No rain on this parade

Pleased but cautious. That describes the mood of America's small investors as the best year for US stocks since 1999 came to a close. Mutual-fund holders cheered the double-digit rebound, pouring more money into Wall Street.

But by and large, they picked conservative funds. And they watched warily as the trading scandals cast a large shadow over the mutual-fund industry in the fourth quarter of 2003.

"In some ways, 2003 can be described as a celebration of survival," says Gina Sanchez, a portfolio manager for American Century. "If a company survived [the bear market], it did really well. It was a time when the worse a company's credit was, the better its stock did. It was a classic first-stage recovery."

Money flows into all types of funds remained strong throughout most of 2003 and even picked up steam in the fourth quarter, according to mutual-fund tracker Lipper Inc. But even though aggressive funds - such as small-company funds, European funds, and emerging-market funds - outperformed most other categories, conservative funds pulled in the most money.

"We saw pretty strong flows of money going in, but into the more cautious funds," says Don Cassidy, senior research analyst at Lipper. "Value funds took in more money than growth funds, even though growth is winning on a performance basis. There's also been a terrific amount of money, a couple of billion dollars a month, going into balanced funds. If it sounds more cautious than aggressive, it's been getting the money."

After three years of dramatic losses, investors weren't ready to jump on any aggressive-fund bandwagon, at least not yet, Mr. Cassidy believes.

Fund companies touched by the late-trading and market-timing scandals did see billions of dollars go out the door after Sept. 3. That was when New York Attorney General Eliot Spitzer announced investigations into trading abuses in the mutual-fund industry. But very little of that money left mutual funds completely, Cassidy says; it just "moved down the street" to fund companies untainted by controversy.

For most of the year, funds that relied on aggressive strategies won the performance contest.

Big-company stocks, represented by the Standard & Poor's 500 index, gained more than 26 percent in 2003. But the Nasdaq, which includes many smaller-company and technology stocks, climbed more than 50 percent. Then, in the fourth quarter, as the economy showed signs of a broader-based recovery, the returns of the two benchmarks edged closer, with the Nasdaq up 12.1 percent and the S&P 500 up 11.7 percent.

A recovery by small-company stocks was not unexpected. Analysts note that prices of such stocks, particularly technology stocks, had fallen so far between March 2000 and October 2002 that some rebound was almost inevitable. But the gains also reflected the improved outlook for the economy and smaller companies.

"Investors have really been focused on small and mid-size companies and companies that they viewed as being much more leveraged to an improvement in the economy," notes Larry Puglia, portfolio manager of the T. Rowe Price Blue Chip Fund. "Some of the sectors, such as technology, were so depressed that when you got any glimmer of improvement in the economy, those stocks moved up much more in percentage terms."

The first nine months of the year were based primarily on expectations that things would get better, notes Ms. Sanchez of American Century. In the fourth quarter, some of those expectations turned into reality, which added more fuel to the markets and brought more money into mutual funds. "We started to see some very positive numbers coming in from areas of the economy that we hadn't seen before" in the fourth quarter, she says. "We started to see profits coming in. We also started to see high-tech spending. We hadn't seen much capital investment for the majority of '03. But in the fourth quarter, we started to see the beginning of some high-tech investment."

That investment should help fuel a continuation of the stock-market rally in 2004, Sanchez and other analysts believe. And, while no one expects the kind of gains that were seen last year, these experts expect to see a broader range of mutual funds, particularly large-company funds, perform well this year.

"Large-cap stocks tend to outperform in the second year of an expansion," Mr. Puglia says. "Also a number of large-company stocks are paying a higher dividend as a percentage of their stock price." Higher dividends will be especially attractive to investors and fund managers now that the federal tax on corporate dividends has been cut to 15 percent, Puglia points out. "It's sort of ironic that in the year in which that legislation passed, companies with strong dividend growth actually underperformed the market. That will change."

Puglia sees three areas that he thinks will benefit as the economy grows: financial services, healthcare, and media.

"We think a number of financial stocks are very well positioned" to benefit from the recovery, he says. "Basically, we think that an improvement in the capital markets and an improvement in credit quality are going to help companies." Also, as the economy continues to improve, more firms will need to borrow to pay for expansion, which also will benefit lenders.

Healthcare stocks, Puglia contends, also currently offer an attractive combination of reasonable valuation - price in relation to profit potential - and strong earnings growth.

Finally, Puglia believes media stocks will do well as the economy expands. Plus, 2004 will see both the summer Olympics and the fall elections. "In the past, these two events have been very positive for media stocks" as they take in advertising revenues, he says.

Still, after the spectacular gains of 2003, investors should approach 2004 with some caution and not expect a repeat of last year, says John Brennan, chairman of the Vanguard Group.

"I am a believer that fundamentally you have to look at valuations," Mr. Brennan says. "Stocks are not cheap. Some sectors may be cheap, but stocks generally are not cheap.... The economy [in 2004] should be good and earnings should be good, but we're traveling at price-earnings ratios in stocks that fully take into account good news."