LABJ Small Cap Index drops as interest rates rise.

Broader indexes also post dismal spring performances

No stock index was safe this spring from the dampening affects of the Federal Reserve Bank's decisions to raise short-term interest rates. Those moves were reflected in the performance of the Los Angeles Business Journal Small Cap 100, an index created for the Los Angeles Business Journal by Santa Monica-based investment management firm Wilshire Associates Inc.

The Fed actually raised interest rates four times in 1994. Three of the four interest rate hikes fell between Feb. 28 and May 31, 1994, the period covered for this report. The Fed raised rates on Feb. 4, March 22, April 18 and May 17. In total, short-term rates went up 1.25 percentage points -- from 3 percent to 4.25 percent.

For that same three-month period this spring, the LABJ Small Cap 100 lost 4.05 percent of its total market value.

The LABJ Small Cap 100 is a stock index of 100 public companies based in Los Angeles County with market capitalizations of between $7 million and $70 million.

The performance of several broader stock indexes were similarly dampened by the March 22, April 18 and May 17 announcements of higher interest rates.

The California Small Cap Index was the biggest loser for the three-month period, losing 7.66 percent of its market value. The California Small Cap Index includes 384 small cap companies based in California.

Likewise, the Wilshire Small Cap Index, a national index of small companies, finished out the period with 6.23 percent less value than at the beginning of the period.

The S&P 500 fared relatively well during the period, losing only 1.52 percent of its value. Analysts interviewed were at a loss to explain why the stocks of major corporations were less affected by the interest rate increases.

All the stock indexes showed similar patterns during the period -- modest gains in the first few days of March followed by dramatic drops in the second half of March. On March 22, the Fed raised interest rates for the second time this year, which sparked a major market pullback.

Ken Ackbarali, senior economist at First Interstate Bank of California, said the pattern is a natural one. "Whenever interest rates begin to rise, the stock market takes a hit and a correction begins," he said.

Ackbarali explained that many investors in the stock market invest by borrowing money from commercial banks. When interest rates rise, such borrowing to invest becomes less attractive.

Rising interest rates drive investors away in another fashion, as well, said Ackbarali. "The markets generally do not like an environment of high interest rates because the ostensible reason for the Fed to raise interest rates is that it believes inflation will spike up," he said. Inflation means the cost of doing business goes up, thereby reducing profit margins. Also, other types of investments, such as certificates of deposit, become more attractive relative to stocks.

Ackbarali also pointed out that the markets did not recover through May 31 because there were three announcements of interest rate hikes during the period covered in this report.

"It hit all kinds of stocks, small cap and blue chip alike," said Greg Nie, a market analyst with Kemper Securities Inc. in Chicago. "There was a heavy dose of profit taking in the last two weeks of March. Everyone sold because they wanted to own cash."

Since March, the Investment Company Institute, a trade organization for the mutual fund industry, has reported low cash reserves in mutual fund accounts, said Nie. Such cash reserves are a "barometer of the potential buying power for stock funds. It is low and is not changing," said Nie, who predicted the markets will continue to drag for some time.

The sectors hardest hit in the LABJ Small Cap 100 were electronics, energy and utilities, business services, finance and producer goods. The electronics sector lost 12.67 percent of its value, which is particularly significant because that sector represents 8.35 percent of the LABJ 100 portfolio's total market value.

The biggest losers, however, were a pair of sectors that probably did not have much of an impact on the overall index. The tires and rubber sector lost 24.07 percent, 1.22 percent and 6.17 percent of its value in March, April and May, respectively. Those losses did not have much impact on the overall index, however, as the sector comprises only 1.02 percent of the LABJ Small Cap 100 portfolio's total market value.

Likewise, energy and utility stocks lost 15.82 percent and 30.16 percent in March and April, respectively. The sector gained back 7.5 percent of its value in May. However, energy and utility stocks comprise only 2.92 percent of the LABJ Small Cap 100 portfolio's total market value.

Not one sector made gains during all three months. Media stocks lost 1.99 percent of their aggregate value during March. They rebounded slightly in April and May by regaining 2.31 percent and 1.91 percent in those months, respectively. Two media companies, West Los Angeles-based Kushner-Locke Co. and Burbank-based dick clark productions inc., made their way into the top ten performers for the spring period.

The business machine sector also made a big comeback in May. That sector lost 2.3 percent and 1.24 percent of its value in March and April, respectively. In May, the sector came back strong and regained 18.69 percent of its value. Contributing to that resurgence were Valencia-based 3-D System Corp. and Woodland Hills-based Incomnet, which both turned in top 10 stock performances for the quarter.

Banks also made a respectable showing for the quarter. Both West Los Angeles-based Metrobank and Santa Monica-based Santa Monica Bank had top 10 stock performances, and the sector as a whole ended up gaining ground rather than losing it. The bank sector lost 1.3 percent of its value in March, but gained back 0.85 percent in April and 6.61 percent in May.