A Wiser Bull?

High-tech frenzy or no, the market could enter a stronger phase

Even for a bull market that's used to surprise and shock, this was a wild turn. In less time than you can say "Internet," investors jettisoned the glamorous hot-growth issues--everything from telecom equipment to pharmaceuticals--and put their money into gritty industrial shares. They even started to snuggle up to long-shunned small-cap stocks. The Dow Jones industrial average, with its heavy complement of smokestack stocks, has added nearly 800 points, or 8%, since Mar. 31 and closed at a record 10,581 on Apr. 21. The Russell 2000, a small-cap stock index, gained 7.3%, while the tech-dominated NASDAQ Composite Index was up a puny 1.1% for the period.

In short order, a bull market long criticized for having too much of its gains concentrated in too few stocks seems to be undergoing a personality change. The long-sought broadening of the market may finally be at hand--and the move into such old-line blue-chips as chemicals, machinery, and paper may give the aging bull a shot of adrenaline. "This shift is healthy," says John S. Tilson, a managing director at Roger Engemann & Associates Inc., an investment management firm in Pasadena, Calif. "The narrow bias that the market had before could have led to something bad happening." Adds Alfred Goldman, chief market strategist at A.G. Edwards & Sons Inc., a longtime bull: "The bears have had another arrow taken out of their quiver."

A SMARTER MARKET. In the next phase, we may see what you might call the wiser bull--a market that provides a more comprehensive view of the economy's overall potential, not just the extraordinary expectations for a few leaders. Indeed, it's a positive sign for the economy when the cyclicals, which had been priced for a recession that didn't happen, suddenly spring to life. In the same vein, market strategists viewed last year's mania for large-cap growth stocks, such as Microsoft, IBM, and Lucent Technologies, as a defense against an uncertain economic environment, since growth stocks stand a better chance of weathering rough times.

The arrival of the wise bull coincides with good news for the economy in general and for the long-suffering manufacturing sector in particular. There's no sign of recession now and, even with a swollen trade deficit acting as a governor, economists still expect U.S. gross domestic product to rise by at least 3% this year. On signs of recovery in older manufacturing businesses, stocks such as Aluminum Co. of America are rising sharply as investors diversify once tech-heavy portfolios. Put another way, the market is getting smarter about the way it prices industrial companies.

The market's new beat may unnerve day traders who have grown accustomed to jumping in and out of a select list of technology stocks. But the turn will no doubt be warmly welcomed by portfolio managers and shareholders in mutual funds that have long lagged the Standard & Poor's 500-stock index, whose huge gains had been driven by several dozen large-cap growth stocks. That left the diversified funds, which typically own 80 to 100 stocks, with a few winners and a lot of losers. The most immediate beneficiaries are the large-cap value funds, such as Vanguard Windsor, which hold cyclical issues in manufacturing, finance, natural resources, and energy.

"MORE COMFORTABLE." You don't have to be a cynic to question whether this shift will last, of course. After all, this is not the first time the cyclicals and small-cap stocks seemed ready to run. Each time, they stumbled, ceding leadership back to the big growth stocks. Early in 1998, stocks such as United Technologies started to build momentum but were pushed back by the downdraft of the emerging-market debt crisis. The same is true for small-cap shares, which over the past few years have periodically surged ahead of large-cap stocks but failed to establish a long-term period of superior returns as they did in the early 1990s.

Will this spring's stock market shuffle fade, too? That's the critical question. If the shift is short-lived, most of the gains for cyclicals may be past, and the market will revert to its obsession with a narrow list of Nifty 50 stocks. But if the move into industrials is more long-lasting, there's a lot more life in the bull market, even though it is now 17 years old.

There's no question that the internal dynamics of the market are notably better than they were just a few weeks ago, when the Dow first climbed above 10,000. Now, more stocks are going up than down. While you would expect as much in a bull market, it hasn't been the case. The week of Apr. 12 was the first time since mid-January that more Big Board stocks made new highs than lows. It was also the first week this year that two stocks advanced for every one that declined. "It should make investors more comfortable because more stocks are participating," says market analyst Laszlo Birinyi of Birinyi Associates Inc. in Greenwich, Conn.

The economic picture is also brighter than many would have expected a few months ago. Of course, the U.S. economy continues to expand at a healthy, noninflationary pace. And as economists at Morgan Stanley Dean Witter note, real money supply--their favorite leading indicator--is growing at its fastest pace since early 1987. That points to very strong economic growth at least into early next year.

But even the global economy, while not robust, is widely perceived to be on the mend. "We have had 108 interest-rate cuts around the world since last year's financial crisis, and the stimulus from those rate cuts is starting to work," says Carson V. Levit, portfolio manager for the Dresdner RCM Large Cap Growth Fund. When the European Central Bank lowered its benchmark rate on Apr. 8 to 2.5% from 3% to spur economic growth on the Continent, the U.S. market cheered loudly with a better than 100-point gain on the Dow.

And there are improvements elsewhere. Japan is making structural changes in its lumbering economy, Asian Tigers such as Korea and Thailand are building steam, and the Latin American economies--mainly Brazil--have been able to avoid a Russian- or Asian-style meltdown. That's giving investors confidence that there will be buyers for big-ticket U.S. exports, such as Boeing Co.'s jumbo jets or Caterpillar Inc.'s earthmovers. And Boeing and Caterpillar shares are both big winners in this new broader market.

PROFIT SURPRISES. With the stronger-than-expected economy, it's no wonder that many economically sensitive companies are reporting first-quarter profits that were well ahead of forecasts. Among them are American Standard, Corning, and United Technologies. Edmund M. Cowart, portfolio manager of the One Group Large Cap Value Fund, points out that topping analysts' targets this quarter was not hard. "Expectations were so low that many companies were able to beat the numbers," he says. Still, the earnings season is shaping up as a strong one. As of Apr. 20, about 40% of the S&P 500 companies had reported profits, and they were 4.9% higher than analysts' estimates, nearly twice the average for the last 13 years, according to Joseph J. Abbott, equity strategist at I/B/E/S International Inc. Abbott says earnings surprises in this quarter are at the highest level since 1988.

While technology stocks have lost some allure with investors, those beyond the E-business startup phase are still delivering good profits. So far, tech companies have reported year-over-year earnings growth of nearly 40%, with Intel Corp. reporting earnings up 57% and Microsoft Corp. reporting a gain of 43%. But investors already have high expectations for these companies and are not impressed. "If earnings are only as good as expected, it's not the little extra edge that brings in the buyers," says John L. Manley Jr., equity strategist at Salomon Smith Barney. Manley recently advised clients to reduce but not eliminate their holdings in technology and health-care stocks and to increase their investments in such cyclicals as equipment maker Deere & Co. and International Paper.

Burned by cyclicals before, many Wall Streeters are wary of them now. "Many of the cyclicals have run up six or nine months' worth of appreciation in six or nine days," says strategist Joseph Battipaglia of Gruntal & Co. He notes that cyclicals usually post their biggest gains when the economy is coming out of recession--which it's not. And in six of the last seven years, cyclicals have had a nasty habit of giving up their early-in-the-year gains in the second half.

But while the cyclicals may sell off a bit, any pullback will set the stage for another runup, says Brian Rauscher of Morgan Stanley Dean Witter. "This gives the bull market another leg." Indeed, Michael Belkin of Belkin Ltd., a New York firm which advises institutional investors, thinks the duration and magnitude of the cyclicals' move will surprise many. The reason: So much money has been made in the big growth stocks that even a modest reallocation into industrials, which have lesser market capitalizations, will keep them aloft.

And the small-cap shares? The Russell 2000 index is looking peppy of late, up more than 7% in April, but it's still up just 1.1% for the year. Moreover, it's a little early to proclaim a new bull run for these long-beleaguered stocks. "I'd love to say this rally is for real, but it's not giving me a warm, fuzzy feeling," says Claudia E. Mott, a quantitative analyst at Prudential Securities Inc. who specializes in small-cap stocks.

Mott says her stocks are coming through on the earnings front, but not as strongly as the big-caps: "The reason to invest in small-cap over large-cap is superior earnings growth, and we're not seeing that yet."

MACRO FORCES. Mutual-fund investors clearly agree. Robert L. Adler, whose AMG Data Services tracks flows to mutual funds, says that while cash flow into equity funds is strong, fund investors have been pulling cash out of the small-cap funds all year--and are still taking it out at a rate of nearly $1 billion a week. Satya Pradhuman, a quantitative analyst at Merrill Lynch & Co., also points out that the market's current increased volatility works against small-caps as well: "The more volatile the market, the harder it is for less liquid stocks."

So is it cyclicals or growth stocks, large-cap or small? The answer could well be all of the above. With better economic conditions and increasing investor confidence, the selected cyclicals and small- and mid-cap stocks can certainly make smart additions to most portfolios. But that doesn't mean that the era of big growth stocks is over, either. The macro forces that made them so compelling--globalization, low inflation, and technological innovation, are still with us. After all, Big Steel isn't going to build the Internet, nor will Big Oil discover new wonder drugs.

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