Wake-Up Call!

That sound investors hear may be the two-bell signal reminding them it’s time to disembark from the 1990s.

After a decade of mostly phenomenal returns in the U.S. stock market, the second quarter and first half of this year were a jarring reality check.

The volatility on Wall Street was in many respects unprecedented, in an environment that saw the bull market’s historic nemesis--the Federal Reserve--aggressively raise interest rates to slow the economy, and perhaps to teach rampaging stock speculators a lesson.

It worked: The wild gains in technology stocks in the first quarter gave way to the worst crash in that sector since the mid-1970s, driving the Nasdaq composite index down 37.3% from its March peak to its May low.

But perhaps more surprising to many investors was the struggle of the blue-chip Standard & Poor’s 500 index.

After managing a 2.3% total return in the first quarter, the index gave that up and slightly more in the second quarter, leaving it down 0.5% for the first half.

There are still six months to go in 2000, of course. Even so, investors who’ve grown to trust those 20%-plus annual returns generated by the mighty S&P; index in recent years may well be wondering whether the streak is in the process of being broken.

As the accompanying stories in this section discuss, a lot of assumptions about future wealth will have to change if the S&P; doesn’t do in this decade what it has done in the recent past.

Yet the irony of the S&P;’s slack performance in the first half was that many other segments of the stock market did OK in spite of--or because of--blue chips’ woes and the sudden lack of confidence in the tech sector.

Indeed, the average domestic stock mutual fund was up 3.5% for the half, despite a second-quarter dip. Nearly 58% of domestic funds tracked by Morningstar Inc. beat the performance of the S&P; index in the half.

By contrast, from 1995 through 1998 the index beat 80% or more of actively managed funds in each of those years.

Many investors rediscovered in the first half of this year that there were other stocks out there, and plenty of them.

Smaller and mid-size stocks staged a surprising first-quarter rally and gave back only a portion of it in the second quarter.

High-dividend-paying real estate investment trust shares rocketed after being ignored by most investors for the last three years.

Drug and biotech stocks were among the hottest shares, amid new excitement over prospects for drug discoveries. Indeed, the list at right of the best-performing stock funds in the quarter is dominated by health funds.

Many energy shares also rallied, as oil and natural gas prices zoomed, thanks to robust demand and dwindling fuel inventories.

And “value” investing--buying shares of companies whose stocks are often dirt-cheap relative to underlying earnings--staged a comeback.

In the second quarter alone, just one broad stock fund category managed to produce positive returns: depressed small value stocks. The average fund in that sector was up 0.8% in the quarter, and 5.4% for the half.

Imagine: buying stocks because they’re cheap, as opposed to just because they’re going up--the latter, of course, being the strategy followed by so many tech stock buyers in the go-go first quarter.

Could the 1990s finally be over, in terms of the financial market trends many investors came to view as their birthright?

When this decade is over, will the stock markets’ performance results look quite different than what we knew in the “nirvana” environment of the ‘90s, with its rock-bottom inflation, falling interest rates (for much of the time), soaring corporate profits and tumbling unemployment?

Many Wall Street pros, understandably, are unwilling to suggest that the markets’ party is over.

For example, Jeffrey Applegate, investment strategist at Lehman Bros. in New York, says there’s no compelling reason to believe that the dominance of technology companies, and their stocks, over the last few years is at an end.

“We’re still at the advent of the virtual economy,” Applegate says. While investors may for good reason have turned away from many money-losing e-commerce companies, that doesn’t change the fact that “we’re going to need more bandwidth, more computer [memory] storage, more routers, etc.” as the Internet infrastructure continues to be built out worldwide, he says.

He expects the S&P; index, led by technology shares, to rise sharply over the next 12 months, in large part because he believes that the Fed is finished with its year-long credit-tightening campaign.

But other investment pros are less sanguine. They point to the surprising surge in energy prices in the first half, and upward pressure on other prices, as signs that the Fed may be justified in harping repeatedly that inflation pressures have been building.

The Fed, in holding rates steady at its meeting last week, showed it’s willing to wait for more evidence that the U.S. economy is easing, and with it inflation.

Yet some experts say it’s wise for investors to use the first-half market shakeup as an excuse to review their overall investment strategy, asset allocation, return expectations--and whether their portfolio can be expected to withstand whatever new shocks may lie ahead.

As the stories in this section point out, autopilot investing may have worked fine in the last five years. Much of what happened in the world benefited the U.S. economy and its markets. Even the bombs that did hit our market failed to produce long-lasting damage.

Will we continue to be so lucky--to the tune of 20%-plus annual returns on blue chip stocks?

What happens if the economy slows more than expected, threatening corporate profits?

Or what happens if growth zooms again, bringing the Fed out firing with both barrels, pushing interest rates much higher?

Needless worries? Not to Doug Cliggott, investment strategist at J.P. Morgan Securities in New York. “I don’t think we know how slow economic growth is going to get, or how high inflation is going to get,” he says, noting that history demonstrates that inflation pressures can continue to build even after an economic slowdown has begun.

Charles Crane, a money manager with Spears Benzak Salomon & Farrell in New York, views the volatile first half of this year on Wall Street as the product of a great storm stirred up by the Fed, inflation concerns, absurd speculation, the bursting of the “dot-com” bubble and other factors.

What we don’t know, he says, is whether the last month or so, with the rebound in Nasdaq and markets’ general calm, reflects that we’re out of the storm--or just in its eye for the time being.

That may be the reason many investors remain wary of certain stock and bond sectors that performed brilliantly in the ‘90s, including the financial services sector and junk bonds, but which now run the risk of becoming prime casualties of a dicier economy.

As investors think about their personal portfolios, financial advisors say the most important consideration ought to be the simple issue of diversification.

What the first half of this year demonstrated was that, even in an environment where the former stars (blue chips and tech stocks) struggled, there was still money to be made in many other market sectors.

That may not last, of course: A severe bear market could take everything down.

Still, the investor whose assets have grown concentrated in U.S. blue-chip stocks in recent years may want to consider whether a prudent move would be to shift some money into sectors that haven’t done nearly as well as the S&P; 500 over the last three to five years.

The concept of “regression to the mean” holds that financial returns that get too far from their historical norms tend to find a way back.

That could be a painful journey for the S&P.;

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Tom Petruno can be reached by e-mail at [email protected].

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New Era?

The blue-chip Standard & Poor’s 500 index lost ground in the first half of the year, after recording five straight years of double-digit gains.

Annual total returns and first-half 2000 total return:First half of

2000: --0.5%

Note: Total return is price change plus dividend income.

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Source: Morningstar Inc.