. More pullbacks could follow in the coming weeks, perhaps even worse than the 400-point slide that the Dow Jones industrial average took between Mar. 24 and Apr. 2. The biggest immediate risk: another inflation-fighting rate hike by the Federal Reserve. And there are plenty of market watchers who are bracing for an outright bear market, on the assumption that a slowing economy will soon drag down earnings.

Until recently, signs of a slowdown have not been evident in the major indexes. Even now, the Dow Jones industrials and the Standard & Poor's 500-stock index have both generated one-year total returns of 20%. Even the Russell 2000 index of small-company stocks has gained, if only by a modest 5% in the 12 months ending Mar. 31 (chart).

But looking behind those numbers, the pain suffered by thousands of investors becomes evident. In the first quarter of 1997, fully 225 of the stocks in the S&P 500 posted negative returns for their shareholders (chart). The losers include such prominent names as AT&T, 3Com, and Amdahl. From W.R. Grace to IBM to U.S. Surgical and Mattel, the ranks of the market's big decliners have been growing. Small biotech companies, as a group, have declined 28% in the past three months. Oil and gas companies are down 21% and hospital-management companies have fallen 15%.

To be sure, it is not unusual for large numbers of stocks to decline even in the best of markets. In 1995, a generally upbeat year, 31% of stocks declined, according to figures compiled for BUSINESS WEEK by Standard & Poor's Corp., a fellow unit of The McGraw-Hill Companies. But the ranks of the losers have been growing. In 1996, even though the market rose 20%, the number of net losers grew by one-third, to 40%. In some cases, the declines can be traced to industry-specific troubles, such as those dogging AT&T and other telecom stocks. Matritech and other small biotech outfits were victims of an unwinding of former "momentum" buying by institutions.

The overall trend is disturbing. Of the 7,900-odd stocks that traded on Mar. 31, 1996, and were still around a year later, nearly 3,600--45%--had declined by mid-March of this year. And, according to S&P, about 50% of all stocks declined between Dec. 31, 1996 and Mar. 31, 1997.

These numbers go a long way to explaining what Morgan Stanley & Co. market analyst Byron R. Wien describes as a "sour, bear-market mood" among portfolio managers. "The market has had too narrow a focus," says Wien, and that has translated into troubles for money managers who have strayed from the herd. "If people didn't care about getting large-cap exposure they were hurt very badly," says Peter Stonberg, chief investment officer of State Street Boston Corp. Global Advisors.

The full extent of the split between small- and big-cap stocks becomes more apparent when you focus on the NASDAQ. According to the S&P figures, 62% of the 1,100 stocks traded on the NASDAQ small-cap market were flat or down during the past year. The NASDAQ national market system and American Stock Exchange were hit almost as badly: 48% and 45%, respectively.

By contrast, only 34% of the New York Stock Exchange's 2,600-odd stocks were flat or losers over the past year. One reason: Institutions stayed in the NYSE and other large-cap issues to avoid risk. But if the big-company indexes stop looking bulletproof, there may be no such haven. In further corrections, the enormous flows that have gone into index funds may go elsewhere, argue Metz and other market analysts.

That could help bring back small-cap issues. For value-hunting investors--with strong nerves--their declines may already represent some alluring opportunities. Arthur J. Bonnel, who runs the Bonnel Growth mutual fund, shrugs off the market's recent troubles as "normal and healthy--a part of life." Bonnel, in fact, is looking for an upturn. "Once the big caps drop, it's closer to the end than the beginning of the decline," he says. Thus he thinks the market will soon be rife with "great companies at realistic prices."

GOOD OMEN. The recent softening in the market for initial public offerings is also viewed as a bullish omen in some quarters. Claudia Mott, a quantitative analyst who tracks small-cap stocks at Prudential Securities Inc., thinks that the large number of IPOs last year had drawn cash away from other small-cap stocks. Yes, bears will continue to focus on the danger of weaker earnings growth. But Mott argues that small-cap stocks are less exposed to the negative ramifications of the rising dollar than are large-cap stocks and that their valuations are increasingly tempting.

A return to favor of the secondary stocks won't come a moment too soon for Matritech. Its market capitalization has now shrunk to $80 million, and its depressed share price has discouraged the company from trying to raise additional capital. But Chubb is hopeful that value-conscious investors will start coming his way. "My wife just joined an investment club and has been reading Peter Lynch. He just loves down markets. When stocks are depressed, it's time to buy," says Chubb. That's the silver lining lurking behind the market's gloom.

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