Lipper Senior Research Analyst Don Cassidy on KTLK AM-760

Thursday, July 3, 2003

A. Definitely. With June 30 falling on a Monday, it's been a short butintense week for us.

Q. So, what do you see? It was a pretty good quarter, right?

A. Definitely! One of the seven best quarters since 1980 in terms ofaverage equity-fund performance. And every single type of bond fund alsoregistered a positive performance in the quarter, so only the shorts haveanything to complain about.

Q. What were the major patterns you saw, after taking a step back from allthe details?

A. It was a very unusual quarter in several ways. First, performance wasunusually positive, to a degree that people should NOT expect it topersist. Second, the leadership was extremely unusual for a strong period:VALUE funds beat GROWTH funds in a sharp rally, and it's usually the otherway around. Third, the Science & Technology funds (+24.5%), closelyfollowed by Telecommunication funds, were the leaders even though thoseparts of the economy are still pretty sluggish.

Q. Let's talk a little about that value/growth thing a little. Maybe youshould start by defining the terms...

A. OK. There are no precise mathematical cutoff points, but in general itis a matter of relative valuations of the kinds of stocks that portfoliomanagers put in a given fund. We at Lipper track the holdings andcategorize the funds accordingly. A growth-style fund tends to own stocksin growing industries, usually with zero or very low dividend yields,above-average P/E ratios, above-average price to sales and price to booknumbers. If the companies do not have positive earnings, they haveabove-average revenue-growth rates. A value-style fund is the opposite: itwill often invest in more mature industries that pay high dividends,although some of the companies may be having hard times but seem to havechances for recovery. The P/E ratios will be below average, as will priceto book and price to sales. (A fund that does not heavily commit to eitherstyle is labeled as a "Core" fund.)

Q. So, why is it unusual for value funds to lead in a rally?

A. Stock market rallies, particularly strong ones such as we saw fromMarch to June, are optimistic times and investors naturally tend to lookfor the more aggressive or growing types of stocks and funds in such aperiod. Usually value funds lead in a flat or down market. Not this time.

Q. Didn't you say, at the end of the year, that you expected value to leadin 2003 during an up market?

A. Yes, I went out on that limb. But I did not see such a strong overallmarket, at least for the full year. And to give the full picture, for the6 months the growth style is ahead by 2 or 3 points. That is because thefirst quarter, a moderately down period, was led by the growth funds -- avery unusual pattern again!

Q. Why do you think investors and the market are acting this way?

A. Two things, really: the big-name growth companies like Gillette, 3M,IBM, McDonald's, Home Depot, Wal-Mart, and the huge drug companies are allselling at pretty generous P/E multiples. So, with the economy still flat,investors are not real excited about bidding those types of stocks up asleaders to even higher multiples. Second, remembering the scars of thebear market, investors are still pretty skittish and they would like a nicedividend and maybe a low price/book or low P/E ratio so they can sleepbetter. Thus value has had more appeal.

Q. What other major patterns did you see in the Q2 numbers?

A. Small-cap beat large-cap. If you start to believe that the economy iscoming around, that is natural since smaller companies will get a biggerboost than big old mature ones will. Small-cap beat large-cap by 9 pointsin growth, 7 points in core, and 5 points in value funds... a very clearpattern. Similarly, the leaders in world equity funds were EmergingMarkets portfolios and International Small-cap. Developing economies gainor lose more than the mature ones in an economic cycle. And a couple oflocal markets made big moves, helping the Emerging group: Russia wasstrong, led by its oil stocks, and Korea rebounded as nuclear tensions witthe North seemed to abate. Latin America (+22%) also helped.

Q. How about bond funds, Don? People have poured a lot of money in therelately...

A. Not a single type of bond funds was down on average. World incomefunds are up 6.5% for the quarter and 11.2% for the half. Domesticlong-term fixed income funds are up 3.5% for the quarter and about 5.7% forthe half -- or almost an average full year's return. Generally, aggressivebond investors did well. Emerging Markets Debt funds gained 10.9% in thequarter, reflecting optimism about recession recovery and also helped byU.S. dollar weakness. High-yield funds are up 8.5% for the quarter, alsohelped by a hoped-for upturn in corporate fortunes. With rates stilldropping, longer-bond funds did a little better than short- andintermediate-term ones.

Q. Where do we go from here, for the second half?

A. Lipper's crystal ball is taking a 4-day weekend, so I'm not positive.But it seems to me that the major drivers are two: does the economyactually start coming around? -- and do we have a benigninternational-events background? I cannot HOPE to predict the latter. Butmaybe the cut in tax-withholding rates and the upcoming $400 child-creditchecks will help consumer spending. The great unknown is whetheralready-stretched consumers will take the extra money and pay down debt, orwill spend it. I think some halfway mix is a fair bet.

Q. And what should investors do?

A. Well, diversification is never a bad starting point: you will not haveall your money bet on any one outcome. But beyond that, the slant of yourinvestments should depend on what you believe will happen. If you arebullish on a firm economic expansion -- and the Fed and Washington surehave made the moves to help that occur -- then you should be in equityfunds and be careful of long-maturity bond funds since interest rates arereal low. If you see continuing problems out there, like a soft economyand the fact that technology drives productivity gains so fast that ittakes 2.5% real growth just to avoid higher unemployment, then you remaincomfortable with your bond funds and stay in conservative types of equityfunds. If you are putting money back in that has been on the sidelines,I'd say do it gradually rather than all in one chunk. I'd be VERYsurprised if the third quarter is anywhere nearly as pleasant as the secondwas.

Q. People enjoyed the big improvement.

A. Right, but they should not inhale too deeply, or believe we're back in1998-99.

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).