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Will the bull market survive the storm?

Investors eked out modest gains last year, but now ill economic winds are whirling through Wall Street.

By Martin SkalaCorrespondent of The Christian Science Monitor / January 7, 2008

Jimmy Holder

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Mutual fund investors may be forgiven if they're feeling a bit queasy as the new year begins.

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With signs of recession mounting, housing in a deep slump, and inflationary pressures brewing, few market forecasters are wearing rose-colored glasses.

The five-year-old bull market is still alive, but its heartbeat is becoming fainter, experts say. And there's no assurance that the market's heightened volatility won't lead to another downdraft in the months ahead.

A piece of advice for investors: Don't set your sights too high for 2008, and be prepared for more market turbulence, at least in the early months of the year.

Despite a roller-coaster fourth quarter, most US stock funds fared reasonably well in 2007 – a year that saw financial service and consumer-oriented stocks rip holes in many fund portfolios. The average US diversified equity fund managed to advance 6.3 percent, according to fund-tracker Lipper. The gain, the slimmest since 2002, nonetheless beat

the S&P 500 index's 3.5 percent rise. If the financial sector is factored out, the S&P 500, after reinvesting dividends, would have risen by more than 10 percent for the year, according to Standard & Poor's. The NASDAQ Composite, buoyed by high-tech stocks, climbed 9.8 percent, its best showing since 2003.

Stock fund returns ran the gamut, with many international funds advancing 12 percent or more, while most small-cap value funds fell. Among 18 types of US diversified stock funds tracked by Lipper, only three declined in 2007. Strong global earnings growth and a sharp decline in the value of the dollar fattened returns from foreign markets.

But the fallout from the subprime mortgage debacle and a softening US economy took a heavy toll on value-oriented funds. Their traditionally hefty stakes in banking, insurance, and consumer-oriented stocks suffered from the mortgage industry's problems and recession fears.

First half of 2007 accounts for most of Dow gains

Virtually all the market's gains occurred in the first half of the year, when dealmaking was rife, lending standards were loose, and corporate profits were still blooming. After midyear, storm clouds gathered over the credit markets as the subprime mortgage crisis intensified and financial stocks imploded. Record oil prices and weakening consumer spending fanned fears of a looming recession.

While the Fed's action to lower the federal funds rate and inject liquidity into the banking system gave stocks a temporary lift late in the year, that wasn't enough to restore investor confidence.

The stock market in 2007 displayed a decidedly "split personality," says David Nelson, investment strategist at Legg Mason Capital Management in Baltimore. "Strategies based on price momentum and steady earnings growth worked exceptionally well. But value-based approaches – picking the statistically cheapest stocks – failed miserably."

Simply emphasizing the S&P economic sectors with the highest percentage of foreign sales would have yielded superior returns, according to Nelson. The energy, information technology, and materials sectors of the S&P 500 index, for example, consist of companies that earn more than one-third of their revenues outside the United States. Stocks in each of these sectors posted gains averaging 15 percent or more last year.

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