A bull market storms ahead

Despite a falling housing market and warnings of an economic downturn, analysts remain confident that the stock market will stay strong in the months ahead.

Unless they were heavily involved in energy funds, mutual fund investors won't have much to grumble about when they open their latest quarterly statements. While few may clap their hands and cheer, many investors will be pleased at the broad-based – albeit modest – gains in their stock portfolios. After swooning in the spring, most stock-fund portfolios benefited from a late-summer rally, the strength of which surprised Wall Street professionals and boosted the S&P 500 index to its highest level in five years.

The market's run-up was sparked by the Federal Reserve's decision in August to pause its two-year-long monetary tightening campaign. That move, together with a sharp drop in oil prices, dispelled Wall Street's fears that an extended bull market, now entering its fourth year, would soon end. With corporate profits still on an uptrend and long-term interest rates easing, many fund managers shrugged off worries about strained consumer finances and a housing slump. Widespread predictions of a "soft landing" scenario for the economy encouraged managers to put cash reserves to work, mostly in large-cap, blue-chip issues. The blue-chip revival was confirmed when the Dow Jones Industrials index, representing 30 of the largest US companies, had record-high closes for three days straight last week.

Most fund categories were solidly in the black during the quarter. Led by the upswing in large-cap stocks, the average diversified domestic equity fund returned 2 percent for the quarter, according to fund tracker Lipper Inc.

Investors with a stake in foreign markets fared somewhat better, with the average world stock fund climbing 3.4 percent. During the quarter, the S&P 500 index rose 5.7 percent, its best quarterly gain in almost three years. In addition, most actively managed US stock fund categories have failed to match the 10 percent increase achieved by S&P 500 index funds so far this year.

"Higher quality, large-cap stocks are now leading the way, and that's not likely to change soon." says James Moltz, vice chairman of ISI Group, an economic research firm in New York.

As the economy slows, corporate pricing power wanes and competition intensifies. Under those conditions, bigger companies with sturdy balance sheets, many of them multinational, are more apt to gain market share from smaller companies, Mr. Moltz says. That's why he expects large-cap funds to outpace small- and mid-cap funds in the near future. After five years of superior gains, current valuations of small and mid-size firms are generally less attractive than large ones, he says.

The improved investor sentiment, however, hasn't yet translated into significant new money flows into US stock funds. International funds continue to be a magnet for investor dollars, according to Tom Roseen, senior analyst with Lipper Inc.

'Life cycle' funds popular for 401(k)s

In the domestic arena, only mixed-equity funds (which include the newer types of life-cycle funds) have garnered steadily rising inflows this year. These one-stop investment choices, many of which adjust their stock and bond allocations with respect to investors' retirement dates, have grown increasingly popular. Their rise is being spurred by employer- sponsored 401(k) plans. Many of these plans, under recently passed pension legislation, will encourage employers to enroll new hires automatically in this less-risky type of fund.

From a performance standpoint, value funds, especially those holding large-cap stocks, outpaced growth funds by a wide margin. Investors have shifted their focus toward big companies with steady earnings and dividend growth in such groups as consumer staples, telecommunications, and utilities, says Mr. Roseen. For the first time since the third quarter of 1998, large-cap funds posted two successive top-performing quarters.

Funds tracking the S&P 500 index had an excellent quarter. For example, investors in Vanguard's 500 Index, one of the nation's 10 largest funds, rose 5.6 percent. Small-cap funds, by contrast, wilted, with those that employed a growth strategy losing 2.7 percent.

Weaker dollar boosts overseas gains

Many world stock funds, a broad category that includes global and foreign funds, fared well in the third quarter. Among them, emerging-market funds rebounded from second-quarter losses by climbing 5.3 percent. As is often the case, currency gyrations played a role in the positive results overseas. So far this year, says Les Satlow, portfolio manager at Cabot Capital Management, a weaker dollar "almost doubled returns for US investors in developed foreign markets."

Among sector funds, real estate was again a standout performer, advancing 8.4 percent. Real Estate Investment Trust (REIT) funds, which invest primarily in commercial, multifamily, and industrial properties, have been on a tear for five years. Annual returns have averaged 22 percent, topping all other domestic fund categories.

"It's a bit late to be adding to REIT exposure, but office and multifamily REITs, where rental income is rising nicely, should continue to do well." says Mr. Satlow.

Sliding oil and gas prices put a crimp in natural-resource funds, which fell 8.4 percent. The underlying supply-and-demand equation for oil hasn't changed much yet, but with the downward price trend, "we wouldn't be adding to energy stock positions," says Moltz.

It's no surprise that the investor shift toward large-cap, dividend-paying stocks has coincided with mounting signs of a slowdown in the economy, analysts say. The momentum of corporate earnings growth has fallen from the mid-teens to below 10 percent, and will probably be less than 5 percent next year, according to Nicocles Michas, an investment strategist with Alexandros Partners, LLC.

"That's traditionally when large-cap growth and value stocks excel, rather than cyclical or small-cap issues," he says.

David Hay, president of Evergreen Capital Management in Bellevue, Wash., agrees that large-cap growth stocks, and the funds that specialize in them, are poised for a turnaround. These funds have languished since the technology bust of 2000. For the past six years, disgruntled investors have consistently pulled money out of these funds.

Applying a contrarian approach, Mr. Hay suggests that this antipathy has now reached extreme levels and should be construed positively. Such prolonged bearishness, combined with the relatively cheap valuations of high-quality companies such as Intel, Home Depot, and GE, enhances the funds' long-term appeal, he says.

Reasons to beware the bear

Looking ahead, some analysts urge investors not to get overly excited about the recent gains. "We're in a late stage of the bull-market cycle, and haven't yet had a 10 percent market correction," says Andy Engel, portfolio manager with Minneapolis-based Leuthold Funds. The Wall Street consensus seems to assume that the Fed is finished with rate hikes, and may even begin to ease in the early part of 2007, he says. "But the Fed may well decide to hike rates again if inflationary pressures pick up later in the year, as we anticipate they will."

Even if the economy expands at no better than a 2.5 percent annual rate in 2007, the stock market won't necessarily stall, according to Moltz. "If we have modest profit growth and price-earnings ratios stabilize – a likely development now that the Fed has stopped tightening – the market can move higher," he says.

Housing market weakens confidence

The November elections may have a significant impact on investor psychology in the fourth quarter, some analysts say. A change in congressional leadership, were Democrats to win a majority in the House or Senate, would probably generate market volatility. "A change of control would raise questions about retention of tax breaks for business and possibly lead to more onerous regulation of the energy, defense, and drug industries," says Fred Dickson, chief strategist for D.A. Davidson & Co.

Investor confidence may also begin to fade once the adverse ripple effects from a downturn in the housing market are more widely felt. A lengthy stretch of flat or falling housing prices would retard consumer spending and shave more than 1 percent a year off US economic output, according to Lord Abbett economist Milton Ezrati.

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