Look for Plenty of Action in Second Quarter

Ready for the second quarter? Considering how wild the first quarter was for stocks in particular and financial markets generally, investors might prefer a little breather. Not much chance of that, though.

Here is a look at investment trends that took shape in the first quarter and what they could mean for the next three months and beyond:

* Stock Funds Zoom: When the quarterly mutual fund statistics are released this week, they’ll show that the average general stock fund soared about 17% in the first quarter. In contrast, the return on the Standard & Poor’s 500 index, including dividends, was about 14.6%.

What does that mean? Well, the S&P; 500 index is considered the “market” return, the benchmark. So the average stock fund will have beaten the market by about 2.5 percentage points. That rarely happens; in fact, the last time the funds did better than the market in a period of rising stock prices was first quarter 1988.

That means the funds will get a lot of positive media attention. Which means they’ll attract a lot of new money, most likely. And that bodes well for the stock market overall, because those fund managers will have to find a place for those dollars.

* ‘Small’ Still Looms Large: Small stocks stole the show in the first quarter. The NASDAQ composite index of about 4,000 smaller issues jumped 29%, versus a 10.6% gain for the Dow Jones industrial average. And the average small-stock mutual fund was up 25.6%.

Chalk up another reason a ton of new money should soon flow to mutual funds, says Harvey Eisen, president of fund company SunAmerica Asset Management in New York. True, he’s got a vested interest in that happening, but Eisen says his point of view is based on pure logic.

For the typical investor who believes that we’re on the verge of a prolonged turnaround in small stocks--after their below-average performance for eight years--the danger in trying to buy individual small stocks is too great, Eisen says. “It’s much harder for the individual investor to compete in that arena,” he argues. The funds, on the other hand, offer an easy way in, and at much lower risk because your money is spread over a large number of small stocks.

There now are 87 mutual funds that specialize in small stocks.

* Too Many Bulls? The bears argue that, once again, too many investment advisers are bullish. When that’s the case, the market often does the opposite of what the majority expect, the bears note.

But take a look: Right now, 50.4% of the 135 investment newsletter writers polled weekly by Chartcraft Inc. are bullish. At the start of the year, only 43.5% were bulls.

Yet in January, 1987, the bullish reading was 64.6%--and the market went up for seven months thereafter.

Still, it’s true that the odds of a temporary setback in stock prices are greater when bullish advisers are in the majority. That’s a good argument for easing into the market now rather than barreling in.

* Where’s the Value? Another argument of the bears is that stock prices are too high relative to corporate profits (which, of course, ultimately are what drives stocks). At the start of the first quarter, the average stock in the S&P; 500 sold for 15 times the previous four quarters’ earnings per share.

Now, with the market’s rise, the S&P; 500 price-to-earnings ratio, or P-E, is 18. By 1970s and 1980s standards, that P-E is indeed high.

But David Dreman, whose $4-billion Dreman Value Management in New York is one of the best-known value stock pickers, notes that 1990 corporate earnings numbers were hurt by another round of one-time writeoffs at many companies. Adjust for those writeoffs, and the market P-E is closer to 15 now, he says.

Isn’t that still high? Some analysts have argued that we’re headed back to a 1960s-type market in the ‘90s--volatile, but highly rewarding of stocks that post healthy earnings growth. If that’s the case, the bulls may not show any fear of current P-E ratios. From 1958 to 1972, the S&P; 500 average P-E on adjusted earnings was almost consistently in the 15 to 18 range.

Where’s the Value, Part II: Dreman says he still finds plenty of value in the market. “Even with the first-quarter rally, a lot of stocks are still awfully cheap,” he says. Federal National Mortgage, for example, has jumped to $45.50 from $35 at the start of the year. But the current price is only 10 times 1990 earnings per share, he says. Why leave a stock like that? Dreman asks. “Our philosophy is just to stay with these issues,” he says. Likewise, he still feels good about Philip Morris ($68), Compaq ($62.625) and Hanson ($20.25).

Elaine Garzarelli, Shearson Lehman Bros.’ ace market analyst, says investors are making a big mistake if they abandon the stocks that have led the market rally since last fall--that is, the “early cyclical” companies that typically see their sales rebound first as the economy recovers from recession.

At some point this year, if not now, the economy probably will start growing again, and that will pump up cyclicals--such as home builders, semiconductor makers, auto makers and airlines, Garzarelli says. “Stocks in these groups will continue to display excellent price recovery for at least the next nine months,” she argues.

The best advice for the doubters: watch the economic statistics. If they continue to show a recovery, you can just about bet that cyclical stocks will soar anew. Investors will assume that the companies’ earnings will catch up later.

* What About Bonds? The 30-year Treasury bond yield started the first quarter at 8.24%. And that’s exactly where it ended. So if you owned long-term bonds during the quarter, you collected three months’ interest (a 2.1% return) and that was it. Pretty paltry next to the S&P; 500 stock index’s 14.6%.

Now what? Many analysts still believe that although interest rates may gyrate wildly during the year, the trend still is down. These optimists see the economy growing only moderately as it recovers from recession, and they believe that higher consumer savings and restrained consumer spending will keep pressure off rates for several years.

Who knows, at this point? But if you’re comfortable with a 7.5% to 8.5% annual return, many bond investments out there are still worth a look. One way to think about bonds is that they could be a great hedge if the recession deepens instead of ends. If that were to happen, stocks would collapse, but so would interest rates--and anybody left holding bonds paying 8% or so would be in heaven.

Meanwhile, almost any investment now looks better than cash accounts, such as money market funds. The average money fund yield was 7.16% at the start of the year. It’s now ready to fall under 6%. If you want the best argument for continuing stock and bond rallies, miserly short-term interest rates may be it.

WHERE THINGS STAND: SIX MARKET SNAPSHOTS Bullish sentiment (pct. bullish, out of 135 stock newsletters) Dec. 31: 43.5% Now: 50.4% S&P; 500 P-E (price dividend by last 4 qtrs.’ earnings) Dec. 31: 15 Now: 18 30-year T-bond yield Dec. 31: 8.24% Now: 8.24% Money fund yield (7-day average) Dec. 31: 7.16% Now: 6.04% The dollar (German marks per dollar) Dec. 31: 1.49 Now: 1.70 Gold (price per ounce) Dec. 31: $394.20 Now: $356.00 Source: Chartcraft; IBDC/Donoghue’s; Standard & Poor’s