Dow's year-end rise a pleasant surprise

Fourth-quarter surge comes with a caution about what may lie ahead.

Mutual fund investors can toot their horns over the surprising success of 2006. An aging bull market that was supposed to eke out modest returns turned out to be a real winner. Major stock indexes hit highs not seen for six years. And unlike 2005, when the fattest gains were confined to a handful of narrow sectors, such as energy and emerging markets, Wall Street's bounty was widespread. Most stock funds chalked up double-digit gains in 2006, enjoying their best year since 2003.

Among 18 types of diversified US stock fund categories tracked by Lipper, only one – dedicated short bias funds – lost ground for the year. The average diversified fund rose a hefty 12.4 percent, the fourth upside year in a row. Fund portfolios packed with big multinational companies fared particularly well, as did those geared to foreign markets, where a weakening dollar boosted returns.

Investors who put their dollars in riskier sectors, such as emerging markets and small-cap growth stocks, experienced considerable volatility, but scored solid gains. While small-cap funds didn't fade, as many analysts had expected, mega-cap stocks – the top 100 companies in the capitalization-weighted S&P 500 index – rebounded in the second half of the year. Value stock funds again beat growth stock funds, a pattern that has persisted for more than five years. The chief laggards were large-cap growth funds, whose penchant for technology and healthcare were a drag on performance.

Almost half of the S&P 500 index's 16 percent rise in 2006 occurred in a robust fourth-quarter rally following August's pause in the Federal Reserve's long string of rate hikes. The rally was stoked by an easing of oil prices and inflationary pressures. Investor confidence was also buoyed by record corporate profits and a growing belief that a cooling economy would not sink into recession.

Last year "showed the importance of being broadly diversified, since there were few consistent trends to exploit," says Harry Clark, CEO of Clark Capital Management Group in Philadelphia. Few investment pros can play the sector- or style-rotation game with much success, he says. "It's awfully tough to anticipate which style of investing will prevail over any given period."

The market's frequent twists and turns placed actively managed funds at a disadvantage relative to index-oriented funds. Reversing 2005's trend, "passive investing strategies excelled in 2006," says Lipper senior analyst Jeff Tjornehoj. S&P 500 index funds, for example, returned 15.2 percent, beating more than three-quarters of the large-cap core funds that use the S&P as a performance benchmark. Over time, he notes, stock funds that mimic indexes typically outdo comparable actively managed funds, owing to lower management and trading fees.

After testing the patience of many fund managers, large-cap funds staged a comeback.

While not outpacing their small-cap counterparts for the full year, they forged ahead in the second half. Investor preference for large companies, whose cash flow is generally sturdier than that of small firms, is likely to continue if economic growth stalls, analysts say. Moreover, says Bryant Evans, portfolio manager with Cozad Asset Management of Champaign, Ill., "Large-cap companies have a distinct valuation edge over small caps, and pay better dividends."

Strength in the financial, telecommunications, and energy sectors again played into the hands of value funds. Large-cap value funds, which seek out underperforming stocks whose fortunes are likely to improve, returned 18 percent. Large-cap growth funds rose about 6 percent, with virtually all of their gains compressed into the fourth quarter.

Foreign funds again rewarded investors handsomely. World equity funds, which now oversee close to 1 in every 4 dollars in equity fund assets, soared 25.6 percent in 2006. Emerging- market funds, recovering from a sharp sell-off in the spring, surged 32.1 percent. Latin American funds added 44.1 percent. Their average annual gain of 31.7 percent over the past five years topped all US and international funds categories. European region funds also sparkled, with almost half their 33.7 percent annual advance owing to the effects of a weaker dollar.

Money flows into stock funds were strong in 2006, but heavily skewed toward foreign offerings. Despite the market upswing, domestic stock funds were largely devoid of fresh inflows, says Mr. Tjornehoj. Besides international funds, money inflows have favored less volatile equity-income funds, which opt for companies with high dividends.

Wall Street strategists anticipate further, if less robust, gains in 2007. S&P's investment policy team, for example, projects a return of 8 percent for the S&P 500 for the year, with almost 2 percent attributed to dividends.

"The risk-reward ratio remains decidedly tilted toward equities," says Stanley Nabi, vice chairman of Silvercrest Asset Management in New York. Price-earnings ratios don't look stretched, especially for large-cap stocks with healthy balance sheets. Some slippage in corporate profits from peak levels shouldn't stymie stocks, as long as US economic growth doesn't dip below 2 percent and inflation remains mild, he adds.

Along with a host of other forecasters, Mr. Nabi expects "mega cap" stocks, the top tier of multinational companies, to be pace-setters. Their global reach, which typically accounts for more than one-third of profits, should help them weather any economic weakness at home. Small-cap stocks, whose valuation appears extended after a six-year run, may take a back seat to large caps.

Fred Dickson, market strategist for D.A. Davidson, agrees with the positive outlook, but with a caveat: "Investors will experience more price volatility, especially during the first half of 2007, and investment returns that will fall short of last year." he says, and Wall Street may be too optimistic in assuming the Fed will lower rates early this year.

Few analysts expect foreign markets to repeat this past year's strong showing. Still, steady economic progress in Europe, coupled with rising per capita incomes in emerging markets like India, Brazil, and Mexico should keep the upward trend alive.

One key question: How will the greenback fare? If the dollar reverses course and rises against the yen and euro, gains from international funds would fall.

What might go amiss in 2007? Sudden geopolitical crises, especially in the Middle East, could cause another spike in oil prices. On the domestic front, the potential ripple effects of a housing slump remain worrisome.

Noting that every recession since 1966 was preceded by a sharp downturn in housing starts, Mr. Clark frets that "we're probably only halfway through the current downturn." In the past six down cycles, the average decline in residential construction, from peak to trough, has been about 50 percent.

To date, the decline from the 2005 peak has been around 30 percent, he says.

To keep their portfolios flush in the months ahead, investors will have to stay well diversified among various asset classes, including international stocks, analysts say. Sector themes that have been hot for several years, such as energy and real estate, merit a more cautious approach.

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