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Playing Catch-Up in the Fourth Quarter

By Ben Warwick

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As many professional investors know, the fourth quarter is typically a good period of the year for equity investors. The jury seems to be split on the potential outcomes for this year’s last three months, however. Some investors, focusing on inflation and energy prices, seem to think that equities don’t have any farther to run. Those who focus on the quality of earnings and the resiliency of the economy are a bit more bullish.

I’m in the latter camp. As stocks have continued climbing a wall of worry, an increasing number of money managers will be forced to buy into the current rally. After all is said and done, I suspect that most market indexes will be higher on the last day of the year than they are today.

The question then becomes how to play a potential rally. The third quarter was dominated by small-cap growth stocks, which gained about 6.3%. The Nasdaq was another big winner, up 4.6%. I think a less risky way to gain exposure to equities is with large-cap stocks.

Consider this: So far this year, narrowly-constructed large-cap indexes such as the S&P 500 and the Russell Top 50 have barely budged, while the broader indexes, such as the Russell 3000, are up 4%. After years of underperformance, many well-known large companies are now boasting solid free cash flow, reasonable earnings multiples, and well-managed balance sheets.

What’s the bottom line? Although small caps have dominated investment returns over the last six years, current valuations should bode well for larger companies.

The Monthly Index Report for October 2005

Index

Sep-05

QTD

YTD

 Description
S&P 500 Index*

0.69%

3.15%

1.39%

 Large-cap stocks
DJIA*

0.83%

2.86%

-1.99%

 Large-cap stocks
Nasdaq Comp.*

-0.02%

4.61%

-1.09%

 Large-cap tech stocks
Russell 1000 Growth

0.46%

4.02%

2.22%

 Large-cap growth stocks
Russell 1000 Value

1.40%

3.88%

5.72%

 Large-cap value stocks
Russell 2000 Growth

0.79%

6.31%

2.51%

 Small-cap growth stocks
Russell 2000 Value

-0.17%

3.08%

4.02%

 Small-cap value stocks
EAFE

4.47%

10.43%

9.50%

 Europe, Australasia & Far East Index
Lehman Aggregate

-1.03%

-0.67%

1.82%

 U.S. Government Bonds
Lehman High Yield

-1.00%

0.92%

2.04%

 High Yield Corporate Bonds
Calyon Financial Barclay Index**

1.47%

1.15%

1.36%

 Managed Futures
3-month Treasury Bill

1.68%
All returns are estimates as of September 30, 2005. *Return numbers do not include dividends. ** Returns are estimates as of September 29, 2005