Small, Mid-Size Issues Overtake Blue-Chip Stocks

Look who’s coming up in the world . . . finally.

Small and mid-size stocks have been outperforming their blue-chip brethren in recent weeks, even as the Dow Jones industrial average has stolen most of the publicity with its rise above the 8,000 mark.

The Nasdaq composite index of mostly smaller stocks jumped 11.12 points to a record 1,605.45 on Monday, bringing its gain since July 1 to 11.6%.

By contrast, the Dow average, which inched up 4.41 points to 8,198.45 on Monday, has gained 6.2% since July 1. The other blue-chip mainstay, the Standard & Poor’s 500 index, is up 6.7% in the period.

And while the Nasdaq index is skewed by moves in its biggest stocks (such as Intel and Microsoft, neither of which are small-company issues, of course), the resurgence of small and mid-size stocks is confirmed by other indexes that are fairly pure benchmarks of those sectors--which, it’s worth remembering, comprise the vast majority of stocks in the U.S. marketplace.

For individual investors, the proof is in their mutual fund portfolios: The average small-stock mutual fund was up 5.4% in the four weeks ended last Thursday, versus a 4.1% gain for the average S&P; 500 index fund, according to fund tracker Lipper Analytical Services.

And since May 1, the average small-stock fund is up 24.5%, a tidy 4.7 percentage points more than the average S&P; fund.

All of this means that the better performance of smaller stocks that began in late April--after a lousy second half of 1996, a dismal first quarter of 1997 and a scary pullback in March and early April--has been sustained.

“Instead of a couple of terrific weeks, emerging-growth stocks have beaten the larger-cap indexes in nine of the past 12 weeks,” L. Keith Mullins, emerging-growth stock strategist at brokerage Smith Barney in New York, noted in a report to clients July 25.

“Such consistency strongly suggests that the newfound attraction to the sector has some staying power,” he said.

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What’s more, Mullins and other small-stock proponents argue that this latest advance is broad-based, not tied to the gains in a mere handful of small stocks.

“Each of the seven [industry] sub-sectors that comprise our growth stock index has beaten the big-cap averages over the past three months,” Mullins said.

Another bull on the smaller-stock sector is Ralph Acampora, Prudential Securities’ technical markets chief, who is perhaps best known for his cheerleading on behalf of the Dow index. (He called the move through 8,000 and now sees the blue-chip index heading to 10,000 by next June.)

The big-name stocks in the Dow, including such issues as General Electric, Coca-Cola and Merck, have led the market since 1994, but their popularity really began to mushroom after last summer’s sharp market pullback, Acampora notes.

While the Dow index slumped about 10% in that market decline (which was triggered by worries about rising interest rates and weaker corporate earnings growth), small-stock indexes such as the Nasdaq composite and Russell 2,000 fell 20% in less than three months’ time, Acampora points out.

He thinks that that abrupt dive in smaller stocks was deeply disturbing to many institutional and individual investors, and convinced many of them to forsake those “secondary” issues for the relative safety of blue-chip giants.

“In our opinion, secondaries truly languished late last year and early this year simply because they were the source of so many bad memories for everyone,” Acampora said.

Now, however, “we believe that these horror stories are quickly fading into the past,” he said, and he believes investors are once again hunting for attractive stocks in the small and mid-cap sectors.

Well, nobody ever accused Wall Street of having a terribly long memory. But as a technical analyst, Acampora watches stocks’ movements on charts. He doesn’t pay much attention to the underlying fundamentals--and they have been a factor in small stocks’ lagging performance.

Many smaller companies simply have been unable to generate the strong and consistent earnings growth that has become an endearing trait of blue-chip multinationals in recent years.

It isn’t as if smaller companies aren’t making money. But their results, on balance, haven’t impressed investors all that much. These companies may be bearing the brunt of the profit-margin pressures exerted by the ultra-competitive U.S. and global business environments.

Small-stock fans concede that may be true. They also contend, however, that the stocks’ lagging prices for the last few years have left them looking cheap compared with blue-chip stocks now sporting price-to-earnings multiples of 30, 40 or higher.

“At current valuations, history would loudly argue that emerging- growth stocks can do well even if the market declines from its recent surge over several months,” Mullins said.

In other words, he thinks that if pricey blue-chip stocks pull back modestly, and slowly, money will naturally continue to seek out promising stocks from among the thousands of smaller issues.

Some Wall Street strategists, however, make the case that even if smaller stocks are less expensive (relative to earnings) than blue chips, they’re not exactly at bargain levels.

“Small-cap stocks look undervalued compared to the S&P; 500, but we do not believe the sector is cheap,” said David Shulman, strategist at Salomon Bros.

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What’s the individual investor to make of this debate?

Basic diversification rules say you should always have some portion of your portfolio in small and mid-size stocks. If you don’t, this may be as good a time as any to make that diversification move--or to “rebalance” a portfolio that has become top-heavy with blue-chip stocks or stock funds.

(A guide to picking small-stock funds appears on D6 today.)

But remember where we may be in the market cycle: This bull market is already nearly 7 years old. When a true bear decline finally arrives, it will most likely devastate higher-risk smaller stocks, because bear markets always do.

That means you shouldn’t be investing any money in smaller stocks that you can’t leave there through the next bear market and into the following bull market. And we could be talking about many years here, from this market cycle through the next two.

While this bull market is still kicking, however, there is a very good argument that it won’t end until small and mid-size stocks attract a much wider following.

What we’re really, saying, of course, is that the speculative fever that has swept blue chips higher ought to spread to the broad market as well. We’ve seen episodes of this in the past--as recently as May 1996. They just haven’t lasted very long for smaller stocks.

Could the last few months be signaling a sustained uptrend in smaller issues?

“We see this shift into secondaries as a normal and integral part of the whole bull market process,” Acampora said. “If we are correct, we have many profitable months ahead of us.”

Briefly: One missing ingredient for market bears who would like to believe that stocks are ready for a meaningful correction: Bullish sentiment on the part of investment newsletter writers has been declining for the last six weeks.

As the Market Barometers chart on this page shows, 45.2% of newsletter writers surveyed weekly by Investors Intelligence of New Rochelle, N.Y., are outright bullish now, while 27% are outright bearish and 27.8% expect a short-term correction.

Since mid-June, the percentage of bullish writers has fallen from 48.3%, while the percentage of writers either bearish or expecting a correction has risen from 51.7% then to 54.8%.

Historically, the bullish consensus has often functioned as a good “contrary” indicator: It’s usually when bullishness is rising that the market fools the majority and heads in the other direction--as it did early this year, when the bullish count reached nearly 55% just before stocks began to slide in mid-February. . . .

. . . Dividends may become less important to many investors in the wake of the new tax law, which favors capital gains. Even so, companies were a little more generous with dividends in July: A total of 168 companies raised dividends last month, up 13% from July 1996, Standard & Poor’s says. That marked the first monthly increase since March. . . . Is Porsche a bull-market beneficiary? The company said its U.S. car sales have doubled so far this year.

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Smaller Is Better, Again

Key indexes of small- and mid-sized stock performance have been running well ahead of big-stock indexes in recent weeks, continuing the trend in place since late April. Year-to-date, however, big stocks still have a commanding lead over small and mid-sized issues.

Small and Mid-Cap Stock Indexes

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Change since: Year- Index May 1 July 1 to-date S&P; mid-cap +22.1% +8.9% +23.3% S&P; small cap +23.3% +7.0% +18.5% Lipper mid-cap fund +22.7% +5.9% +17.7% Russell 2000 +20.2% +5.5% +14.6% Lipper small-cap fund +24.5% +5.4% +15.7% Lipper micro-cap fund +26.3% +5.3% +16.4%

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Big-Stock Indexes

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Change since: Year- Index May 1 July 1 to-date S&P; 500 +19.0% +6.7% +28.3% Dow industrials +17.5% +6.2% +27.1% Lipper growth fund +20.9% +5.3% +24.1% Lipper growth-inc. fund +18.5% +4.3% +24.0% Lipper S&P; index fund +19.8% +4.1% +29.7% Lipper equity-inc. fund +16.9% +3.5% +22.1%

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Stock index data is price only (not including dividends).

Fund data, which includes dividends, are through last Thursday.

Source: Lipper Analytical Services; Times research