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Mutual funds: Investors battle the bear

A stock-market sag spilled into the second quarter, leaving little to be gained.

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Among sector funds, natural-resource funds were sparked by inflation fears. Loaded with oil, gas, and coal, the sector soared over 19 percent. Over the past three years, natural-resource funds have surged 29 percent annually, topping all other sectors except precious metals.

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Still, many experts argue that the swift run-up in crude oil prices over the past year is unsustainable. "The underlying supply-demand equation doesn't justify the speculative fever," says Stanley Nabi, vice-chairman of Silvercrest Asset Management. "The asset valuation of the big integrated oil companies suggests crude should be priced closer to $80 a barrel." With a global oil consumption beginning to flatten, "I'm much less bullish on energy stocks," he says.

'A bottoming-out process'

Going forward, investors should be leery of further downside risks, analysts say.

With the Dow Jones Industrials off 20 percent from its previous high – a standard definition of a bear market – "safety first" strategies are still in order, according to James Stack, editor of Investech Research, an advisory service. Mr. Stack's model portfolio is currently 50 percent invested in equities, tilted toward large-cap multinational companies such as Microsoft and PepsiCo. The remainder of the portfolio is invested in US Treasuries and money-market funds.

Should the market reverse direction – "good odds in the last half of a presidential election year," Stack says – he is prepared to shift assets from "defensive" industries such as foods and utilities into technology, telecommunications, and consumer discretionary issues, traditional leaders when stocks advance.

"We're in the middle of a bottoming-out process that has a ways to go," adds Fred Dickson, chief strategist at D.A. Davidson & Co. Historically, the market turns up well before recessions are over. Barring a collapse in oil prices, consumer malaise is likely to prolong the economic contraction beyond year-end, according to Mr. Dickson.

"Until investors are convinced that the worst of the housing slump and bank loan write-offs are behind us, we're not likely to see much more than relief rallies," he says.

Over the next few weeks, Dickson believes a spate of negative second-quarter earnings reports will keep the market off balance.

Meanwhile, fixed-income investors should hew toward short-term, high-quality bonds, says Mr. Shackelford at T. Rowe Price. With heightened inflation risk, "we're in for a tough period for bonds. The premium on safety has largely been removed from Treasury bonds, but yields are relatively low compared with good-quality corporate bonds.

Yields on lower-rated bonds may appear enticing, but defaults rates are likely rise," he warns. A better choice for those seeking higher income are senior bank loan funds whose payouts float upward as interest rates rise.