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Bonds Still Socking Stocks, but Don't Bet on a Repeat

Experts see signs that the trends of recent years will turn in 2002.

Fund investors will remember 2001 as a dreary odyssey, but the clouds over Wall Street and Silicon Valley are slowly lifting.

The dreary part is obvious. Stocks are finishing up their worst two-year stretch in nearly 30 years thanks to the potent combination of an economic recession, shrinking corporate profits, steep stock valuations and September's vicious terrorist attacks. For fund investors, that translated into a repeat of

last year with even lower lows. In a repeat of 2000, bond funds are about to beat stock funds, and the buckling tech sector has dragged tech and tech-heavy growth funds to the fund world's musty cellar. But that ravaged pocket of the market is now finishing the year on a tear, as investors look to rosier days ahead.

The upshot: The tech mania of the late 1990s and the past two bonny years for wallflower types like bonds and cheap, small-cap stocks have put the value of diversification in stark relief. The idea is that for most of us it makes more sense to spread our money among a blend of growth, value and bond funds, rather than relying heavily on one style or sector.

As If

"This year was another argument for diversification, as if we needed another one," says Scott Cooley, a senior fund analyst with Chicago research house Morningstar. "I'm hoping after the past three years' volatility, people will follow an asset allocation plan and not just buy what's hot," adds Phil Edwards, director of Standard & Poor's global funds research unit.

For the second year in a row, what's hot has been bonds. The average taxable bond fund has risen 5% since Jan. 1, compared with a 12% loss for the average U.S. stock fund, capping stocks' worst fall since the early 1970s. How abnormal is it for bonds to beat stocks two years in a row? It has happened just four times since the Depression.

It's not hard to see why stock funds have had such an ugly year, since real estate funds were the only sector category that finished in the black and losses in more mainstream areas reached historic proportions. Thanks to a glut of tech products and a dearth of demand for them, tech funds fell 36% on average and communications funds dropped 35%. That's each category's worst loss since Morningstar started tracking them in ye olde 1970 and 1984, respectively. The hardest hit tech funds were the

(BTECX)

Berkshire Technology,

(VTFAX)

Van Kampen Technology and

(VWTKX)

Van Wagoner Technology funds, which are all down more than 60% this year. The biggest losers in the communications-fund bin were the

(TCFQX)

Firsthand Communications,

(ISWCX)

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Wireless funds, which have all lost more than half their value since Jan. 1.

The third-worst sector was utilities, where the average fund is down 24% this year, the category's worst fall since 1975, thanks in part to the sudden demise of energy trader

Enron

(ENE)

, which

cast a pall over the sector. The

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Invesco Utilities and

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Galaxy II Utility Index funds fell hardest, losing more than a third of their value so far this year.

Because growth-fund managers tend to focus on the riskier, more expensive parts of the market like tech and telecom stocks, it's no surprise they trailed bargain-hunting value managers for the second year in a row. In the large-, mid- and small-cap bins, value funds, which typically have about 10% of their money in tech stocks, beat their growth peers, which have about a quarter of their money invested in the mercurial sector these days.

Wax and Wane

What's interesting is that after the growth style's tech-fueled rally in 1998 and 1999 and the value strategy's comeback during the past two years, the performance of both over the past five years is pretty even. The average big-cap value fund, for instance, is averaging an 8.8% annual gain over the past five years, compared with 8.2% for its average growth peer.

The most pronounced bias among stock funds this year was in favor of smaller-cap stocks. The top-performing fund flavor was small-cap value funds, which rose 15% by looking for bargains among companies' with a

market capitalization south of $1.5 billion. The year's leading fund heading into 2001's final weeks is the small-cap

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Schroder Ultra fund, which has rung up a 69% gain by blending the growth and value styles.

Foreign stock funds didn't have a great year either. Every category is under water and the average foreign fund is down 23.3% since Jan. 1. Japan funds were the hardest hit, falling more than 30%, while European funds fell 23.1%. The brightest spot in foreign stock investing was in perhaps its most risky pocket: Latin America. Funds focused on those other emerging markets fell less than 7% this year.

It was such a tough year for stocks that every major bond-fund category beat the average stock fund. Risky emerging-markets bond funds led the way with a 9.9% gain, but, keep in mind, they lost some 24% on average in 1998. The average intermediate-term bond fund, the category where you'll find most core bond funds, is up 6.5% this year and averages a 4.8% annual gain over the past three years, beating the

S&P 500

.

While bonds' solid gains over the past two years illustrate why most investors should at least

consider putting some of their money in bond funds to smooth their portfolio's returns over time, they also augur for stocks.

"There's a reason to have bonds in your portfolio, and it's stability," says S&P's Edwards. "But given their returns over the past two years, I might not expect much from them next year."

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Bonds have never beaten stocks three years in a row, and bonds' yields aren't all that high these days. Also, stocks are looking more attractive today than two years ago. Over the past 90 days, the average tech fund is up 32% and the average growth fund is up more than 15%, compared with an 11% gain for the S&P 500.

Elevator Funds?

It seems that one of the few constants in investing may bear out next year: The sectors and styles that have been in the doghouse may be headed for the penthouse.

"I think we'll see an economic recovery in the second and third quarter, and we'll see growth

funds come back," says Robin Thurston, global director of research at fund-tracker Lipper.

S&P's Edwards agrees that more opportunity may soon begin returning to growth funds. "It might be a good time to get into some growth funds," Edwards says. "If you're taking some profits in your value funds and bond funds, you might consider putting that to work in growth funds

The bottom line: Rather than obsess over what will go up or down in the next quarter or year, build a diversified portfolio and keep you allocation in line -- here's a

blueprint. It's far from sexy, but it will ensure that your holdings rise and fall with the market, rather than tracking the hectic cycles of the sector du jour. Investors who've seen their growth- and tech-heavy portfolios fall through the floor over the past two years might now agree it's time to take the diversified approach.

"The simpler

that people keep investing, the more likely they are to be successful," says Morningstar's Cooley.

I agree.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.