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January 03, 2006 at 07:00 PM
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.
