The main trends in the stock market during the 2nd quarter of 1999 were the resurgence of
small-company stocks and "value" stocks (companies with low prices relative to
their earnings), and
suspense about what the Federal Reserve would do about interest rates.
Trend #1 - The Resurgence of "Value" and "Small is Beautiful"
Two long-term historical trends that have been documented during the past few decades
re-established themselves in the 2nd quarter (April 1-June 30). The first is that smaller
company
stocks have typically outperformed larger company stocks. The second is that
value-oriented stocks
(companies that have relatively low prices compared to their earnings) have typically
outperformed
growth-oriented stocks (companies that have relatively high prices compared to their
earnings).
While those trends had not held up over the previous two years, the second quarter showed
us that
in the capital markets history usually does repeat itself.
In my April commentary, I stated the following:
"Over the past couple of years, you would have been better to solely invest in the
big-name U.S.
stocks, and not diversify across different sectors such as value, small-cap, and
international. But
that's the past. Going forward, the sectors that haven't done as well as the U.S.
large-cap portion of
the market are now undervalued relative to that portion. The reason we recommend broad
diversification is not to enhance your returns during good times, but to cushion the
downside during
bad times. Now, more than ever, is the time to continue to follow our well constructed,
diversified,
investment advice."
Now let's look at results for the 2nd quarter. The S&P 500, a measure of large company
performance, increased in value by 8% for the quarter, which of course is very favorable
performance for an investment. However, small company stocks, measured by the Russell
2000,
increased in value by 15%. Moreover, the average "value" stock outperformed the
average
"growth" stock by 7%. These results are reminders that it is not wise to bet
against long-term trends,
even though these trends might not always hold up over relatively short time periods.
Bond returns were sluggish, as the Lehman Brothers Aggregate Bond Index fell by 1%.
International stocks also had modest performance, gaining only 2%, mainly because of
falling
currency values in Europe. However, some international sectors performed very well --
particularly
emerging markets, which rose by 29%.
Trend #2 - Inflation, Interest Rates, and the Federal Reserve
The rises and falls in the U.S. market were mainly driven by concerns about inflation and
whether
the Fed would raise interest rates.
After the market enjoyed an outstanding April, analysts began expressing concern that the
economy
might be expanding too rapidly. In early May the first signs of increasing inflation began
appearing in
economic data. By mid-June, it was a foregone conclusion that the Fed would soon raise
interest
rates -- the only question was by how much.
The mere 1/4% increase announced on June 30 was a relief to the stock market, and this was
reflected in rising stock values.
Looking Ahead
Looking forward to the 3rd quarter, there are many reasons to believe the market will
continue to
establish record highs. However, I see three main concerns.
The first is whether the interest rate increase will truly reduce the inflationary
pressures on the
economy. It will be difficult for the economy to continue to grow at a fast pace without
triggering
increasing consumer price levels. If the Fed senses the potential for an increase in
inflation, it may
very well increase interest rates again before autumn, which is likely to dampen stock
prices.
A second and more serious concern relates to corporate earnings. The relatively high stock
valuations in today's market reflect optimism about continued growth in profits. If many
companies
announce earnings below expectations, we could see a potentially severe decline in stock
prices.
The final potential danger is the risk presented byY2K. Although this may turn out to be
much ado
about nothing, the press will certainly express more hyperbole as the year rolls on. If
investors
believe the concern about widespread problems to be valid, they may take their money out
of
stocks as a precaution, and the market may decline.
What this means is that there is a fair degree of risk in the stock market – as is
typically the case!
You should be aware of this risk. However, if you are not planning to retire for several
years or
more I still believe it is wise to invest a large proportion of money in stock funds.
If you are planning to retire within the next couple of years, though, I think it would be
a good idea
to consider investing a substantial amount of your savings in safer bond and money market
funds.
Moreover, it is always prudent to obtain broad diversification within the stock market,
allowing you
to benefit during periods like the past quarter.  Lummer's
Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.
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