The S&P 500: This Powerhouse Is Losing Muscle

Investors are getting antsy as S&P 500 funds falter

If you're one of the millions who invests in Standard & Poor's 500-stock index funds, FYI: Your fortune may be growing a lot more slowly than you think.

The S&P 500 is up only 8.21% so far this year, compared with 28.3% last year and 31% the year before. A slowdown in the growth of some of the biggest, most popular stocks like Microsoft Corp. and America Online Inc., combined with diminishing money flows into S&P 500 funds, has pushed the index' growth back to more historical levels.

But there is good news. The index has broadened out dramatically, meaning that more than just a handful of stocks are now performing well. "This means there's more sustainability," says Jeffrey M. Warantz, equity analyst at Salomon Smith Barney.

With the Dow Jones Industrial average already up twice as much as the S&P 500, this will likely be the first year since 1996 that the S&P 500 has underperformed the Dow. "The great performance of the S&P 500 was wonderful while it lasted, but we think the trend is over," says Douglas R. Cliggott, U.S. equity strategist at J.P. Morgan & Co.

Granted, an 8% year-to-date gain may not seem so worrisome. But it may come as a shock to those who expect spectacular double-digit returns. Since its peak on July 16, $577.8 billion of investor wealth has vanished from the S&P 500. Not only that, the average S&P 500 stock is 20% off its 52-week high.

"HUMDRUM." Rising interest rates have had an eroding effect on some of the big S&P 500 stocks. "You just haven't seen the huge gains this year, especially in some of these tech stocks," says Warantz.

Just look at Microsoft. It is up a "humdrum" 34% this year, compared with a 115% gain in 1998. AOL is down 48% from its 52-week high. Compaq is 53% off its year-to-date high. Dell Computer and Merck & Co. are down 14% and 21%, respectively, from their year-to-date highs.

The broadening is clear. In 1998, 87% of the gain in the S&P 500 was due to the so-called Nifty Fifty stocks, including Microsoft and General Electric. But in the last year, the index' increase comes from 181 stocks, including these two. Conspicuously absent are stocks like Compaq Computer Corp. and American Home Products Corp.

Indeed, the overall market has gotten broader. In early April, four out of five stocks in the U.S. trailed the S&P 500 by 15% or more on a 12-month basis. Now, only three out of five stocks trail the S&P 500 by 15% or more. "A dramatic improvement has occurred in the overall market within a very short period of time," says Warantz. One reason is that traditional value stocks, primarily the industrial cyclicals that make up most of the Dow, sprang back to life this spring. "The smokestack stocks edged out some of the cutting-edge stocks," says David M. Blitzer, chief economist at Standard & Poor's. Small-cap and mid-cap stocks have also gained ground.

In the face of all of this is rising S&P 500 corporate profits. According to I/B/E/S International Inc., an earnings research firm, third-quarter profits are expected to rise 21.8% over last year. And fourth-quarter earnings are estimated to be up 21%. "Rising interest rates and rising profits probably means the market will be stuck in a trading range, with a downside bias toward the S&P," says J.P. Morgan's Cliggott.

The S&P 500: This Powerhouse Is Losing Muscle

Some investors, it seems, have had a downside bias toward the S&P 500 since May. According to Financial Research Corp. in Boston, investment flows into S&P 500-index funds dropped off dramatically that month--from $4.3 billion in April to $2.8 billion. "You can attribute some of that to IRA investors rushing to meet the Apr. 15 tax deadline, but also key is that the market shifted away from some of these big growth stocks," says Michael Evans, an analyst at FRC. And in July, flows were only $1.8 billion; in July of last year, they were $3.3 billion. Meanwhile, flows into "total stock market" index funds that pattern themselves after the Wilshire 5,000 have seen increases--with some $4.3 billion flowing in so far this year, compared with just $3.3 billion for 1998.

Says S&P's Blitzer: "Active fund managers should be happy with the comparisons. Even if the S&P ends up gaining 13% or 14% this year, it will still look pretty terrible compared to the past three years." But in this market environment, double-digit returns of any kind may be the best investors can hope for.

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