A ROCKY CLIMB.

Found investors profited in 1998, but not without some bumps. Here's what's up in 1999.

MUTUAL FUND INVESTORS COULDN'T HELP BUT BE dazzled by a Houdini of a stock market in 1998. It was, after all, a year of high-wire drama, frightening falls, harrowing escapes, and, to cap things off, a happy ending. Yes, the Standard & Poor's 500 did manage to end the year up 27%, but there was more than enough suspense packed in between the end of December and New Year's Day to keep us all holding our breath.

Talk about a high-wire act. Stocks started 1998 off with a boom, as the S&P raced off to a 17% gain by mid-year, despite concerns that Asia's economic quagmire was likely to suck in the U.S. economy. Initiated by economic difficulties in Russia, this changed in August when worries that corporate earnings were thinning, coupled with a Clinton presidency under siege, socked the market. The year's previous gains were swiftly brushed aside and in little time, the S&P index found itself in negative territory, down 1.4%. Then, in late fall, Internet mania set in, turning the market another 180 degrees. Investors flocked to nearly any stock with a Web address, a computer chip or even a phone jack--a stampede which helped the market rebound strongly to end the year with its fourth straight finish above 20%.

Divide the market into segments, however, and you'll see that 1998's results were far from uniform. Thanks to the late-year blast off by computer and Internet shares, technology stocks computed a 72% gain for the year. A big year by pharmaceutical stocks, lifted health care shares to a 43% climb. Meanwhile oil prices caused energy stocks to skid, with the group posting a 2% decrease for the year. Airlines lost altitude and dragged transportation shares down 3% for the year.

That kind of disparity was also apparent between large and small company shares. Investors spent much of the year edgy over turmoil overseas and the prospect of slower earnings growth for companies at home. As a result, they stuck with familiar, dependable names that could deliver steady earnings such as Microsoft, AT&T and IBM. They also gravitated to such powerhouses as Pfizer and Dell with solid reputations for profit growth. But with the economy's strength and direction under question for much of the year, the market neglected smaller, unproven companies whose shares languished for much of 1998. In fact, the S&P Small Cap 600, an index for the group, retreated 2% for the year.

Mutual fund holders couldn't help but notice the difference. According to Morningstar, the Chicago firm that monitors the industry, large cap growth funds, the type that invest in big, household names, racked up a 36% gain on average. That's not only a full 16 points above the S&P 500, but it marks the first time since 1993 that an entire fund category outdid the market benchmark. Things weren't so peachy for small cap fund investors, however. The average small cap value fund fell almost 7% last year, while small cap growth funds managed only 5%.

DEJA VU ... AGAIN

So just where does that leave us for 19997 Well, in an odd way, figuring out 1999 is likely to give you a case of deja vu ... all over again. That's because at this point last year and the year before, investors faced similar scenarios. The market had zoomed off to the stratosphere. Stocks were high priced and the experts predicted more modest gains for the market with a lot of wild swings up and down during the year. What followed over the next 12 months? The market promptly blasted off, and ended the year with an impressive gain--31% in 1997 and 27% last year.

The moral of the story? You can't time the markets. For you, the individual investor, that means it's best to get into the market and hold the course--after all, stocks have rewarded the patient handsomely, averaging a more than 10% return over time.

Still, it's good to check the market's vital signs before jumping in for the first time or building onto your investment portfolio. Start with share prices. The S&P 500 currently trades at a price-to-earnings multiple of 25. Translation: the average company's share price is 25 times what analysts predict it will make in profits. Gaze back into history and you'll find that to be the highest P/E (price/earnings ratio) ever--the market has typically traded between 9 and 22 times earnings. That's a sure sign that share prices could undergo a good deal of volatility in the year ahead--the kind that prompted investors to go for big, sturdy companies last year.

It's also good to check on interest rates. Remember, rates are a good gauge of how attractive bonds and other interest-bearing investments are. In that sense, rates can tell you just how strong demand for stocks will be. If interest rates are high, investors will opt for bonds and the market will fall. If rates fall, investors will turn to stocks, and push the market higher.

In the year ahead, don't look for interest rates to bother the market much. Sam Stovall, senior investment strategist for Standard & Poor's, says rates may even fall a bit this year as the Federal Reserve monitors slowing economic growth.

Which brings up the question of how strong the economy is and what that holds for corporate profits--the "e" in P/E. Toward year-end 1998, the pundits felt the U.S. economy could recoil, a prediction that meant rough times ahead for corporate America's bottom line, and the market, in turn. Now, the outlook is rosier, and many economists believe the economy could grow modestly in the year, which should spell a rise in corporate profits in the year ahead. Whereas the S&P 500's earnings actually fell 5% or so last year, look for 15% earnings growth in 1999, says Stovall. That alone could help propel the market 15% as well.

MAPPING OUT A STRATEGY

Keep in mind, though, that just like 1998, experts think different segments of the market are likely to advance at varying rates. What does that spell out for you? Well, for one, its a good time to spread your money around. If your savings are all clumped in large cap stocks--move some to a small cap fund in anticipation of that sector's bounce-back. If most of your portfolio is in domestic stocks and funds, scout out an international fund to add to your investment mix. "It doesn't seem like the best time to be greedy and keep everything in one place," says Russ Kinnel, an editor at Morningstar. "You don't want to get out of stocks, but don't want it all lumped in one sector of the market."

To help you get started on the road to a diversified portfolio, we've included our annual list of top-performing mutual funds, compiled with the help of Morningstar. This year, you find the list carved up into 10 categories, from large cap value to bond funds. Within each group, we looked for the top five funds according to 3-year average annual total returns. We also limited our survey to no-load funds, which charge no sales fee. Our reasoning: first off, no-load funds don't dip into your return. Secondly, why pay a sales fee when you haven't dealt with a salesperson--after all, you're making the choices here.

Between here and the charts, we've compiled a brief list of fund categories that might warrant a closer look in 1999--large cap, international and global and finally small cap funds.

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THE RESILIENCE OF LARGE CAP FUNDS

Let's face it. Regardless of right or wrong, monstrous earnings growth or a major retreat in profits, the stock market is nothing more than ... a market. If demand goes up and supply remains steady, prices rise. And when demand slumps relative to supply, share prices slide.

That was certainly the case with large cap stocks in 1998. Earnings growth slowed--normally just the thing to put the brakes on a bull market. But, with interest rates low, and many investors fretting over the strength of the economy, large cap stocks became the market refuge of choice.

S&P's Stovall says 1999 is shaping up much the same way as last year. Trouble in such overseas markets as Asia and Latin America is likely to give more than a few investors the shakes. Then, there are still question marks hanging over the broad market and how it will fare this year. Put the two together and they spell a year in which large caps should make out quite well.

Like 1998, though, the wealth probably won't be spread evenly. Stovall thinks investors are likely to mob technology, pharmaceutical, telecommunications and retailing stocks in search of the highest earnings growth possible. That's a signal that growth funds, the kind that scour the market for big earnings opportunities might be a good bet this year.

Another way to play large caps is by investing in index funds. Index funds that track the S&P 500, for instance, buy and hold all 500 shares in the index without trading and retrading shares throughout the year. Our recommendation for index funds: stick to Vanguard Equity 500 (800-662-7447) or TIAA-CREF Equity Index (800-842-2252).

INTERNATIONAL FUNDS' UPHILL CLIMB

Page through the headlines these days, and it's hard to get excited about investing overseas. From the looks of it, Brazil is caving in and the Pacific Rim seems mired in an economic mess that shows no signs of ending soon. So why would you ever look beyond the U.S. where you can park your savings safely in a stock market that has kicked in returns of 20% or 30% over the past few years?

The answer: because you'd miss out on something big. True enough, the prognosis for Latin America might be shaky this year and next. Asia, meanwhile, is grappling with some deep-seated cultural and economic issues that have major stock markets in Tokyo, Hong Kong, Singapore and Malaysia tied up in knots. However, turn your focus to the other direction--across the Atlantic--and there's a veritable boom going on. (See "Submerging Markets" in Moneywise, this issue.)

Europe is where the action will be. For one, the same restructuring push that U.S. corporations underwent in the late 1980s and early 1990s, is just taking hold on the other side of the Atlantic. "When it comes to getting lean and mean, we're in inning seven or eight," says Lou Holland, portfolio manager of the Lou Holland Growth Fund. "In Europe they've just gotten to the top of the third." For investors that means expect the same earnings-boosting belt American companies underwent not long ago to keep stocks climbing in Europe.

That's only the beginning. The Euro, the long-awaited currency linking some of the continent's strongest economies, made its debut this year, and should unleash a groundswell of economic growth. All told, says Wayne Weddington, president of Pennoyer Capital Management, a Manhattan international hedge fund, you can look for some of the continent's smaller markets to make substantial gains. "The markets in Belgium and Ireland have been rising 50% annually over the last three years," he says, "there's no reason not to expect them to do so in 1999." In all, Weddington says several markets on the continent should bypass the U.S. stock market by 10% or more.

How do you put that advice to use? We'd say look to invest in international funds, which concentrate on overseas markets exclusively and global funds, which mix U.S. and foreign stocks.

SMALL CAPS SEARCH FOR THE MOUNTAINTOP

Sooner or later, the law of averages is going to have to catch up. And that's when small cap funds will finally have their day in the stage lights.

Small cap stocks were hammered in 1998 and that's putting it mildly. But to write off small companies and their potential for outsized growth is to make the biggest of mistakes. Why? Statistics show that small company shares have historically outgained the broad market by 3% to 5%. So, it's only logical to expect small caps to dust themselves off and head up the hill sooner rather than later.

To better illustrate how much of a difference that makes over time, consider this: invest $1,000 over 10 years, growing at 10% annually, the market's average rate and a decade from now, you'll have $2,594. Invest that same sum at 13%, the historic average for small company shares, and you'll have $3,395 stowed away, 31% more.

We might have gotten an indication of small caps' return during the fourth quarter of 1998, in fact. That's when small cap growth funds, the ones that bet on smaller companies with good earnings prospects, charged upward 24% beating out the 20.9% advance the S&P 500 made during the same period.

PUTTING IT ALL TO WORK

From here, it seems like pretty easy work to glide through our listings of top mutual funds. It isn't, however. If you're set on investing, we suggest you not only go through the list, but also make use of the 800 numbers we've included by calling for prospectuses and background information before you invest. That way, whether the market pulls a Houdini or not in 1999, you'll have all the info you need to make a wise decision.

B.E. Black Mutual Funds

                              3-Year              1-Year
                              Average             Average
      Fund Name              Annualized          Annualized
       (Ticker)             Total Return        Total Return
                          (1/22/96-1/22/99)   (1/22/96-1/22/99)

    Ariel Capital              25.82               18.86
       (CAAPX)
     Ariel Growth              20.95                7.20
       (ARGFX)
  Ariel Premier Bond            6.64                7.72
       (APBFX)
Brown Capital Balanced         18.17               21.69
       (BCBIXl)
 Brown Capital Equity          21.46               25.69
       (BCEIX)
Brown Capital Small Co.        16.63               15.89
        (BCSI)
     Edgar Lomax                N/A                11.59
        (N/A)
    Kenwood Growth              N/A                -0.13
        (KNWD)
     Profit Value               N/A                36.58
        (PVAL)
  Lou Holland Growth            N/A                31.56
       (LHGFX)
MDL Broad Fixed Income          N/A                 8.72
        (N/A)
MDL Large Growth Equity         N/A                30.77
        (N/A)
  Victory Lakefront             N/A                19.08
        (N/A)
 Liberty Freedom Fund           N/A                 N/A
        (N/A)

                               5-Year
                              Average
                             Annualized
      Fund Name             Total Return         Telephone
       (Ticker)           (1/22/96-1/22/99)        Number

    Ariel Capital              17.59          800-292-7435
       (CAAPX)
     Ariel Growth              14.95          800-292-7435
       (ARGFX)
  Ariel Premier Bond            N/A           800-292-7435
       (APBFX)
Brown Capital Balanced         15.09          800-525-3863
       (BCBIXl)
 Brown Capital Equity          17.79          800-525-3863
       (BCEIX)
Brown Capital Small Co.        16.34          800-525-3863
        (BCSI)
     Edgar Lomax                N/A           888-263-6438
        (N/A)
    Kenwood Growth              N/A           888-536-3863
        (KNWD)
     Profit Value               N/A           888-335-6629
        (PVAL)
  Lou Holland Growth            N/A           800-295-9779
       (LHGFX)
MDL Broad Fixed Income          N/A           800-932-7781
        (N/A)
MDL Large Growth Equity         N/A           800-932-7781
        (N/A)
  Victory Lakefront             N/A           800-539-3863
        (N/A)
 Liberty Freedom Fund           N/A           800-645-1704
        (N/A)

      Fund Name                Minimum
       (Ticker)                Initial
                               Investment

    Ariel Capital            $ 1,000
       (CAAPX)
     Ariel Growth              1,000
       (ARGFX)
  Ariel Premier Bond           1,000
       (APBFX)
Brown Capital Balanced         10,000
       (BCBIXl)
 Brown Capital Equity          10,000
       (BCEIX)
Brown Capital Small Co.        10,000
        (BCSI)
     Edgar Lomax               2,500
        (N/A)
    Kenwood Growth             2,000
        (KNWD)
     Profit Value              2,500
        (PVAL)
  Lou Holland Growth           2,000
       (LHGFX)
MDL Broad Fixed Income          500
        (N/A)
MDL Large Growth Equity         500
        (N/A)
  Victory Lakefront             500
        (N/A)
 Liberty Freedom Fund          1,000
        (N/A)

Figures as of 1/22/99

Source: Morningstar Inc., Chicago IL3