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Yearly Review & Outlook

2002: Breakout --or Bust?

As 2002 dawns, the bulls are running again. But harsh experience has taught investors to watch their backs.


Just as the thought of staying in the stock market was becoming almost too much to bear for some investors, the fourth quarter arrived.

The rally that has lifted share prices since September has fanned hopes that the worst market decline in more than 25 years finally is over.

But the damage that has been done may take a long time to repair. Start with this harsh reality: With the market's slump since March 2000, even investors who've been in stocks for three years may have only losses to show for their efforts, as measured by average returns in key mutual fund categories.

The average large-stock "growth" fund, for example, rebounded 14.8% in the fourth quarter, according to fund tracker Morningstar Inc. Yet the annualized return for that category is a negative 3.2% over the three years ended Dec. 31.

It's as if investors have traveled a long and tortuous road and wound up back where they started, or even behind their starting point.

As 2002 dawns, however, the bulls are running again on Wall Street. The Standard & Poor's 500 index rose 2.1% in the first three trading days of the new year, padding its 10.3% price gain in the fourth quarter. Market optimists see share prices decisively breaking out to higher ground this year, assuming the U.S. economy is growing again after last year's recession and the Federal Reserve leaves short-term interest rates at 40-year lows well into 2002.

But if the last few years have taught investors one lesson, it's to be suspicious of glowing consensus forecasts. After all, Wall Street analysts almost uniformly believed Internet stocks were worth their sky-high prices early in 2000. And as recently as last summer, many of the most respected fund managers still considered now-bankrupt energy trading giant Enron Corp. to be a premier investment.

What's more, not one of the market strategists at the biggest U.S. brokerages foresaw the extent of last year's stock plunge, which left the S&P 500 index down 11.8% for the year (including dividends), the worst calendar-year loss since 1974.

Yet as share prices rebound nearly across the board, many of those same strategists are projecting double-digit gains for equity investors in 2002.

The favored sector of the late 1990s--technology--has led the rally since September, with the average tech-stock mutual fund up 36.8% in the fourth quarter, according to Morningstar. But the rally was broader than just tech: All but two of the 28 stock fund categories tracked by Morningstar rose in the quarter.

Still, the average tech fund lost 38.3% for the year. The average domestic stock fund slumped 10.9%, which, as in the case of the S&P 500 index, was the biggest calendar-year drop since 1974. In 2000 the average domestic stock fund fell 1.9%.

One strategist who is wary of the market's recent comeback is Tobias Levkovich at Salomon Smith Barney in New York. It is "somewhat disconcerting to see markets ... bounce back with the volatility and magnitude we've seen in the past 10 weeks, because it suggests that the investment community is still seeking the same kind of returns it once took for granted," he said.

Virtually every mutual fund manager now professes to be paying close attention to stock valuations--in other words, none of them wants to run the risk of overpaying for stocks relative to earnings potential. But so far, that hasn't stopped many investors from riding the market's new momentum, even as price-to-earnings ratios rocket again.

The average blue-chip stock is priced at more than 20 times analysts' consensus estimate of 2002 earnings per share. Even if that P/E is "fair," it still raises the question of whether a continuing rally this year could quickly make many stocks overvalued again.

Technology remains a worry for many fund managers.

"I think the economy has bottomed and it's possible we're already in recovery mode, but certain parts of the market have already anticipated that, perhaps overdoing it," said Brian Berghuis, manager of the T. Rowe Price Mid-Cap Growth fund.

"I'm not overenthusiastic about technology, where excesses in supply still need to be worked off and the valuations of some of these companies remain high," he said.

Berghuis said his fund, which lost 1% last year but has averaged gains of 9.6% in the last three years, remains underweighted in tech and communications. He noted that, historically, the leaders of one bull market don't normally lead the next one. Berghuis said he believes the health-care sector--and the biotechnology industry in particular--could be a key growth area in the next bull move.

For 2002, uncertainty over the strength of an economic recovery and corporate earnings, along with the risk of new terrorist attacks or other unforeseen global political traumas, mean that forecasting the market's near-term course may be as difficult as ever.

It could be a new bull market, as some predict. Or stocks could be stuck in a trading range--a cycle of rallies and sell-offs that leaves prices overall no higher a year from now.

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