The Stress Is Just Beginning

(By Spencer Platt -- Getty Images)

Early last year, the U.S. stock market rallied on shares of small companies and stocks that money managers believed were undervalued. Stocks hit record highs despite a drop in quarterly earnings growth to single digits for the first time in four years. Many overseas markets also rose.

By midsummer, volatility hit the stock and bond markets as the problem in U.S. subprime mortgages developed into a credit freeze. The mortgages, made to home buyers with poor credit, had been pooled by Wall Street investment banks; packaged into billions of dollars of complicated securities; and sold to financial institutions, hedge funds and pension funds around the world. Financial shares took a nose dive, as did economically sensitive consumer discretionary stocks, which include issues by textile, leisure-equipment and apparel companies.

Unsure about who exactly was holding the deteriorating mortgage-related assets, fearful investors sold off risky securities of all types and headed for shelter in investments such as U.S. Treasury securities.

Central banks in the United States, Europe and Asia responded by pumping billions into the financial system as the cost of borrowing for many consumers and businesses rose. In September, the Federal Reserve reduced its benchmark short-term interest rate for the first time in four years and continued cutting through the remainder of the year.

Stock markets, helped by the policy moves and some encouraging economic data, appeared headed for a recovery in the fall. But it wasn't to be. Share prices plunged again in the final months of the year as one Wall Street bank after another revealed further losses from mortgage-related securities on its balance sheet. Questions arose about just how well capitalized the banks were; the interest rate charged between banks rose globally, illustrating their unwillingness to lend.

Against this backdrop, large-cap stocks, or shares of large companies, began outperforming small-cap stocks in the second half of the year after spending the last several years in their shadows. Large companies are thought to be able to better weather economic downturns.

The shift became apparent in mutual fund returns. Funds that invest in growth-oriented companies overtook so-called value funds. For the year, large-cap growth funds gained 14.2 percent, compared with 8.7 percent for small-cap growth funds, according to Lipper Inc., which provides fund information and analysis. Large-cap value funds, on the other hand, gained 2.3 percent in 2007, while small-cap value funds shed 5.6 percent.

One reason for the shifts, analysts said, is the end of the leveraged-buyout boom, in which private-equity firms, fueled by the availability of cheap credit, bought record volumes of companies. The buyout targets were often small and mid-size value companies, purchased at a hefty premium. When buyout firms swooped in, the shares of the target companies climbed, inflating their market performance. Some $331 billion in such deals was announced in the first half of 2007, compared with $107 billion in the second half, according to Dealogic, which provides merger and acquisition data.

Investors increasingly favored large multinational corporations, because they are seen as better positioned to take advantage of stronger overseas economies. Small companies, on the other hand, are thought to have a harder time accessing credit in a shrinking economy.

As a whole, U.S. diversified equity funds gained 6.3 percent for the year, despite a lackluster fourth-quarter performance (a loss of 3.1 percent), Lipper said. The Standard & Poor's 500-stock index, a benchmark for many mutual funds, returned a modest 5.5 percent, assuming the reinvestment of dividends.

Helped by rising commodity prices, funds that invest in natural-resources companies did best, returning 39.7 percent for the year; unsurprisingly, funds that invest in real estate and financial services companies fared the worst, with losses of 14.8 and 13.2 percent respectively, according to Lipper. By any measure, those are dismal returns for funds that had average returns of 17.7 and 10.1 percent for the past five years.

So what's a small investor to do now?

For at least the first half of 2008, many money managers expect the shifts in trends to continue, with growth stocks and large-cap stocks outshining small and value shares. Investors, they say, would do well to stay away from financials and consumer-discretionary stocks such as home builders and auto companies.

And while investors shouldn't expect the double-digit-percentage returns seen in many emerging markets in recent years, some analysts said now may be as good a time as any to increase foreign stock holdings. A long-term outlook and an emphasis on diversification are key, they said.

"In the current market environment, in which the U.S. economy is sputtering, you're probably better off owning securities outside the U.S. market," said Coffelt of Empiric Funds. His fund, Coffelt said, is now made up of 60 percent overseas stocks and is shorting, or betting on the decline of, domestic financial and consumer discretionary stocks. "Russia, Brazil are still great places to invest. South Korea is a great place. . . . Obviously, you're not going to keep getting 30, 40, 50 percent gains, but I think over time they should do better than the U.S. market."