Will the bull market survive the storm?

Investors eked out modest gains last year, but now ill economic winds are whirling through Wall Street.

Jimmy Holder

Mutual fund investors may be forgiven if they're feeling a bit queasy as the new year begins.

With signs of recession mounting, housing in a deep slump, and inflationary pressures brewing, few market forecasters are wearing rose-colored glasses.

The five-year-old bull market is still alive, but its heartbeat is becoming fainter, experts say. And there's no assurance that the market's heightened volatility won't lead to another downdraft in the months ahead.

A piece of advice for investors: Don't set your sights too high for 2008, and be prepared for more market turbulence, at least in the early months of the year.

Despite a roller-coaster fourth quarter, most US stock funds fared reasonably well in 2007 – a year that saw financial service and consumer-oriented stocks rip holes in many fund portfolios. The average US diversified equity fund managed to advance 6.3 percent, according to fund-tracker Lipper. The gain, the slimmest since 2002, nonetheless beat

the S&P 500 index's 3.5 percent rise. If the financial sector is factored out, the S&P 500, after reinvesting dividends, would have risen by more than 10 percent for the year, according to Standard & Poor's. The NASDAQ Composite, buoyed by high-tech stocks, climbed 9.8 percent, its best showing since 2003.

Stock fund returns ran the gamut, with many international funds advancing 12 percent or more, while most small-cap value funds fell. Among 18 types of US diversified stock funds tracked by Lipper, only three declined in 2007. Strong global earnings growth and a sharp decline in the value of the dollar fattened returns from foreign markets.

But the fallout from the subprime mortgage debacle and a softening US economy took a heavy toll on value-oriented funds. Their traditionally hefty stakes in banking, insurance, and consumer-oriented stocks suffered from the mortgage industry's problems and recession fears.

First half of 2007 accounts for most of Dow gains

Virtually all the market's gains occurred in the first half of the year, when dealmaking was rife, lending standards were loose, and corporate profits were still blooming. After midyear, storm clouds gathered over the credit markets as the subprime mortgage crisis intensified and financial stocks imploded. Record oil prices and weakening consumer spending fanned fears of a looming recession.

While the Fed's action to lower the federal funds rate and inject liquidity into the banking system gave stocks a temporary lift late in the year, that wasn't enough to restore investor confidence.

The stock market in 2007 displayed a decidedly "split personality," says David Nelson, investment strategist at Legg Mason Capital Management in Baltimore. "Strategies based on price momentum and steady earnings growth worked exceptionally well. But value-based approaches – picking the statistically cheapest stocks – failed miserably."

Simply emphasizing the S&P economic sectors with the highest percentage of foreign sales would have yielded superior returns, according to Nelson. The energy, information technology, and materials sectors of the S&P 500 index, for example, consist of companies that earn more than one-third of their revenues outside the United States. Stocks in each of these sectors posted gains averaging 15 percent or more last year.

"If you stayed with large-cap names and avoided financials and consumer stocks related to discretionary spending," adds Les Satlow, money manager at Cabot Money Management in Salem, Mass., "you had a decent year."

Growth funds topped the winners' list with mid-cap growth funds scoring a hefty 16.5 percent rise. Large-cap growth portfolios, market laggards for the past six years, also shone with a 14.2 percent rise. Value funds of all sizes lagged badly.

Renewed risk aversion hurt most funds with small-cap mandates, whose portfolios sported relatively high valuations after five years of double-digit gains.

For the sixth year in a row, globally oriented investors were handsomely rewarded Despite a fourth-quarter setback, world equity funds climbed 16 percent. Hot Asian and Latin American markets benefited emerging-market funds, which soared 36.4 percent in the wake of brisk economic growth in countries such as Brazil, China, and India.

International funds derived a large part of their returns from a sagging dollar. In 2007, the greenback fell in value against 14 of the 16 most actively traded foreign currencies including a 10 percent drop against the euro, according to Federal Reserve data.

Natural resources sector, multinationals did well

Among specialized offerings, the natural resources sector was again a big winner, advancing 39.6 percent. Record high oil prices, coupled with brisk demand for industrial metals and agricultural commodities among fast-growing Asian nations, especially China, buoyed the funds.

Still, the prospect of slower global growth has curbed some analysts' enthusiasm for natural resources after a prolonged advance. A growth pause in China, the result of tightening Chinese monetary policy, could exert downward pressure on commodity prices, according to Nicholas Michas, investment strategist for Alexandros Partners in Waltham, Mass. "That could also put a damper on other emerging markets' as well," Mr. Michas says.

Investors' preference for large-cap stocks with multinational reach is likely to persist for some time, analysts say. "We've entered a multiyear growth-stock cycle with large-cap stocks likely to dominate," says Cabot's Mr. Satlow. Many foreign economies are growing more robustly than the US, and multinational firms are more likely to post more consistent earnings and raise dividends regularly than those linked solely to the US market.

Since corporate profits are shrinking, investors are more willing "to pay up" for dividend-paying stocks with predictable earnings growth, says John Merrill, president of Tanglewood Capital Management in Houston.

Large-cap stocks are reasonably valued from the standpoint of price/earnings ratios and price-to-book metrics. Many technology, healthcare, and food and beverage stocks fit the mold of defensive growth stocks, Mr. Merrill says. "But I would avoid most financial stocks until we get greater clarity on the quality of the banking industry's assets," he concludes.

Looking forward, investors may want to turn more defensive, for instance, by trimming small-cap or emerging markets exposure and adding to cash reserves. According to Charles Schwab & Co., a moderately conservative portfolio with a 40 percent allocation to equities, 50 percent in bonds, and 10 percent cash would have lost only 3 percent in down years between 1970 and 2006.

Raise the stock portion to 80 percent, holding 15 percent in bonds and 5 percent cash, and your average loss would have been three times greater.

"The first half promises to be bumpy, as the economy struggles to avoid recession," says Fred Dickson, chief strategist at D.A. Davidson in Great Falls, Mont. "You have to be concerned about additional huge write-offs by banks and other financial companies, and the implications those write-offs could have for corporate and consumer lending. A likely spate of negative fourth-quarter earnings surprises, bad news on the inflation front, and rising joblessness doesn't bode well for stocks over the near term," he says.

Maybe not recession, but 'mild stagflation'?

So far, the Fed's steps to lower interest rates and relieve the credit crunch have had a limited effect. Despite a consensus view that the Fed will lower its benchmark funds rate again in January, high oil prices and a sagging dollar don't give the central bank much wiggle room, according to Chuck Zender, portfolio manager at Leuthold Group in Minneapolis.

While Mr. Zender doesn't foresee the economy tipping into recession, he predicts "mild stagflation," defined as sluggish economic growth combined with inflationary pressures, which historically depresses stock valuations.

"A high single-digit rise for S&P 500 appears achievable this year," says Stanley Nabi, vice chairman of Silvercrest Asset Management in New York. "But most of the market's progress is likely to occur in the second half of the year, when the economy is likely to stabilize and corporate profits prospects brighten." Historically, he notes, markets tend to strengthen following national elections.

With credit markets in flux, fixed-income investors are advised to stick with high-grade corporate bonds. Last year, a "flight to safety" sentiment lifted returns on long-term US Treasury securities to 8 percent.

This year, bond markets are likely to show more stability, with prices of high-quality corporate issues likely to rise as bond yields ease, analysts say.

For higher-tax-bracket investors, municipal bonds have special appeal. Many high-grade tax-exempt bonds currently pay out more than 10-year Treasuries do. FDIC-insured bank certificates of deposit, some of which now yield close to 5 percent, are another way to ride out volatile markets with less anxiety.

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