Markets exceed modest expectations

Experts predicted only single-digit rises this year – something the markets have already achieved at the halfway mark.

"Gee, what a pleasant surprise!" That's what many stock fund investors are likely to exclaim when they pore over their midyear statements in the coming weeks.

Despite market jitters in June, when a sudden jump in long-term interest rates and leveraged hedge- fund woes made headlines, equity-oriented mutual funds turned in a strong showing in the second quarter. Although major stock market indices backed off from record highs set in May, little damage was done to most diversified stock portfolios.

It didn't matter whether investors held international funds or domestic offerings – both types enjoyed solid gains. See chart (PDF).

Among 18 types of diversified US stock funds tracked by Lipper, only one – dedicated short bias funds, which thrive in bear markets – lost ground. The laggards were funds with heavy stakes in real estate and financial stocks. Bank stocks, in particular, suffered from their sensitivity to rising interest rates and growing concerns about credit quality.

Funds that diversify their assets globally fared somewhat better than domestically oriented funds, but the differences were fairly slim. The average diversified US equity fund advanced 6.2 percent in the second quarter. World funds, a broad universe ranging from single-country funds to global funds with a stake in the US market, climbed 8.3 percent.

A narrow slice of this universe, funds specializing in Latin America, was a big winner last quarter, rising 20.2 percent. Other prominent gainers were funds that invest in China (up 21.5 percent) and the Pacific, excluding Japan (up 16.1 percent).

An overview of fund performance during the quarter suggests that large-cap stocks may soon emerge into the forefront again, analysts say.

Small companies, with their zippier earnings growth, have been market darlings for the past six years. But slower consumer spending, subpar US economic growth, and rising interest rates create stronger head winds for small companies than they do for larger ones.

Large-cap stocks typically outpace small-cap stocks in the later stages of a bull market cycle, says Lipper senior analyst Jeff Tornehoj, and that appears to be happening. "We're beginning to see signs of a trend reversal," he says.

Large-cap core funds advanced 6.4 percent in the quarter, closely matching the rise in the S&P 500 index (6.1 percent). Large-cap growth funds perked up as well, aided by renewed strength in information technology and healthcare stocks. For the quarter and year-to-date, mid-cap funds were the strongest performers, with the mid-cap core group returning 6.5 percent and 19.9 percent, respectively. Small-cap value funds trailed the pack, rising 4.8 percent.

"With risk averseness becoming more acute and corporate earnings growth fading, investors are more quality conscious," says William Hack­ney, managing director of Atlan­­ta Capital Management. High-­quality companies have sturdy balance sheets and a proven ability to boost earnings and dividends under varying economic conditions. For him, that makes a compelling case for buying multinational US companies, many of which are represented in the top capitalization tier of the S&P 500. "For the typical S&P 500 company, sales of foreign affiliates account for more than one-third of total revenues," he notes. "They will likely emerge as future market leaders."

Judging by money flows, investors aren't displaying much exuberance in their fund choices, according to Lipper data. Money market funds, many of which offer yields above 4.5 percent, received the lion's share of new money flows in May.

Can perky world markets last?

New purchases continue to favor mixed-equity and multicap funds over large-cap funds, which have seen sizable withdrawals since Jan­uary. World equity funds, on the other hand, are still a magnet for investors, garnering more than $11 billion in fresh money in May. "There has been little letup in investors' love affair with global markets," Tornehoj says.

In the overseas arena, emerging-market funds continued their lengthy winning streak, with a 14.3 percent rise for the quarter. Over the past five years, emerging markets have climbed close to 30 percent annually. A gradually tightening global credit cycle, however, has some fund managers fretting about a downturn. "The outsized returns over the past few years are unsustainable, especially since valuations in some markets such as India and China are no longer that attractive," says Ray Mills, portfolio manager of T. Rowe Price International Growth and Income fund. As a result, his fund has pared emerging-market issues to about 3 percent of its total assets, down from almost 10 percent a few years ago.

Among sector funds, natural resources were a standout, advancing 14.7 percent. Higher oil and gas prices, coupled with brisk demand for industrial metals and agricultural commodities, gave the funds a hefty boost. Although the upswing in the commodities cycle is five years old, Derek Van Eck, portfolio manager of the Van Eck Global Hard Assets fund, doesn't see it collapsing any time soon. China's blistering economic growth has had a huge impact on energy and metals markets, "and supplies of most basic commodities remain tight," he says. Geopolitical problems in the Middle East and Africa are a deterrent to expanding oil production, which continues to lag behind projected demand. "We don't foresee crude oil quotes falling much below $70 a barrel anytime soon," he says.

Real estate funds, once a front-runner, were hit by a rise in long-term interest rates. The valuations of Real Estate Investment Trusts (REITs) "were lofty after five years of superior returns," says Tim Courtney, chief investment officer for Oklahoma City-based Burns Advisory Group. "They have far less appeal now since their dividend payouts had fallen well below bond yields," he says. He expects "bondlike" returns from REITs over the next couple of years.

Looking ahead, many market strategists are still bullish, despite the market's heightened volatility. "You may see a healthy pause over the summer months, but the underlying market trend is still upwards," says S&P strategist Alec Young.

Signs the bull is growing tired

Others are less sanguine. The market has already scored the high single-digit gains many strategists projected for the year, and the second half of the year may not see such smooth sailing, says Nicocles Michas, strategist with Alexandros Partners, LLC. "Apart from large, multinational firms with strong overseas exposure, upward earnings momentum is clearly deteriorating for most companies," he says. "The combination of higher long-term rates,

stubborn inflation, and skimpier profits creates a problem for the market." The Fed­­eral Reserve is unlikely to ease rates anytime soon, since global interest rates are edging higher. "There's clear evidence that excessive debt leveraging in the economy may well unwind in a painful way." Mr. Michas adds.

To guard against a market downturn, some advisers are encouraging investors to take profits in funds that have done well, reallocating money to underperforming or more conservative asset classes. Since the summer months are historically volatile for stocks, "now is a fine time to review asset allocations and rebalance a diversified stock portfolio," says Chris Neubert, president of Moneco, an asset manager based in Southport, Conn. "Periodic rebalancing of a portfolio, at least annually, equates to selling high and buying low," he says. "You generally don't want to deviate more than plus or minus 5 percent from your target asset-allocation."

In addition to building up cash reserves, investors may be more defensive by adjusting sector exposure or investment styles. Burns's Mr. Courtney suggests a greater emphasis on large-cap value funds and equity-income funds that favor high-dividend paying companies. Mixed-asset, or target allocation funds that hold bonds as well as stocks, also pose less downside risk. Adding global funds that hold income-oriented stocks may also reduce the volatility of portfolios primarily invested in US shares, he adds.

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