Fundamentally: Why Haven?t Investors Played It Safe With Blue Chips?

HAVE blue-chip stocks suffered another setback?

Last year, professional money managers were finally warming up to large-capitalization stocks, after favoring their smaller and sexier small-cap cousins throughout much of this decade. This spring, large-cap stocks started to look even more attractive, thanks to the booming global economy and the falling dollar, which benefit the large caps because big companies tend to do a greater share of their business overseas.

Then came what was supposed to be the clincher. In July, as market volatility spiked, the consensus view on Wall Street was that investors would finally flock back to large-cap stocks because of the stability and safety that big, industry-leading companies can provide.

Well, July came around, and while the smart money said investors would bite, many of them didn’t. In fact, nearly $3.1 billion in net new money was pulled from large-cap stock funds in July, according to Citigroup Investment Research and Strategic Insight. In fact, more money was yanked from large-cap stock funds than was pulled from small-cap funds, which had net redemptions of $1.1 billion that month.

To be sure, this is only one month’s worth of data. And Tobias Levkovich, Citigroup’s chief United States equity strategist, points out that large-cap stock funds sit on a bigger mountain of assets to begin with — so larger outflows aren’t necessarily troubling.

Still, why did investors flee from — rather than run to — the relative safety of blue-chip stocks?

One possible explanation is that the recent market sell-off was set off by growing troubles in the mortgage market. And credit troubles clearly affect the financial services sector, which happens to be the biggest sector in the Standard & Poor’s 500-stock index of blue-chip stocks, representing 20 percent of the benchmark.

“To the extent that there are a lot of financials in the large-cap space, and that those financial companies have credit exposure, I think this would retard the development of the case for large-caps,” said John S. Osterweis, president and chief investment officer for Osterweis Capital Management in San Francisco.

Of course, it’s not clear cut.

For starters, while the financial sector makes up one-fifth of the S.& P. 500, small-cap stocks aren’t devoid of exposure to banks and brokers. In fact, 15 percent of the Standard & Poor’s 600 index of small stocks is made up of financial services firms.

And among mutual funds, the gap is even narrower. While the average large-cap value stock fund invests 26.3 percent of its assets in financial companies, small-cap value funds have nearly as much exposure: 22.2 percent, according to Morningstar.

Also, keep in mind that while many large investment banks like Bear Stearns have garnered big headlines recently because of their exposure to mortgage-backed securities, many of the stocks that were hit hardest recently were small-cap subprime lenders and savings institutions, said Wendell L. Perkins, chief investment officer for Johnson Asset Management in Racine, Wis.

This may explain why, even with their slightly greater weighting to financial stocks, large-cap stocks fell less than the small-caps when the market began to sink. “In July, you were much better off in the large caps,” said Russel Kinnel, director of mutual fund research for the fund tracker Morningstar.

The mega-cap Russell Top 50 Index, which tracks the 50 largest domestic stocks, lost only 2 percent of its value in July. By comparison, the Russell 1000 blue-chip index, which includes 950 less gigantic stocks, fell 3.1 percent. The Russell 2000 index of small-cap stocks tumbled 6.8 percent. And the Russell Microcap index, made up of the market’s tiniest companies, did the worst as it shed 7 percent of its value.

Mr. Perkins, who also co-manages the JohnsonFamily Small Cap Value and JohnsonFamily Large Cap Value funds, said blue-chip stocks should continue to hold up well as investors turn their attention away from the immediate financial troubles in the mortgage market to what those financial troubles could mean for the broader economy. Once that happens, it will put even more pressure on the equity markets, which in turn should drive more interest into the large-cap stocks, he said.

Ernest M. Ankrim, chief investment strategist at the Russell Investment Group in Tacoma, Wash., agrees: “There’s a reasonably strong case for large caps for the remainder of the year and going into 2008.”

Market strategists point to several factors that should work to the advantage of the blue chips.

For starters, many economists now expect the Federal Reserve to cut short-term interest rates, either at the upcoming Federal Open Market Committee meeting this week or sometime later this year. If the Fed trims rates, Mr. Ankrim said that would put even more downward pressure on the dollar. And that, in turn, “would almost certainly be good for firms with global reach,” he said. This means the blue chips.

Furthermore, Mr. Levkovich at Citigroup points out that historically, large-cap stocks tend to outperform during periods of slowing earnings growth and increasing market volatility.

EARNINGS for companies in the S.& P. 500 are expected to expand just 4.5 percent in the third quarter, according to Thomson Financial. That’s down from 7.9 percent in the first quarter and 10.6 percent late last year. As for volatility, the Chicago Board Options Exchange Volatility Index, or VIX, is now consistently trading above a reading of 20 now, after being in the teens in recent years.

While these signs are bullish for blue chips, investors must still be judicious when hunting in the large-cap space, said Steven Romick, manager of the FPA Crescent Fund, which invests in stocks of all sizes.

Mr. Romick noted that while large-cap stocks are cheaper than their small-cap counterparts, “they’re not ridiculously cheaper.” He added that the recent troubles in the financial services sector show that “one still has to be quite selective” even when dealing with the bluest blue-chip stocks.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.