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First Quarter in Funds: Small- and Mid-Caps Lead Again

Equities surge, while bonds continue to founder.

John Coumarianos, 04/04/2006

Equity markets surged in the first quarter, despite continued rising interest rates, fears of a housing bubble bursting, and threats of an economic slowdown.

Small caps and mid-caps outperformed large caps, while international stocks outpaced their domestic counterparts. Both of these are familiar patterns.

Bonds were weak, as they continued to feel the effects of the Federal Reserve's multiple rate increases for the second straight quarter, though high-yield  and emerging-markets bonds continued their multiyear runs.

Equity Funds

The smaller the market cap, the better the performance for the first quarter of 2006. Among the diversified funds, small caps rallied the hardest, with small-growth, small-blend, and small-value adding 12.7%, 12%, and 10.8%, respectively. Mid-caps were right behind with growth, blend, and value adding 9%, 7.2%, and 6.7%, respectively. Interestingly, growth outperformed value in both market-cap ranges, perhaps signaling a rotation toward growth and away from value. Small-growth and mid-growth have outperformed their value counterparts for the past year now.

Large caps brought up the rear, and in their case, there has been no rotation from value to growth. Large value rose 4.8%, while large-blend added 4.5%, and large-growth tacked on 3.6%. Morningstar analysts have been anticipating a rebound for large growth, but it has yet to materialize. In the meantime, some of our favorite large-value and large-blend funds are also picking up slow-growth names. We've heard many managers remark that large-growth stocks haven't been this cheap in a long time.

In the specialty categories, real estate continued its multiyear run, leading all categories with a 14% gain. Analyst Dan McNeela warns that real estate is richly priced by many measures, "including price/cash flows, yield relative to the 10-year Treasury bond, and earnings relative to the S&P 500." Although there doesn't seem to be overbuilding, which has traditionally been the cause of the worst downturns in the sector, McNeela signals caution, seeing limited upside in the sector.

Telecommunications and natural resources finished the quarter with 10% and 8.4% gains, respectively. The telecom funds that did the best were generally those that had the most hardware and technology exposure. We think this is a tough and volatile category with short product cycles and intense competition. Similarly, natural-resources analyst Sonya Morris points to energy's downturn in the fall of 2005 in the wake of Hurricane Katrina as a warning to investors about commodity price volatility.

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