March 4, 2004 — The party wasn’t over last month, but investors have apparently decided to avoid racier fare, according to domestic equity fund returns so far this year.

“In February, investors pulled back from the more aggressive styles that dominated returns over the past year and into January,” said Rosanne Pane, mutual fund strategist for Standard & Poor’s. Investors are now focusing on consistent earnings at attractive prices, she noted.

Signaling the market’s greater concern about valuations, value funds have led so far this year across all market capitalization categories. While returns were solid across domestic equity fund styles, value funds’ outperformance is somewhat atypical for the second year of a bull market, when growth investing generally leads.

February was marked by a rotation into deeper cyclical issues, particularly into materials, energy, and consumer staples, said Sam Stovall, chief investment strategist for Standard & Poor’s. Investors are likely focusing on energy and materials as a hedge against inflation, Stovall noted. The interest in consumer staples may be due to investors’ concerns about a possible interest rate hike, Stovall said.

Investor caution also likely stems from the sharp losses of the recent bear market, said Diane Jaffee, manager of TCW Galileo Diversified Value Fund/N (TGDVX). The bear market losses were “too huge for people to ignore,” she added.

Unusual for the second year of a bull market, investors are continuing to favor smaller-cap issues, with small-cap funds leading so far this year, and mid-cap funds leading in February. Investors may be shifting to less aggressive value issues, but they’re still looking for growth by favoring smaller-cap issues.

Mid-cap funds’ great performance may signal that investors, becoming less aggressive, are shifting from small-cap stocks toward larger-cap stocks, Stovall said. Mid-cap funds tend to have higher growth rates relative to large-cap funds, but aren’t as risky as small-cap funds.

Bull Market Continues

Standard & Poor’s Stovall feels investors’ increasingly cautious moves, as seen in the shift toward value-oriented inflation-resistant sectors, may be premature. He notes that previous economic expansions have lasted an average of 57 months. Thus, the current expansion, which started near the end of 2001, is probably only at its midpoint, according to Stovall.

Stovall predicts a market advance through 2004, with the S&P 500-stock index rising 11% for the full year to 1230. As for sectors, he notes that Standard & Poor’s currently has a greater portion of buy recommendations in the consumer discretionary, health care, and technology sectors, but this pattern reflects individual company fundamentals, rather than a top-down view of those sectors.

– Bill Gerdes