Unexpectedly Upward Bound

Big-Company Stocks Make a Strong Showing in a Traditionally Weak Period

(BY Philippe Lecchein for The Washington Post)

Many things came up roses for the stock market in the third quarter: The Federal Reserve stopped raising interest rates, oil prices fell sharply from their record highs, and the long-anticipated residential housing market slowdown has not been as bad as some feared.

Taken together, all three developments raised hopes that consumers will still have money to spend, businesses will have access to cheaper energy and capital, and the economy will continue to grow, albeit more slowly, rather than sliding into a recession.

The rule of thumb for the three months ended Sept. 30 was the bigger the company, the better it fared. The Dow Jones industrial average, made up of 30 of the bluest of blue-chip stocks, added 4.74 percent in the period and surpassed its previous record-high close set in January 2000 just a few days into the fourth quarter. The Standard & Poor's 500-stock index, made up of the 500 largest widely traded public companies, shot up 5.17 percent. Those results are all the more surprising because the third quarter is historically the weakest.

By contrast, smaller companies, which led the markets in 2004 and 2005, have slowed down. The Russell 2000 index, made up of small and midsized companies, barely rose at all, closing 0.13 percent higher at the end of September than it did in June. That's a fairly typical cyclical pattern, analysts said. Small companies have the highest growth potential, so they often do best in rapidly rising markets, whereas larger companies with more-stable earnings tend to improve when growth slows.

Breaking down the quarter's performance by market sector shows that health-care, telecommunications and information technology companies led the way. Those three sectors of the S&P 500 all gained more than 8 percent in the third quarter. Health-care stocks tend to do well when investors think the economy is fading because health care is something consumers can't do without, and telecommunications has done so badly for so long that those stocks are still relatively cheap.

The big corporate winners tended to fit into that pattern. Drugmaker Pfizer Inc., which forced out its chief executive during a controversy over his retirement package, was the single largest contributor to the increase in the S&P in the third quarter. It rose nearly 21 percent. Microsoft Corp. (up 16 percent), AT&T Inc. (up 17 percent) and Apple Computer Inc. (up 33 percent) weren't far behind. General Motors Corp., which is trying to make a turnaround after years of trouble, also thrived, gaining 13 percent in the quarter.

The losing sectors included industrials (think air freight and construction), materials (steel, gold, aluminum) and energy. They were hurt by falling commodity prices as well as the slowing economy. Oil prices, which climbed close to $80 a barrel for light crude this spring, have now fallen below $60.

The single biggest drag on the S&P was delivery company United Parcel Service Inc., which issued a warning in July that its growth would slow along with the economy. UPS fell 13 percent. Oil and oil services companies ConocoPhillips (down nearly 11 percent) and Halliburton Co. (down almost 23 percent) and manufacturer 3M Co. (down 8 percent) also hit rough patches.

Many market watchers have hopes for a continued rally in the rest of the year. Traditionally, the stock market does well in the fourth quarter, and the trend is even more pronounced in mid-term congressional election years.

"The one thing the market hates is uncertainty, and we're uncertain just who is going to be leading the Congress," said Al Goldman, chief market strategist for the brokerage firm A.G. Edwards. "I'm looking for some pullback in the next few weeks, and then a pretty good year-end rally. . . . If an investor is sitting on some cash, I would keep hands in pockets . . . and stay on the sidelines until the end of October."

Full disclosure: Those same historical statistics predicted that the third quarter would be a money-loser, and we all know how that one turned out. Advocates of historical trends argue that the evidence for a fourth-quarter rally is far stronger than it was for a third-quarter downturn -- the market has gone up in 16 of the past 18 fourth quarters.

That optimism should be taken with a grain of salt, market analysts said. Investors who have been sitting on the sidelines should be cautious and not rush into areas simply because they have had good results recently. Small investors are typically so late to the party that bullish sentiment among them is considered one of the best predictors of a market correction.

"Putting your money in something that has done well is an emotional decision. It's not an investment decision. That's how you do serious damage," said Stephen P. Wood, senior portfolio manager for Russell Investment Group.

Instead, investors should consider this a good moment to rebalance their portfolios. That's market slang for making sure that the ratio of money an investor has in stocks versus bonds, and small-company stocks versus large-company stocks, returns to the original investment plan. The process almost always involves selling some of the stocks and funds that have done well and putting the money into areas that have lagged. "If there's been really good performance, then it's a cautionary sign," Wood said. "If it [the good performance] is unexplained, then it's a red flag."

Looking ahead, many market watchers foresee choppy seas but not necessarily a big storm. The economy is clearly slowing down after four years of rapid expansion. Fed Chairman Ben S. Bernanke remarked last week that the housing slowdown might chop a full percentage point off economic growth. But most analysts aren't expecting a full-blown recession, and stocks remain cheaper in comparison with corporate earnings and other investments than they were before this economic cycle started.

Jerry Webman, chief economist for OppenheimerFunds Inc., said this kind of market is more challenging because not all companies will be winners. "The tide is not going to raise all ships. . . . Investors should look for quality and the ability to grow earnings [in a slower economy]. As the economy gets more selective, it's more and more important to be a stock picker, whether you do it yourself or pay [a mutual fund manager] to do it for you."

If control of the House of Representatives turns over, a Democratic ascendancy could create opportunities in some sectors and new hurdles in others, said David M. Darst, chief investment strategist for Morgan Stanley's individual investor group.

Generic drug manufacturers, renewable-fuel makers and the government-backed mortgage companies Freddie Mac and Fannie Mae have traditionally received support from Democrats, Darst said. Coal mining and oil companies, as well as defense contractors, could experience a loss of patronage if the Democrats win more control.

"This is not necessarily a negative or a positive but something that investors should keep in mind," he said.