Will Longtime Wallflowers Keep New Star Status?

To make money on Wall Street in the first half of this year, a patient approach with a broadly diversified portfolio of stocks turned out to be the best way to go.

But failing that, just jumping aboard the Next Hot Thing as soon as you could recognize it would have worked fine too.

Two contradictory strategies? Well, that’s the kind of market we’ve got today, and it may be what we’ll all have to deal with for some time. Remember all that talk about a new millennium? At least in terms of the stock market, maybe they weren’t kidding.

For much of the last few years, two market sectors enjoyed an embarrassment of riches at the expense of most everything else: technology stocks and blue chip stocks as represented by the Standard & Poor’s 500 index.

In the five years ended Dec. 31, technology stock mutual funds produced a 40.9% average annualized gain, according to Lipper Inc. The average fund that mimics the S&P; 500 index generated a yearly return of 28% in that period.

By contrast, the average diversified U.S. stock mutual fund gained about 22% a year in those five years. Many small-stock funds fared far worse, as did funds in such industry sectors as natural resources and utilities.

Now consider what transpired in the first half of this year. As anyone who reads the business headlines well knows, technology stocks tripped in the first half. Actually, it was more like a fall down a five-story flight of stairs.

The tech-dominated Nasdaq composite index reached its zenith on March 10 at 5,048.62. From there it plummeted 37.3% to its recent low of 3,164.55 on May 23. That was the worst decline for the Nasdaq index since the mid-1970s.

Things have gotten better for Nasdaq in recent weeks. By Friday the index was back to 3,966.11, a rebound of 25% from its May low.

But with the second-quarter plunge, the average tech-stock mutual fund is up 5.3% so far this year--a minuscule number by Silicon Valley’s standards.

True, that’s still better than the average U.S. stock fund, which rose a net 3.8% in the first half, according to fund-tracker Morningstar Inc.’s preliminary figures.

Yet tech’s usual starring role in the market was eclipsed in the first half by such long-standing wallflowers as natural-resources funds (up 15.6%, on average) and real estate funds (up 12.9%).

Tech even was beaten by small-stock “value” funds that target arguably cheap shares of often boring industries. The average small-stock value fund gained 5.6% in the half.

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Meanwhile, for the vaunted S&P; 500 index, the first half turned out to be a loser: The Vanguard Index 500 fund, the largest fund tracking the index, lost 0.4% for the half--a victim of the heavy weighting of technology stocks and financial-services stocks in the index.

That modest loss probably won’t change the minds of many investors who believe in the wisdom of “passive” investing--i.e., simply owning the index, as opposed to trying to beat it via an actively managed fund. And it probably shouldn’t change their minds, if they have a truly long-term view.

Still, the market’s shifting fortunes in the first half ought to at least prompt investors to wonder, “What if?”

What if, for example, the stellar returns of the S&P; 500 and the tech sector over the last five years are giving way to a lengthy period of much lower returns? Does that mean the market as a whole must suffer--or does it mean investors will increasingly turn to other market sectors they have largely ignored in recent years?

The argument was often put forth at the end of 1999 that many blue-chip growth stocks and technology stocks were “priced for perfection.” In other words, their share prices, relative to underlying earnings and other fundamentals, were so high that the only way you could justify buying at that point was if you believed that absolutely nothing could go wrong in the economy at large or within the individual companies.

But in the first half of this year, of course, many things happened to raise doubts about the “perfect” status of the economy, and to call into question the outlooks for some key technology companies.

First, there was the Federal Reserve, which aggressively raised interest rates to slow an economy it said couldn’t sustain last year’s growth rate without fueling inflation.

Add to that the soaring prices of oil and natural gas, which reached levels few analysts expected, and which continue to be held up by doubts that even planned output increases by major producers in the second half of this year will be enough to make a big difference.

In the tech sector, meanwhile, the Internet bubble finally appears to have burst, as the public’s willingness to finance new “dot-com” ventures has ebbed drastically in the face of the inevitable shakeout of once highly regarded players.

What’s more, the government’s plan to break up Microsoft helped hammer what had been one of the tech sector’s most important stocks.

The net effect of these and other events in the first half of this year was to turn many investors, especially at the institutional level, far more cautious about the stock market--and in particular, about the technology sector.

“It all forced a lot of managers to start buying some things they didn’t have” in their portfolios, as a way to hedge their bets, says Doug Cliggott, investment strategist at J.P. Morgan Securities in New York.

Hence, the sharp gains in the first half in energy stocks, drug stocks, real estate investment trust shares and small-cap value stocks, among other sectors.

The key question, of course, is whether that shift in investors’ focus was just a temporary change, or whether the market is likely to face such a sustained level of uncertainty on so many counts (inflation, interest rates, the economy’s growth rate, tech companies’ earnings, etc.) that many investors will continue to follow the only sensible route under such circumstances: Spread your bets over many market sectors, and hope for the best.

Ironically, one of the side effects of the first half’s diversification push was that it produced plenty of newly hot stocks.

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So while tech-stock investors lamented the collapse of the “momentum” game in that sector in March and April, suddenly there was plenty of momentum in such unlikely areas as real estate investment trusts and energy stocks.

Lately, the momentum has shifted back to some groups more accustomed to that attention--biotechnology, for example.

The point is, no matter what the backdrop for the stock market in the second half of this year, there will always be something new and hot for investors so inclined to chase. Maybe it will be technology again, for a month or so, until it again gives way to something else.

For those investors who have no interest in playing that game, the likelihood of such an ongoing rotation of sectors brings us back to the idea that the only logical strategy is diversification--large and small stocks, growth and value, tech and non-tech, domestic and foreign.

That is rarely as lucrative as correctly picking the hot stock sector of the moment. But it avoids the risk of having too much in the next sector that collapses.

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The Stock Market’s Shifting Fortunes

Many stock mutual fund investors will find they made money in the first half of this year, despite the technology sector’s dive. But the market’s leadership shifted dramatically.

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Many broad fund categories are up for the year ...

Average year-to-date changes by mutual fund category

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Small-cap growth: 9.8%

Domestic stock avg.: 3.8

Large-cap growth: 2.8

European stock: 2.4

Utility stock: 1.9

S&P; 500 (Vanguard index fund): -0.4

Foreign stock: -4.3

Emerging-markets stock: -9.1

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... but the hottest sectors were areas long out of favor.

Average year-to-date changes by mutual fund sector

Healthcare: 38.1%

Natural resources: 15.6

Real estate: 12.9

Small-cap value: 5.6

Technology: 5.3

Communications: -3.9

Financial: -1.9

Precious metals: -15.3

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Nasdaq’s Cautious Comeback

The tech-dominated Nasdaq composite index has rebounded from its worst levels of late May but still is 21% below its record high reached March 10. Weekly closes and latest:

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Friday: 3,966.11

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Interest Rates: Is the Fed Done?

Long-term bond yields have pulled back over the last month on hopes the economy is slowing enough to preclude further interest rate hikes by the Federal Reserve. Monthly closes and latest for the 10-year Treasury note:

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Friday: 6.03%

Sources: Bloomberg News, Morningstar Inc.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com