The Less Loved Stocks Have Their Day

Formerly out-of-favor sectors such as homebuilders and utilities are gaining popularity

Ralph Waldo Emerson said: "Do what we can, summer will have its flies." He could have been referring to the stock market.

Despite a recent tech rally, the indexes remain mostly flat for the year, with the Nasdaq up only 1%, the Dow Jones industrial average down 3.4%, and the Standard & Poor's 500-stock index up 2.3%. And with all of Wall Street seemingly taking a breather, trading volume is in a summer slump. "It's definitely a directionless market--people who were burned in the tech correction are afraid to jump," says Timothy Ghriskey, a portfolio manager at Dreyfus Corp. Not to mention the spate of negative earnings warnings from companies such as Bausch & Lomb Inc. and Albertson's Inc. In fact, with bonds outperforming stocks--10-year Treasuries have posted a total return of 6.8% for the year to date--some investors may think it's time to throw in the beach towel on equities.

Here's some advice: Hold on to that towel. There are signs the market may soon emerge from its summer doldrums: Inflation seems to be in check, possibly warding off further Federal Reserve interest-rate hikes, and, despite a slowing economy and a leveling-off in corporate profits, future earnings still look healthy. Even energy prices, though they continue to spike, are close to peaking and aren't likely to derail the economy, say economists. Yet another positive indicator is the summer surprise of falling government bond yields--10-year Treasuries are still near their lowest in a year--boosting the market and possibly encouraging the Fed to cut rates after the election or early next year.

But perhaps the most bullish market aspect is improving breadth and valuations. Outperforming the S&P 500 are 53 industry groups, compared with 43 in the second quarter and 34 for all of 1999. That means there are more sectors of the market that are healthy, offer good value, and are poised to advance. The upshot: It's unlikely that the indexes will stage a remarkable recovery by yearend, but that doesn't mean investors can't do well by picking individual stocks and sectors wisely.

"The market isn't as bad as the indexes portray. You've got just as many groups with double-digit advances this year as double-digit declines," says Thomas M. Galvin, chief equities strategist at Donaldson, Lufkin & Jenrette Inc. Galvin points out that while telecommunications and consumer cyclicals stocks are down 25% and 20%, respectively, areas such as utilities and financials are up 35% and 15%. "We've had significant rotation activity to previously unloved areas," he says.

The same goes for earnings projections in once unpopular sectors. Sure, tech--particularly semiconductors and fiber optics--looks as if it will lead again in the third and fourth quarters. But the likes of homebuilders, gas utilities, and finance also have strong earnings momentum, according to I/B/E/S, the earnings research firm. And earnings for the overall market are poised to grow 16.5% in the third quarter and 14.5% in the fourth quarter over last year. "It's a good showing in light of difficult year-over-year comparisons and the leveling-off due to higher interest rates," says Joseph Kalinowski, an equity strategist at I/B/E/S.

For investors who have loaded up on tech over the past few years, it may be time to look at some less-loved areas. "We're seeing a growing conviction that value is finally beginning to catch up to growth," says Robert Balentine of Balentine & Co., an Atlanta money-management firm.

Small-cap and midcap value stocks, for instance, are performing strongly for the first time in five years. The Russell 2000 Value Index has gained 12.82% so far this year, while the Russell 2000 Growth Index is down 1%. "Mergers and acquisitions activity has been the story in small-cap value all year. There are many viable companies that are significantly undervalued, and they'll just continue to get taken over," says Richard Bernstein, chief quantitative strategist at Merrill Lynch & Co.

A SPIKE. And though small-cap growth stocks have fallen, mainly because of busted dot-coms, they are starting to take off, too. "Investors are becoming increasingly comfortable migrating down the market cap chain in search for growth," says L. Keith Mullins, emerging growth strategist at Salomon Smith Barney. The catch: The stocks must have strong earnings. He favors energy and capital equipment companies such as Apache Corp. and LAM Research Corp. Mullins points out that large-cap growth stocks' price-earnings ratios average 69, vs. 24 for small-cap growth stocks.

A not-so-sexy sector that continues to look good: real estate investment trusts. Boosted by a spike in rents and values of office and residential properties, REITs have gained an impressive 20% so far this year. Plus, dividends average 8%. "REITs will do well because they are still cheap and they are the antithesis of what the consensus wants to invest in," says Merrill's Bernstein. Indeed, studies show that the Nasdaq and real estate stocks tend to move in opposite directions. The same goes for utilities.

Finally, financial stocks should continue to post gains. The NYSE financial index has netted a 17% return so far this year--mostly recently because many investors think the Fed will cut rates. One believer is DLJ's Galvin, who notes that the two-year Treasury note yields are below the fed funds rate. "That has only happened three times in the last decade--and each time effectively predicted a rate cut," he says.

With expectations like that, the pesky summer flies should be out of the market in no time.

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