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Mutual Funds: THIRD-QUARTER REVIEW FOR INVESTORS : STOCK FUNDS : Summer Left Them Tanned and Rested, but Now What?


Wall Street's surprise summer rally pulled most stock fund owners' feet out of the fire.

The average general stock fund jumped 5.7% in the third quarter ended Friday, after tumbling 5.8% in the first half of the year, according to Lipper Analytical Services in New York.

As a result, the typical U.S. stock fund is down just 0.5% year to date--hardly the bear market casualty that some investment pros had expected to see by now.

Foreign stock funds that target emerging markets also saw a big comeback in the quarter, rising 18.5% on average after a 12.6% dive in the first half.

General international funds, meanwhile, gained 3.4% in the quarter and are up 3.2% for the year. That means they're well on their way to a second consecutive year of beating the average U.S. stock fund.

Among other fund categories:

* Gold funds rebounded 15.3% in the quarter on average, after slumping 11.4% in the first half. Economic growth has fanned inflation worries, always good for gold.

* Small-company funds were up 8.6% for the quarter, leading the market up just as they led it down in the first half.

* Health care funds soared 14.0% on average, responding in part to Congress' inability to enact health care reform this year.

* Japanese stock funds were the only big losers in the quarter, down 6.5% in profit taking after a 28.6% first-half gain.

While surging interest rates had knocked the U.S. stock market to its knees in winter and spring, buyers took control again in summer. The market rallied even as rates rose further.

Stock fund investors themselves were greatly responsible for the summer comeback: Despite wild market swings this year, investors have continued to pump cash into funds at a strong pace.


Yet many on Wall Street contend that stocks are defying gravity. Long- and short-term interest rates are two full percentage points higher today than at their 20- to 30-year lows 12 months ago.

Meanwhile, the Standard & Poor's 500-stock index, at 462.69 on Friday, is only marginally below its year-ago level. Historically, rising interest rates often prompt investors to significantly cut the prices they're willing to pay for stocks. Not this time.

As a result, "the stock market is way ahead of itself in valuation," says Michael Lipper of Lipper Analytical.

Wall Street bulls have another view: that investors are responding to rising corporate earnings as the economy grows. Though stock prices are roughly even with those of a year ago, higher earnings this year mean prices are lower versus earnings, thereby offsetting some of the effect of rising interest rates.

Still, even the optimists say that if the latest surge in interest rates does not reverse soon, stocks could be headed for new trouble.

"The tension between the bond market and the equity market has yet to be resolved," said Stephen Doyle, head of Montgomery Asset Management in San Francisco.

If rates go higher from here, of course, stocks could tumble again. If rates fall, stocks may rally--unless investors fear a recession.

One big bull is Ron Elijah, whose San Francisco-based Robertson Stephens Value Plus fund is up 16.3% this year thanks to well-timed investments in health care and technology stocks.

He compares this year's overall flat market to 1984, when worries about inflation and rising interest rates gripped investors and stocks stalled after rocketing in 1982 and '83. But as economic growth moderated in 1985, rates came down again and the bull market resumed, Elijah notes.

Lipper has a different forecast. He sees a good chance that the market won't accommodate the bulls or the bears anytime soon. Imagine, for example, if interest rates rise slowly with the expanding world economy in 1995 while corporate earnings also advance.

"The economic function of the market is to create humility," Lipper said. If the market careens through periodic rallies and selloffs but in the end makes little progress, "it will frustrate the hell out of the bulls and the bears." Such a prolonged comeuppance for both camps may be overdue, he says.

For fund investors looking for new opportunities, the way to play that kind of environment would probably be to continue to buy on the selloffs--a strategy that worked well in the third quarter with emerging-market, small-stock and gold funds in particular.

In addition, if U.S. stocks on average can't get their motors revving, long-term investors will increasingly look for alternative stocks.

Ken Gregory, editor of the No Load Fund Analyst newsletter, says he is advising clients with a two- to three-year time horizon to focus new investment in funds that target emerging markets, international small stocks and real estate issues--all areas that he believes should outperform U.S. stocks.

For investors in general U.S. stock funds, this is one period when looking to recent fund standouts may not be a bad strategy. Managers who do well in this push me-pull you market are either very smart or very lucky or both.

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