Still a bit skittish of the bull market

Investors are pleased that the third-quarter Dow has recovered from its July slump. What lies ahead?

Many mutual fund investors will breathe a sigh of relief when they open their third-quarter statements in coming weeks.

Unless their fund holdings were heavily laced with small-company or financial stocks, this summer's stock market gyrations didn't make much of a dent in their net worth. Although Wall Street gave investors a wild ride, the upshot might have been a lot worse if the Federal Reserve hadn't sprung into action with aggressive rate cuts.

By lowering the discount rate twice and slashing the federal funds rate by half a percentage point on Sept. 18, the central bank sent the credit-easing message that investors were craving after the stock market's late-July nosedive. The Fed pumped liquidity into stressed credit markets, calming Wall Street's fears that a protracted housing slump would trigger a recession.

Besides bolstering lenders and mortgage-backed security holders, the Fed's moves also reassured investors that monetary policy had clearly reversed course and would probably ease further.

For the quarter, the average US diversified equity fund returned a mere 0.9 percent, according to fund tracker Lipper Inc. Most overseas markets provided heftier gains, aided by a weakening US dollar. International multi-cap core funds, the most widely held type of foreign equity fund, rose 3.1 percent. Emerging-market funds, which focus on regions such as Latin America and Southeast Asia, scored double-digit gains.

Wall Street's midsummer swoon, followed by a torrid September rally, didn't affect all stock groups equally. Although banks and mortgage-related stocks suffered from the credit crunch, large-cap stocks in such sectors as basic materials, healthcare, and information technology generally held up well. Most growth funds beat their S&P 500 index benchmark by steering clear of financial-service companies and firms dependent on discretionary consumer spending. Large-cap growth funds benefited from owning a variety of globally diversified companies, especially in the thriving capital goods and basic materials sectors. Value funds, on the other hand, were hobbled by their broader exposure to financial stocks.

Following the technology bust of 2000, growth-oriented investment strategies took a back seat to value strategies. The latter favored smaller, cyclical companies as well as financial stocks, whose profits rose rapidly while US economic growth was brisk. That's now changing as America's economy hits a rough patch and corporate earnings growth falters.Heightened aversion to risk is common in the late stages of the business cycle, analysts say. That's why many investors are gravitating toward large companies with more stable income streams rather than speculative stocks promising fat capital gains. "Large-cap growth issues are assuming a leadership role again after a lengthy dry spell," says Harry Clark, president of Clark Capital Management, a Philadelphia-based invest­ment adviser. "Our technical models point to multinational companies that sport steady growth, pay above-average dividends, and have solid cash flows as future standouts."

Investors go global

A global growth theme has worked well for investors whose portfolios are tilted toward large-cap information technology, basic materials, capital goods, and energy stocks, agrees Les Satlow, portfolio manager at Cabot Money Management in Salem, Mass.

The tech sector, in particular, offers many attractively valued stocks with superior growth prospects, he says. Companies such as Cisco Systems, Microsoft, and Texas Instruments, for example, enjoy significant earnings growth from exports and overseas operations. Many new product cycles are ramping up, including Microsoft's new Vista operating system, video-game platforms, and numerous broadband applications for the Internet and wireless systems. "The global growth theme should continue to play out well because many foreign economies, especially China and India, are more robust than the US," Mr. Satlow says.

The market's wide swings have led jittery investors to the safety of money-market funds. In August, investors poured a record $150 billion into money-market funds, triple July's figure, says Jeff Tornejoh, senior analyst with Lipper. Moreover, domestic stock fund flows continued to decline sharply with the exception of mixed-asset type funds, which place asset-allocation decisions into the hands of professional mana­gers. The increasingly popular target horizon funds, for example, adjust stock and bond allocations with respect to an investor's planned retirement date. Globally focused funds again garnered the lion's share of fund inflows.

Bigger is better

From a performance standpoint, fund results during the quarter diverged between capitalization sizes and investment styles. Big was definitely better than small, as most small-stock categories slid several percentage points into the red. As was the case in the first quarter, a style shift toward growth strategies was clearly evident in the large-cap arena. The large-cap growth category advanced 6.2 percent compared with flat results for large-cap value funds.

In the international arena, funds specializing in China and emerging markets were prominent pacesetters, advan­cing 28.9 and 11.8 percent, respectively. "Emerging markets are growing much faster than the US, yet stock valuations are, in most cases, cheaper than in the US," says Thomas Melendez, international fund manager at MFS Investments. "The risk profile of emerging markets such as Brazil and India, though still much higher than the US, has improved considerably in recent years. That's one reason why they bounced back surprisingly fast after the summer's market slide."

A decade ago, many emerging economies were burdened with international debt, and their foreign-exchange reserves were skimpy. After several years of rising commodity prices, moderate inflation, and soaring trade surpluses, they are less tightly correlated to US market swings, according to Mr. Melendez.

Among sector funds, natural resources led the pack, rising 7.2 percent. Energy-related stocks, in a strong uptrend for more than three years, fueled the sector's gain as crude oil quotes touched record levels . Gold funds also sparkled, extending a three-year-long winning streak, with an 18.3 percent gain. The greenback's decline, which accelerated following the Fed's rate cuts, made gold more affordable to foreign buyers.

"It's a hard asset and inflation hedge," says Satlow. "Still, you probably don't want gold to be more than 5 percent of a diversified portfolio."

Reasons to be bearish

Looking ahead, some advisers urge investors not to get too complacent because of the market's September snapback. "Despite the likelihood of additional Fed rate cuts before year-end, the risks in this late-stage bull market remain elevated," warns James Stack, editor of Investech Research, an investment advisory service.

The Fed's easing of rates has given stocks a boost, but it may only be temporary, he says. With "housing in a free-fall" and consumers pinching their pennies, "the economy can't be assured of a soft landing," Mr. Stack says.

The Fed doesn't have as much room to maneuver as it did in 2001 when a long string of rate cuts helped prevent a lengthy recession. This time, the Fed must worry about a sagging dollar, which adds fuel to inflationary forces, Stack says. An advocate of capital-preservation strategies, he recommends that no more than half of one's portfolio be in stocks at this time – mainly in recession-resilient industries like consumer staples and healthcare – and more than 30 percent be held in US Treasury bills.

Although the fourth quarter is historically an upbeat one, says Fred Dickson, chief strategist for D.A. Davidson in Great Falls, Mont., "the bulls have their work cut out for them this time." With a troubled financial sector, oil prices remaining above $80 a barrel, and housing in a deep recession, the economic outlook doesn't look so good. Corporate third-quarter earnings reports will have "a lot more unpleasant surprises," he says.

Still, with more than $2 trillion held in money-market accounts, investors have plenty of cash on the sidelines – a "potentially bullish sign," says Mr. Dickson. "With stock valuations at historically reasonable levels, a major stock setback is unlikely."

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