What the Market Taught Us in 2006

Maybe the problem with investors is that too many of us nodded off in high school physics. Anyone who was awake knows Newton's first law of motion: An object at rest tends to stay at rest, and an object in motion tends to stay in motion.

I'm half joking, but the market, to a surprising degree, seems to follow Isaac Newton's law. Market sectors tend to do well -- or poorly -- for what seems unwarranted periods of times, often years. That lesson was underscored in 2006 and is something investors should keep in mind for the year ahead.

Look at stocks of small companies in 2006. The most popular small-cap index, the Russell 2000, is poised to beat or at least tie Standard and Poor's 500-stock index again. Through December 14, the Russell is up 18% while the SP 500 is up 16%.

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That would make it eight years in a row that small caps have topped or tied large caps. The tie was last year. Dummies like me keep expecting the tide to turn. After all, small caps are pricey compared with large caps, and large caps typically do better in the later states of an economic cycle. What's more, large caps are better positioned than small caps to profit from globalization and a weakening dollar.

Nevertheless, the market continues its love affair with small caps, particularly stocks of what once were undervalued small companies. And that's hardly the only place Newton's law seems at work in the market. While the edge between small caps and large caps has narrowed the past two years, value stocks are continuing to swamp growth stocks -- just as they have ever since the tech bubble popped in early 2000. Large-company growth stocks have had a mediocre year, up just a bit more than 7% in 2006. That compares to a torrid 26% for large-cap value stocks, according to Morningstar's indexes.

At the start of the year, I thought large-cap growth stocks were precisely the place to stick a little extra money. Shares of these companies, most of them with significant operations overseas, are undervalued by most measures and should hold up relatively well even as the economy slows. After all, they are the quintessential blue chips. But they sure didn't come through this year.

Looking ahead

The market won't continue indefinitely to favor small caps over large caps. Nor will it forever fail to recognize the beauties of large-cap growth stocks. Large caps are generally cheap compared with small caps and large-growth stocks are the cheapest part of the market.

Reversion to the mean is perhaps the most powerful force in the market. It means, essentially, that although market sectors may stray from their norms, they tend to come back into balance. More simply, it means that what goes up must come down -- or that what goes up super quickly must eventually go up at a slower pace.

But what's achingly clear is that the market often takes its sweet time bringing sectors back into fair value. The tech bubble of the late 1990s was a classic example. It was apparent for years that tech stocks -- many of them trading at triple-digit price-earnings ratios or with meaningless P/E ratios because the underlying companies had no earnings (and possibly no revenues as well) -- had to crater.

My colleagues at Kiplinger's and I often sent e-mails to one another relating signs of a market top. They stemmed from the apocryphal story about Joseph Kennedy dumping his stocks before the 1929 crash after hearing stock tips from his shoeshine boy. We sent e-mails when we got tech stock tips from taxi drivers, waiters and the like. The timeliest sign of all came in March 2000 during a visit to CNN's Washington, D.C., offices, where I was appearing for a TV interview. That tech-stock tip came from a security guard.

But we exchanged those e-mails for several years -- years during which we could have been making killings buying tech stocks. In short, you can sometimes be reasonably sure of what the market will do, but you can rarely tell when it will do it. Or, as economist John Maynard Keynes put it, "The market can stay irrational longer than you can stay solvent."

Just as the market turned in 2000, it will turn again. Small caps are nowhere near as overvalued as tech stocks were when they finally collapsed. Nor are large-cap-growth stocks as cheap today as small-cap-value stocks were in 2000. The excesses of the late 1990s were a once-in-a-generation type thing. The next change in the markets will likely come sooner than later.

Investing strategy

So what do you do as an investor? Do you put most of your chips on the cheapest part of the market and wait patiently for the turn? Do you pile into whatever has been working lately and hope it will continue to work regardless of the fundamentals? Do you stay sector neutral, figuring the market is a lot smarter than you are? You can make a good argument for any of those approaches, and each has plenty of advocates among professional investors.

I favor another approach. I think you should add a little extra to those sectors that look cheap and take a little money away from those that are dear. So I'm continuing to put a bit more in large caps -- and especially large-cap growth -- than I normally would, while putting less into small caps.

But don't overdo it. Make small bets -- say move 5% or 10% more of your money into attractive sectors. If you own solid funds, often the managers will make those wagers for you. Value managers such as Bill Nygren at Oakmark (OAKMX) have already -- indeed, prematurely -- moved into traditionally large-cap-growth fare. (For more about Nygren, see December's Kiplinger 25 update.)

Predicting the market is a humbling endeavor. Even Newton couldn't do it, losing some pound;20,000 in the 1720 stock crash that followed the South Sea Company bubble. "I can calculate the motions of heavenly bodies, but not the madness of people," he subsequently wrote.

Steven T. Goldberg is an investment adviser and freelance writer.