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'Divergences' Offer a Timely Lesson: Stay Diversified

April 21, 1996|TOM PETRUNO

Perhaps the most basic investment advice is to have a well-diversified portfolio. Rarely do you get to see the wisdom of that demonstrated as vividly as this year.

U.S. blue-chip stocks soared early on, but in recent weeks they have been sharply outrun as market leaders by small-company issues.

Many foreign stock markets, meanwhile, have been rising faster than the U.S. market for the first time since 1993, with hefty share gains recorded so far in countries as diverse as Mexico, Germany and Taiwan.

On the downside, many U.S. bond investors have lost money, at least on paper, as market interest rates have surged, devaluing older bonds. But the losses have been uneven: Municipal bond owners are faring much better than Treasury bond owners, for example.

And across the broad spectrum of markets, few investors have won bigger this year than those who bet on a resurgence in prices of "hard assets" such as oil, grains and precious metals. Mutual funds that focus on such natural-resources stocks have gained 15.3% so far in 1996, on average, compared with a 6.6% rise for the average general stock fund.

In Wall Street parlance, this is shaping up as a year of wild "divergences" among markets. Which is just another way of saying that there is a lot of zigging and zagging among investments, and that the linkages one usually expects to see between certain markets aren't necessarily there.

The U.S. stock market, for example, has steeled itself remarkably against the surge in bond yields this year--a surge that, in years past, might have proved devastating.

But in some cases the linkages between markets are in fact very strong, if subtle. The Mexican stock market, for example, has rocketed 20% since March 8--which coincidently was the day the U.S. reported a shockingly huge gain in jobs in February, signaling that the American economy was rebounding smartly. For Mexico, still mired in recession, the most encouraging development naturally would be stronger growth for its principal trading partner.

On Wall Street, the performance split between big-company stocks and small-company stocks is partly a function of the dollar's surprising gain in value this year against key foreign currencies like the Japanese yen.

A stronger dollar is potentially bad news for big multinational firms because it can depress their overseas earnings (those weaker foreign currencies translate into fewer dollars when repatriated by the companies).

Because smaller U.S. companies often are more focused on the domestic economy, and thus are less vulnerable to currency fluctuations, some investors are bailing out of big-name stocks like Boeing and Coca-Cola in favor of smaller names. Hence, the Russell 2,000 index of smaller stocks jumped 2.2% last week to a record while the blue-chip Dow Jones industrial index was virtually unchanged.

Some of this horse trading among market sectors is merely reactionary and not well thought out. Plenty of smaller American companies are just as dependent on foreign business as major blue-chip companies. And many multinational companies protect their foreign earnings against currency shifts by using currency options or futures contracts to hedge.

Nonetheless, fighting market trends once they begin to snowball is usually a loser's game. If Wall Street is turning positive on smaller stocks, the simple fact that smaller issues have on balance lagged blue chips for the past two years suggests that many investors may now scramble to get aboard the small-stock train.

The same temptation to chase what's hot afflicts individual investors, of course. And as markets diverge, you can easily become distracted by streaking stock sectors, foreign markets and specialty mutual fund groups, raising the risk that you will plunge willy-nilly into investments without a logical long-term plan.

Which brings us back to the original point about portfolio diversification: If you permanently own a piece of each of the major equity market subgroups--big U.S. stocks, smaller U.S. stocks and foreign stocks--you won't have to chase them at times like this. You'll already be there.

Over the last two years, it has been easy enough to be happy owning nothing more than a blue-chip U.S. stock fund. Those shares held up well in 1994, when smaller stocks and foreign shares dived. And U.S. blue chips outgunned most other stocks last year: The Standard & Poor's 500 index, a broad blue-chip index, soared 34.1% in 1995, its best calendar-year return since 1958.

But now "the U.S. stock market has a lot to contend with," argues Steven Nagourney, global investment strategist at Lehman Bros. in New York. Interest rates are up and are threatening to go higher as the economy picks up speed; earnings growth, at least for many large companies, is slowing as the benefits of corporate restructurings of recent years wane; and the dollar is flexing its muscles again.

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