Are they? Two not very terrible events supposedly triggered the upset. First, striking workers won concessions from United Parcel Service. Nervous Wall Streeters saw that labor victory as a harbinger of inflation. Then Coca-Cola and Gillette hinted that quarterly earnings would fall short of expectations, inciting fear that similar deficiencies would pop up at other large corporations. These are setbacks, but hardly substantial enough to fashion a noose for the bull market. ““There doesn’t seem to be any major economic news that would suggest everything is going to fall apart,’’ says Melissa Brown, a director at Prudential Securities.
The real story behind August’s dip is an old one: a love affair with a special category of stocks that sours. The special plot twist is that this time the objects of affection have been blue-chip giants like General Electric and IBM that dominate the well-known Standard & Poor’s 500. The unraveling of this romance will lead the nightly news and feel like a national disaster, even if it’s not. The S&P 500 and the Dow Jones industrial average–those closely watched indicators that presumably tell us how ““the market’’ is doing–really reflect the performance of only a very small group of stocks.
Brand power: To understand how excessive devotion can whipsaw supposedly stable market measures like the S&P 500, you need to go back three years. That’s when the robust prospects of drug stocks started attracting investors. The stocks were relatively cheap. The companies had powerful brand names not only in this country but in others where a global expansion was kicking into gear. And because they had drastically restructured, they were poised to make money. When that formula began to work, it wasn’t hard to find other companies with the same attributes. You know the names: GE, Coca-Cola, Procter & Gamble, Wal-Mart, Johnson & Johnson, Disney.
Wall Street’s attraction to these household names would have been nothing more than a dalliance but for two key developments. First, the new favorites whipped up a stunning display of earnings. Profits for the S&P 500 grew 37 percent in 1994, the biggest pop since 1948. In fact, the current string of uninterrupted double-digit gains in S&P 500 earnings is unprecedented.
The other factor that triggered a mad scramble for the same stocks: mutual-fund investors. They’d been pumping money into the stock market. But by 1994 they began noticing that index funds, designed to mimic market measures like the S&P 500, were cheaper than funds with stock pickers at the helm–and often performed better. The index itself promptly confirmed that with a return of 37.6 percent in 1995.
Investors began shoveling money into index funds. By last year they had stuffed $92.7 billion into 133 index funds, compared with just $5.8 billion in 28 funds in 1990, according to Morningstar. Stocks in the S&P index, naturally, scooted up. Racing to keep up, managers of nonindex funds began throwing money at the big kahunas in the index: the already favored consumer stocks. ““It became a self-fulfilling cycle, and the stocks’ prices began to go parabolic,’’ says Bob Farrell, senior investment adviser at Merrill Lynch.
But manias usually have painful endings. Look at the above chart. Emerging-markets, biotechnology and semiconductor stocks suffered dramatic tumbles after doubling, quadrupling and quintupling in value. A 40 percent loss in semiconductor stocks may look tolerable after a 555 percent run-up, but most of the money that propelled those sectors into the stratosphere flooded in at the end of the upswing, not at the beginning. And don’t forget that it takes only a 50 percent loss to erase a 100 percent gain.
‘Nifty Fifty’: There’s another key lesson: those stocks were experiencing bear markets while the bull market was in full swing. The same thing could be happening now–but in reverse. In this scenario the S&P 500 index will get pounded as large consumer stocks fall out of favor and individuals yank money out of their beloved index funds. But meanwhile, other corners of the market will perform quite nicely. Is it realistic? Certainly the Nifty Fifty, as Wall Street calls the largest stocks in the index, are teetering. A classic sign of failing strength is that they fell about twice as much as the overall market did during last month’s swoon. ““The stocks that attracted the most money show signs of peaking,’’ says Merrill Lynch’s Farrell.
Meanwhile, the stocks of small companies are going like gangbusters. The small fry tracked by Prudential are hiking their earnings 7 percentage points faster than large companies. They’ve also produced more positive earnings surprises–those coveted moments when a company announces that profits will be higher than analysts expect–than downbeat earnings reports. While the S&P 500 was being hammered, the Russell 2000 reached a record high of 420.84 last week.
It’ll take fortitude to profit from such diverging trends. First, you’ll have to invest in unfamiliar areas. In addition to small-company stocks, Farrell suggests midsize companies and the stocks of oil-drilling and service, cable, biotechnology, capital-goods and satellite-communications companies. Morgan Stanley’s Byron Wien recommends energy and basic-industry stocks.
Next, you’ll have to withstand a barrage of scary developments. It’s one thing when remote Latin American currencies wreak havoc on an investment niche. But it’s another when the sector taking the beating is one of the most public, all-American symbols on the globe. A steadily falling index would create a massive drumbeat of worry, not to mention spark a complete reversal of investment truths now held to be gospel. Actively managed funds would out-perform index funds. The market as a whole could gain while the indexes slump. And you can’t assume the market will go up forever. It may feel like inside-out thinking–but that’s what’s required when an investment strategy peaks. Because all fairy tales have to end sometime.
When investors pile into a corner of the market, stock prices rocket up. but history shows that there is plenty of excitement on the way down, too.
STOCK SECTOR YEARS RISE YEARS DECLINE Semiconductor 1992-95 555% 1995-96 40% Biotech 1989-92 350% 1992-93 55% Emerging Markets 1992-94 103% 1994-95 28% SOURCE: MERRILL LYNCH, MORGAN STANLEY CAPITAL INTERNATIONAL
Talk about unequal partners. The 53 largest stocks in the Standard & Poor’s 500 represent half of the index’s weighting. Here are the 10 heavyweights at the top of the list:
MARKET VALUE PERCENTAGE 3-YEAR ANNUAL STOCK IN BILLIONS OF S&P RETURN (%) General Electric $206.6 2.9 42.97 Microsoft 161.8 2.3 71.34 Exxon 152.8 2.2 33.5 Intel 151.3 2.1 82.67 Coca-Cola 146.3 2.1 39.44 Merck 110.7 1.6 44.22 Royal Dutch Petroleum 110.4 1.6 30.52 Philip Morris 109.6 1.6 40.78 IBM 102.6 1.5 48.31 Procter & Gamble 92.8 1.3 37.15 SOURCE: STANDARD & POOR’S
