On the whole, it wasn’t a bad year at all, considering.

Despite rising interest rates and oil prices, U.S. stocks in most sectors of the market saw price gains in 2005. While domestic equity funds rose for the year, with all fund style categories in the black, returns were far from spectacular, falling below those of 2004.

The average domestic equity fund gained about 6.8% for the year through December 19, versus 5.8% for the S&P 500. Mid-cap funds led the pack, with mid-cap blend portfolios topping all categories, rising 8.9%. Small-cap growth funds finished last among domestic equity fund categories, gaining 5.4%.

The year may have witnessed the beginnings of a market rotation away from small-caps toward mid- and larger-caps. Standard & Poor’s had expected large-cap funds to do well in 2005, given how late it is in the economic cycle, and because such an environment tends to favor bigger, more stable companies.

While large-caps generally outperformed small-caps in 2005, mid-cap companies did even better. “They tend to be more stable than smaller companies, yet have stronger growth rates than larger firms,” explains Rosanne Pane, mutual fund strategist at Standard & Poor’s. “You get the best of both worlds.” (See High Noon for Mid-Caps? )

The divergence fuels speculation that, small-cap fund dominance may have peaked. Over the 10-year period through 2004, small-cap value funds rose 14.5%, small-cap blend funds 13.3%, and small-cap growth funds 9.9%. However, after an uninterrupted six-year bull run, it would be hard to expect small-caps to continue to beat the market as they have. In addition, Pane points out, small-cap stocks are no longer trading at a discount.

Looking to Large-Caps

Common sense now expects that the tide will turn more in favor of large-caps, which have mostly sputtered for the past six years. In 2005, large-cap funds averaged a 6.4% return overall (6.7% for large-cap growth funds). That represented an appreciable improvement over their sorry results of the 2000-04 period, when large-cap value funds eked out a 3.7% gain, blend funds lost 2.0%, and growth funds shed 7.1%.

Investors may also now have more reason to switch toward “growth” and away from “value.” Large-cap growth stocks look promising with respect to projected 2006 operating earnings. The S&P 500 Growth index is expected to see operating earnings increase by 28%, while the S&P 500 Value index could lose 3%, according to our forecasts. Among other asset classes, mid-cap growth and value stocks are projected to see their earnings rise by 24% and 14%, respectively; while, small-caps may again bring up the rear, albeit with 18% higher earnings for growth stocks, and 19% for value. The projections are as of December 20.

Overall, however, large-cap stocks are projected to deliver lower operating earnings in 2006 relative to mid- and small-caps. Standard & Poor’s projects 2006 operating earnings among the S&P 500 companies to average 11%, which is below, but not too far behind, the 14% achieved in 2005. Mid- and small-cap stocks are expected to log figures of 18% and 19%, respectively, compared with estimated figures of 10% and 16%, respectively, in 2005.

On a valuation basis, large-caps look like a bargain with lower price/earnings multiples. Large-cap shares’ projected valuations for 2006 are 14.9, compared with 17.0 for mid-caps and 16.4 for small-caps. Nonetheless, valuations for all asset classes have declined substantially since 2004. “We would not be surprised to see investors take a more cautious approach by gravitating toward larger companies with high S&P earnings and dividend quality ranks,” says Sam Stovall, Standard & Poor’s chief investment strategist.

Modestly Bullish for 2006 If Oil and Rates Behave

Looking forward, Standard & Poor’s Global Investment Policy Committee (IPC) believes “there are more reasons to feel optimistic about stock returns than not,” including healthy GDP growth and tame inflation numbers. IPC recommends that investors keep a 45% portfolio weighting in domestic equities, on top of a 20% allocation in foreign shares. This would produce a slightly more aggressive mixture than the neutral, balanced portfolio of 60% equities and 40% fixed income. “We’re mildly optimistic about 2006 — we’re not raging, but single-digit, bulls,” says Stovall.

However, from a short-term perspective, Standard & Poor’s chief technician, Mark Arbeter, thinks that the market could experience a pullback in share prices in the first quarter of 2006. Overall, equity performance next year will greatly depend on what happens with interest rates and oil prices. After 13 consecutive rate hikes since June 2004, the Fed Funds rate currently stands at 4.25%. Standard & Poor’s expects the Federal Reserve to stop raising rates in the first quarter of 2006, with the benchmark reaching 4.75%.

If inflation is held under control, U.S. companies, especially large-caps, might get a second wind and pick up their capital investment and hiring. Standard & Poor’s equity market strategist Alec Young believes the fear of higher rates has been the primary obstacle to greater gains this year. (The S&P 500 rose a relatively modest 5.8% year-to date through December 19.) However, he foresees that if rates stop rising in 2006, this “will act as a major equity market catalyst.”

The other overhanging variable is, of course, energy. After ascending to nearly $71 per barrel in late August following catastrophic hurricanes in the Gulf Coast, the price of oil is now trading just under $60. For 2005, oil averaged about $56, a 36% jump over the prior year. However, Standard & Poor’s expects crude prices to remain relatively stable and average about $58 during 2006.

Stovall cautions that reality could turn out quite differently from Standard & Poor’s projections. “We could find that the economy is actually stronger than we expect, or that inflation is more of a concern,” he says. If the Fed is forced to raise interest rates “longer and higher than we anticipate,” the result could be dampened consumer confidence, and lower spending by both businesses and consumers. All of which would have a negative impact on corporate earnings growth.

Below is a look at how domestic equity funds performed by style category in 2005 and in the fourth quarter, along with the best- and worst-performing domestic stock funds in each category.

Fund Investment Style 2005 Average Returns* (%) Fourth-Quarter 2005 Average Returns (%)**
Large-Cap Growth +6.70 +3.50
Large-Cap Value +6.57 +2.20
Large-Cap Blend +5.79 +2.55
Mid-Cap Growth +8.80 +2.32
Mid-Cap Value +8.68 +1.45
Mid-Cap Blend +8.90 +1.98
Small-Cap Growth +5.44 +1.06
Small-Cap Value +6.19 +0.62
Small-Cap Blend +5.54 +0.83
All-Cap +7.35 +2.03
Domestic Equity Funds (excluding sector and balanced funds) +6.68 +2.15
S&P 500-Stock Index +5.75 +2.9

Domestic Equity Funds — Year-End 2005 Returns

Best Individual Performer

Returns (%)

Worst Individual Performer

Returns (%)

Large-Cap Growth Morgan Stanley Aggressive Equity/D (AEQDX)

+23.23

Reynolds Funds Opportunity Fund (ROPPX)

-9.89

Large-Cap Value Jennison Blend Fund/Z (PEQZX)

+18.29

ING Large Cap Value/C

-8.54

Large-Cap Blend Jennison 20/20 Focus Fund/Z (PTWZX)

+22.86

ProFunds:UltraBear/Svc (URPSX)

-7.41

Mid-Cap Growth Hennessy Focus 30 (HFTFX)

+31.80

Ameritor Investment Fund (AIVTX)

-63.64

Mid-Cap Value CGM Capital Development Fund (LOMCX)

+24.99

ING Mid CapValue Q

-21.29

Mid-Cap Blend Timothy Plan Large Mid Cap Value Fund/A (TLVAX)

+19.32

ProFunds:UltraShort Mid Cap/Svc (UIPSX)

-19.44

Small-Cap Growth Hartford Small Company Fund/Y (HSCYX)

+19.32

Frontier MicroCap Fund (FEFPX)

-33.33

Small-Cap Value Gartmore Small Cap/IS (GSXIX)

+21.80

STI Classic Fds Small Cap Value Equity/C (STCEX)

-10.44

Small-Cap Blend Bogle Small Cap Growth Fund/Institutional (BOGIX)

+17.56

Potomac Small Cap/Short/Investor (POSSX)

-11.24

All-Cap Growth Permanent Port Family of Fds Aggressive Growth (PAGRX)

+22.25

American Heritage Growth Fund (AHEGX)

-42.86

All-Cap Value Leuthold Select Industries Fund (LSLTX)

+23.04

Weitz Value Fund (WVALX)

-2.50

*Source: Standard & Poor’s. Total returns include reinvested dividends. Preliminary data as of 12/19/05.

**9/30/05 – 12/19/05.

For a year-end review of Foreign Equity Funds and ETFs, click here.

For a year-end review of High-Yield Bond Funds click here.

For a year-end review of High-Quality Bond Funds click here.