Analysts Split Over Which Sectors Will Lead Next

Wall Street ought to win a big award for inclusiveness in 2003.

The equity market rally was good for just about every type of stock. Of 100 industry sectors within the blue-chip Standard & Poor’s 500 index, 96 rose last year.

On the New York Stock Exchange, 88% of shares gained for the year. On Nasdaq, 87% were winners.

But in 2004 investors are expected to become pickier about where they put their money. For those who believe the bull market has further to run, one key question is whether to stay with last year’s leaders -- or bet that new sectors and individual stocks will move to the forefront.

Here’s a look at the debates involving four principal market sectors:

* Cyclical stocks versus defensive stocks. “Cyclical” is Wall Street shorthand for companies whose sales and earnings trends are closely tied to the economy’s swings. “Defensive” generally refers to companies that post relatively steady sales and earnings growth, regardless of the economic backdrop.

Last year was a great one for many cyclical stocks, as investors anticipated, and responded to, the U.S. economy’s sharp acceleration in the second half.

Some of the standouts were heavy industry stocks in businesses such as chemicals, mining, steel and machinery. A Merrill Lynch index of 25 of those shares, including Dow Chemical Co., copper miner Phelps Dodge Corp. and U.S. Steel Corp., zoomed 32.6% for the year, beating the S&P; 500 index’s gain of 26.4%.

By contrast, defensive stocks in such industries as drugs, packaged food and household products attracted relatively little buying. A Merrill index of 34 of those shares, including Merck & Co., Campell Soup Co. and Colgate-Palmolive Co., was up 10.2% for the year.

It’s logical that investors would get excited about industrial stocks as the economy booms, because that’s the peak earnings environment for those firms.

But cyclical stocks performed better than defensive issues, on average, in 2001 and 2002 as well -- suggesting that some investors have for a while been betting on the economic pickup that now seems evident.

Can the cyclical sector stay in the lead in 2004? Richard Nash, chief market strategist at Victory Capital Management in Cleveland, argues that it makes sense to continue betting on industrial stocks including Alcoa Inc., International Paper Co. and Emerson Electric Co.

His reasoning rests in part on the assumption that the industrial economy will benefit from federal business tax incentives aimed at spurring capital spending. Those incentives, including the right to take big tax write-offs for capital equipment purchases, were passed by Congress in May and are set to expire at the end of 2004.

The sunset provision “should keep capital spending and the economy strong in the second half” of this year, Nash said. And that expectation should keep investors interested in cyclical stocks for the time being, he said.

His view is a popular one: A Merrill Lynch survey last month of 300 money managers worldwide found that most were maintaining hefty bets on industrial stocks.

That is making some market pros nervous that the majority opinion could be foiled.

Tobias Levkovich, equity strategist at Citigroup Global Markets in New York, said he’s still positive on cyclical stocks, but figures that more investors will begin to look to “rotate” to defensive issues by midyear.

Why? If investors figure that cyclical companies’ earnings could decline in 2005, the time-honored strategy would call for jettisoning the stocks well before a downturn begins.

Some money managers say they’re already siding with defensive issues.

John Thompson, who helps manage the Thompson Plumb Growth stock fund in Madison, Wis., owns such names as Pfizer Inc., Johnson & Johnson and Coca-Cola Co. The drug stocks, in particular, look good to him in part because he expects fewer big-name drugs to go off patent in 2004 and be subject to generic competition.

In general, Thompson said, he believes this year’s market will favor “big, high-quality companies” that took a back seat to more speculative issues in 2003.

What about technology stocks? They were stars in 2003 after plummeting from 2000 through 2002.

Many analysts see the tech sector in the same light as industrial stocks -- as classic cyclical issues. The difference is that many tech stocks, after last year’s rally, already are priced at high levels relative to expected earnings per share in 2004 and 2005. The question is how much more investors are willing to pay for the stocks, with memories of their bear market crash still vivid.

* Smaller stocks versus larger stocks. Thompson’s view provides a good segue to another major market debate: Can smaller stocks -- which are of course the majority of publicly traded issues -- continue to beat bigger names?

Standard & Poor’s index of 600 smaller names jumped 37.5% last year, compared with 26.4% for the blue-chip S&P; 500 and 25.3% for the Dow Jones industrials. That made it four straight years that smaller stocks have beat big names.

What’s more, investors’ interest in smaller stocks was global in 2003. In Tokyo, for example, the Nikkei over-the-counter stock index gained 42.8%, compared with a 25% rise in the Nikkei 225 blue-chip index.

The last four years reversed the market trend of 1994 through 1999, when big-name stocks ruled and smaller names lagged.

Because they often were ignored during the late 1990s, smaller companies found fans during the bear market as investors hunted for value in the market, analysts say.

In 2003, smaller stocks led because that has been typical in the first year of new bull markets: As money pours into the market in anticipation of better economic times, small companies often are favored because investors figure they have a better chance of posting surprising gains in sales and earnings than many bigger companies.

Some analysts believe smaller stocks are ready to fade after four years of besting bigger names.

It began to look that way in December: Blue chips trounced smaller stocks last month. The S&P; 500 jumped 5.1%, compared with 1.7% for the S&P; 600 small-stock index.

Tom McManus, chief investment strategist at Banc of America Securities in New York, is telling clients that the shift in leadership should continue.

“As the robust economic recovery trend matures into a more gradual expansion, we think the larger-capitalization, higher-quality companies are the ones that are better positioned to outperform in that environment,” he said.

Another potential plus for bigger stocks: Last year’s cut in the top federal tax rate on dividend income from 38.6% to 15% could attract more investors over time to dividend-paying shares, which tend to be bigger stocks.

But some market pros say investors, on balance, may still prefer to bet on riskier stocks, including smaller names, in 2004 rather than play it safer in bigger stocks.

Bernie Schaeffer, a veteran investor who heads Schaeffer’s Investment Research in Cincinnati, said one clue is that many mutual fund investors for most of last year were favoring funds that buy big-name, “value”-oriented shares, even though small-stock funds have performed far better.

Those investors may be primed to take on more risk in the new year, he said.

Schaeffer also said he believed that many institutional investors were loaded up with big stocks even though those issues had underperformed smaller stocks for four years.

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Index performance

How key stock indexes performed in the bear market period of 2000 through 2002 and their gains in 2003:

*--* Pctg. change: Index 2000-02 2003 Nasdaq composite -67.2% +50.0% Russell 2,000 -24.1 +45.4% S&P; small-cap -0.6 +37.5% S&P; mid-cap -3.3 +34.0% Dow transports -22.4 +30.2% Wilshire 5,000 -39.6 +29.4% S&P; 500 -40.1 +26.4% Dow industrials -27.4 +25.3% Dow utilities -24.1 +24.0%

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Source: Bloomberg News