Dec. 3, 2002 — Have the horses broke from the gate before they’re ready to race again?
That appears to be the view of several fund managers on the market’s rally since October 9. While they’re glad gains have continued, these managers feel investors haven’t considered modest company fundamentals and high stock valuations.
“We’ve had too much success too fast,” said Ron Sloan, manager of AIM Mid Cap Core Equity Fund/A (GTAGX). Sloan believes the market is anticipating an economic recovery early next year, but he expects it will actually start in the second half of 2003. AIM Mid Cap Equity Core Equity, a mid-cap blend fund, rose 6.4% in November alone, but is down 7.2% this year through the end of last month.
The market is always premature, according to Scott Barbee, manager of Aegis Value Fund (AVALX). A value investor who focuses on the long term, Barbee sees few opportunities in the market currently as investors have been bidding up stocks across several sectors. A continued market upturn is possible, in Barbee’s view, but it depends on an economic recovery and a moderate response by regulators to the recent corporate scandals, which “no one can predict.” His fund, a small-cap value portfolio, gained 4.7% last month. It has risen 2.4% this year through the end of November.
Alexander Thorndike, manager of Century Small Cap Select/Investor (CSMVX), agrees that this year’s rally is premature, saying: “earnings will drive us into a recovery, and we aren’t there yet.” Rising 6.1% last month, Century Small Cap Select, a small-cap blend offering, gained 2.8% this year through November.
Year of Surprises
One interesting anomaly this year, said Sam Stovall, Standard & Poor’s chief investment strategist, is that the market’s growth and value categories have been “neck and neck” since the rally started October 9. In the early stages of a market rebound, one would expect value stocks to hold up better than growth issues, but this hasn’t happened, Stovall notes. He believes similar results across style categories stem from the low valuations of many high beta stocks hurt in the steep downturn before October 9.
In November, fund style categories continued October’s steady gains across the board. Small-cap funds, for the most part, did modestly better than their larger style counterparts. Growth funds generally led within the small-cap arena, while they trailed value in the mid- and large-cap categories.
Growth funds may have suffered this year because growth managers have continued to focus on stocks with high valuations, said John Park, manager of Liberty Acorn Twenty Fund/A (LTFAX). Prior to the 1990s, growth managers generally sought stocks selling for less than their fair values, Park said. His fund is up 4.0% this year through November, making it the best performer among mid-cap growth funds. The portfolio rose 5.0% in November alone.
Stovall believes that small-cap stocks have led this year because of more reasonable valuations and limited international exposure. So far this year, small-cap stocks, particularly small-cap value issues, have benefited from tremendous inflows into small-cap funds, according to Aegis’s Barbee. He feels that investors looked to small-cap value stocks as “a panacea in a market where there was no place to go.”
Despite an occasional setback, the market trend is higher, but gains are likely to be modest, said S&P’s Stovall. He predicts that high valuations will dampen the market’s upside, noting that the current price/earnings ratio on trailing earnings of the S&P 500 is more than twice the average coming out of a bear market.
Next year, “the only thing we can take comfort from” would be that the S&P 500 hasn’t been down for four consecutive years, something that has not happened since the Great Depression, said Liberty’s Park. While a market decline this year would be its fourth year of losses in a row, a downturn in 2003 is unlikely, according to Park, since a lot of the excess has been rung out of the market. As a result, the manager is “cautiously optimistic.”
Century’s Thorndike is also optimistic, particularly for small-cap stocks, which he predicts are likely to outperform over the next 12 to 18 months. While hopeful, Thorndike doesn’t expect a sustained market recovery until the middle of next year.
AIM’s Sloan expects a market rally to solidify sooner, since he thinks the economy will pick up in the second half of 2003, and that investors will begin to discount that rise earlier in the year. Sloan said he predicts the market will “tread water until next spring,” when we get a clear picture of capital spending.
While the market is likely to recover next year based on stronger earnings, particularly for growth companies, value and small-cap stocks are less likely to outperform at the rates of the last few years, according to David Wallack, manager of T Rowe Price Mid-Cap Value Fund (TRMCX). The outsized gains of those segments in recent years limits their upside potential, Wallack said. His fund, which was up 6.2% last month, fell 4.4% this year through November.
Fund Investment Style2002 Returns Through 11/29/02
Large-Cap Growth Average-22.55
Large-Cap Value Average-15.94
Large-Cap Blend Average-18.27
Mid-Cap Growth Average-21.82
Mid-Cap Value Average-10.21
Mid-Cap Blend Average-16.14
Small-Cap Growth Average-24.01
Small-Cap Value Average-9.81
Small-Cap Blend Average-15.46
Domestic Equity Funds Average*-18.55
Fund Investment StyleNov. 2002 Returns
Large-Cap Growth Average+4.95
Large-Cap Value Average+6.42
Large-Cap Blend Average+5.42