Mutual funds: Investors battle the bear

Dazed and more than a little squeamish. That describes the mood of many mutual-fund investors after navigating a second quarter that saw most stock funds wind up with few, if any, gains.

After a painful first quarter, investors were expecting stocks to stabilize and perhaps get out of the red in response to the Federal Reserve's concerted campaign to avert a liquidity crisis in the banking system.

But Wall Street's consensus view – that any recession would be short and shallow – faded in June amid rising joblessness, plummeting auto sales, and an upward spike in oil and commodity prices. Credit-rating downgrades on major bond insurers and analysts' predictions of additional asset write-downs by major banks sent battered financial stocks into another tailspin. Dismal consumer-confidence indicators triggered a broad sell-off in automotive and retail stocks.

The Federal Reserve decision to hold its key federal-funds rate steady in late June did little to assuage nervous investors that inflation would be reined in.

Investors had a severe "reality check" in June, when the Dow Jones Industrial Average sank to its lowest level in nearly two years, says James Awad, investment manager with W.P. Stewart, an asset-management firm. Hopes that the recession would be relatively mild and that the worst of the credit crunch was about over "were pretty well dashed," he says. Many investors now reckon the Fed is more likely to tighten monetary policy to dampen inflationary expectations and support the dollar rather than act to spur the economy.

"The economy averted a liquidity calamity, but there's a big question as to how quickly it can stabilize with consumers paying more than $4 a gallon at the pump," adds Dan Shackelford, manager of the T. Rowe Price New Income Fund. Although constrained so far, "inflation has become a wild card" that doesn't bode well for corporate earnings or for stocks over the near future, he notes.

The market's woes were reflected in the disparate performance of US stock funds, which averaged a slim 0.2 percent gain for the quarter, according to Morningstar Inc., in Chicago. Growth funds trumped value funds, bolstered by the market's stronger sectors – energy, information technology, and basic materials. Value offerings struggled because of their heavier concentration in the financial sector and consumer-related stocks.

For the year to date, a majority of the 25 biggest mutual funds, including the Vanguard's S&P 500 Index fund, showed losses of 10 percent or more. Still, most actively managed US funds have outpaced the S&P 500 index, which is off 12 percent in 2008.

"We've had a bifurcated market, says Les Satlow, portfolio manager at Cabot Money Management in Salem, Mass. "If you weren't invested heavily in the energy or technology sectors this quarter, you had very hard time making money. Growth strategies certainly are working better than value strategies, which have been a train wreck lately."

A setback overseas

For the first time in several years, investors trolling foreign waters fared worse than their domestic counterparts. International funds, a broad category that includes funds with a stake in the US market, were off 1.6 percent for the quarter. International funds were dragged down by European markets, which, for most part, have fallen harder than the US market this year. Asian markets, which collapsed in the first quarter, continued to wobble in the second quarter. Despite strength in Latin America (up 12.6 percent), emerging-market funds fell 0.2 percent.

Setbacks in overseas markets have come as a shock to investors whose fund holdings have become increasingly global in recent years. Driving this trend has been superior investment returns abroad and a sagging US dollar. The typical S&P 500-stock index fund, for example, has gained an average of 7 percent annually over the past five years, but the average foreign blend fund experienced a 16 percent a year increase over that period.

Proponents of international investing point out that foreign economies produce 70 percent of the world's gross domestic product, and many developing nations, such as China and India, have more robust growth prospects than the US.

While some analysts have argued that a credit crunch and recession in the US would have little spillover effect on foreign stock markets, that view is currently being severely tested. "There are good reasons to own foreign equities, but downside protection in a bear market isn't one of them," says Mr. Satlow.

The long stretch of overseas dominance is probably over, and major developed markets are likely to track US stocks more closely, says Alec Young, an equity strategist for Standard and Poor's.

"You're seeing mid-cycle slowdowns in Eurozone economies, aggravated by banking credit problems and gradual tightening of monetary policy," he says. "Anti-inflationary policies are also beginning to bite in emerging markets, where prices of basic foodstuffs and fuels are rising sharply."

From 2003 to 2007, robust economic growth raised the stock prices of companies traded in emerging markets, Now, their valuations are no longer cheap compared with developed markets such as the United States, Canada, and Australia, says Anthony Craddock, comanager of Highmark International Opportunities Fund. "There's considerably more risk ... as export growth slows and corporate earnings soften. It's hardly a good time to jump into emerging markets," he says.

Near the end of the road for oil profits?

Among sector funds, natural-resource funds were sparked by inflation fears. Loaded with oil, gas, and coal, the sector soared over 19 percent. Over the past three years, natural-resource funds have surged 29 percent annually, topping all other sectors except precious metals.

Still, many experts argue that the swift run-up in crude oil prices over the past year is unsustainable. "The underlying supply-demand equation doesn't justify the speculative fever," says Stanley Nabi, vice-chairman of Silvercrest Asset Management. "The asset valuation of the big integrated oil companies suggests crude should be priced closer to $80 a barrel." With a global oil consumption beginning to flatten, "I'm much less bullish on energy stocks," he says.

'A bottoming-out process'

Going forward, investors should be leery of further downside risks, analysts say.

With the Dow Jones Industrials off 20 percent from its previous high – a standard definition of a bear market – "safety first" strategies are still in order, according to James Stack, editor of Investech Research, an advisory service. Mr. Stack's model portfolio is currently 50 percent invested in equities, tilted toward large-cap multinational companies such as Microsoft and PepsiCo. The remainder of the portfolio is invested in US Treasuries and money-market funds.

Should the market reverse direction – "good odds in the last half of a presidential election year," Stack says – he is prepared to shift assets from "defensive" industries such as foods and utilities into technology, telecommunications, and consumer discretionary issues, traditional leaders when stocks advance.

"We're in the middle of a bottoming-out process that has a ways to go," adds Fred Dickson, chief strategist at D.A. Davidson & Co. Historically, the market turns up well before recessions are over. Barring a collapse in oil prices, consumer malaise is likely to prolong the economic contraction beyond year-end, according to Mr. Dickson.

"Until investors are convinced that the worst of the housing slump and bank loan write-offs are behind us, we're not likely to see much more than relief rallies," he says.

Over the next few weeks, Dickson believes a spate of negative second-quarter earnings reports will keep the market off balance.

Meanwhile, fixed-income investors should hew toward short-term, high-quality bonds, says Mr. Shackelford at T. Rowe Price. With heightened inflation risk, "we're in for a tough period for bonds. The premium on safety has largely been removed from Treasury bonds, but yields are relatively low compared with good-quality corporate bonds.

Yields on lower-rated bonds may appear enticing, but defaults rates are likely rise," he warns. A better choice for those seeking higher income are senior bank loan funds whose payouts float upward as interest rates rise.