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updated 4/12/2004 11:03:39 AM ET 2004-04-12T15:03:39

Throughout the economic recovery, small companies have been the markets' all-stars.

Where multinational goliaths have sunk or treaded water as they clung to leaky life rafts fashioned during the downturn, the little guys have used their agility and the fuel of stronger national economic data to shoot into the stratosphere. In the process, mutual fund investors who put their money in small-cap funds have been richly rewarded, while those who bet heavily on large cap have seen their portfolios stagnate.

Last quarter was no exception, with small-cap value funds leading the pack at a robust 6.1 percent return, according to Lipper Inc. Large-cap growth funds were the laggards at just 1.1 percent.

But all that may be about to change, with small companies reaching the pinnacle of their value and large firms starting to capitalize on the rebound. As mutual fund experts look ahead to the rest of the year, many say that once again, bigger will be better.

"What we saw last year is that once the economy starts growing, small to mid-size companies are the ones that can react first to the changing economic environment. That's why they did so well last year, and that continued into this year," said Rosanne Pane, mutual fund strategist at Standard and Poor's.

"In the second year [of a recovery]," she continued, "you tend to see the larger companies picking up speed."

Pane said she sees, too, the possibility for fast-growing companies to supplant undervalued bargains as the best buys in the rest of 2004. In the first quarter of the year, value funds beat growth funds in every size category. Pane said she sees growth stocks making their move soon.

But she adds one major caveat that dogs all experts' predictions for the markets in the coming months: Between the continuing violence in Iraq, the specter of international terrorism, a presidential election and the possibility that the Federal Reserve will raise interest rates, a substantial amount of uncertainty hangs over Wall Street in the remaining three quarters of 2004.

That's not, of course, what investors want to hear. After a first quarter in which the markets rode a week-to-week roller coaster -- sinking with the terrorist attacks in Madrid and the initial lack of employment growth, but also bobbing up with generally positive economic reports and strong earnings numbers -- many investors have had high hopes for a more uniformly upward trajectory.

"There are going to be some big expectations in the second half of the year," said Anna Dopkin, manager of T. Rowe Price's growth and income fund. "Investors have been waiting for the back half to be strong."

Robert Morris, director of equity investments at the Lord Abbett fund group, thinks they'll get what they want. Much as the markets rallied in the latter part of 2003 following initial jitters over Iraq, Morris said he sees stocks taking off and quickly outpacing bonds as the investment of choice for the next 12 to 24 months.

The reason for his sanguine outlook? Morris sees positive overall economic growth, rising employment, high corporate earnings and low inflation as a recipe for a banner year on Wall Street. Plus, he doesn't see Chairman Alan Greenspan and the Federal Reserve putting the reins on the economy until at least 2005.

"People are going to have to get back on the horse," he said. "The fundamentals are too good."

Not everyone is so bullish. Dopkin said those who proclaim that Greenspan wouldn't dare raise rates before the November election do so at their own peril. "If he sees numbers that support a rate rise, it definitely could happen this year," she said. "Greenspan is going to do what Greenspan thinks is right for the economy and is not likely to be swayed just because there's an election."

Some worry, too, that the market might be at a high-water mark following the 2003 rally, and isn't likely to grow much more anytime soon. "It's becoming harder and harder to identify new opportunities," said Kunal Kapoor, director of fund analysis at the Chicago investment research firm Morningstar Inc. "Maybe that's a sign that the market is becoming a little bit expensive."

But Kapoor does see some bright spots, most notably in large-cap funds. Not only have the companies in those funds underperformed the past few years, meaning they may be due for a resurgence, they've also got other trends working in their favor. Because many are multinationals, for instance, they're in a better position to benefit from the weak dollar, he said. Plus, they can pay dividends even when the markets are off.

Other fund watchers say there's gold to be found in individual sectors, though they disagree on exactly where the treasure's buried.

Thomas McManus, chief investment strategist at Banc of America Securities, said he's expecting major drugmakers to be smart investments because their stock prices have taken such a battering in recent years. "Pharmaceuticals are looking very cheap. There are very low expectations," he said.

McManus said, too, that he thinks reliable, time-tested companies in the food and beverage business should be able to hold their own better than more speculative firms in industries such as technology if the markets start to dip. "People should be focusing on large corporations with high quality and steady growth. The small-cap, low-quality, cyclical play is over, or is nearly over," he said.

Dopkin said she's high on the materials sector -- including steel, aluminum and chemicals -- but has a more conflicted view when it comes to drug companies. "There have to be 40 different markets going on in health care," she said, noting that biotechnology companies have been on a tear even while big pharmaceutical companies have plummeted. Dopkin said some of the latter group may be primed for a turnaround, but investors need to be selective because others will continue to sink. Dopkin also sees potential for energy companies, insurance firms and the wireless side of the telecommunications business.

Morris said he's betting on blue-chip tech stocks and the industrial sector, which despite negative publicity surrounding offshoring and job loss should be strong through 2004, in part because of a weak dollar.

One area Morris said he'd avoid is financial services. The sector has been climbing for years, but Morris doesn't think that can last much longer, particularly as market interest rates head north. Now that people have their consumer loans locked in at low rates, he said, it's inevitable that the demand for financial services will drop. "Who doesn't have a dozen credit cards in their wallet? And who hasn't refinanced their mortgage half a dozen times?" Morris asked. "That might be one area where I'd be willing to take some profits." Translated from Street-speak, that means, take the profits and run.

Morris said he isn't enthusiastic about real estate investment trusts, either. They've had a spectacular run in recent years, and were among the biggest winners last quarter, but he feels their time may be running out. "I don't see how REITs can do much from here," he said. "They're overvalued, and rates are not going to be friendly."

Analysts agreed that certain sectors -- notably health care, energy, defense and tobacco -- could head sharply up or down depending on what happens in the November elections, though they said the elections are unlikely to have a major effect on the markets as a whole.

Instead, the overall success or failure of most mutual funds -- and, by extension, most investors' portfolios -- will hinge on far more anomalous forces, such as interest rates, earnings reports and inflationary fears.

Even the experts admit that, taken together, all of that is tough to forecast.

"It's very easy to talk about what might happen, but at the end of the day, very few people can predict [that]. So the most important thing to emphasize is having a well-balanced portfolio," Kapoor of Morningstar said.

In other words, buy a little bit of lots of things, and hope for the best.

© 2013 The Washington Post Company

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