Can you blame mutual fund investors for feeling it's not safe to go outside?
Almost everyone in the stock market has been trampled by a stampede of bad news.
The subprime mortgage problem that appeared to be contained a few months ago has evolved into a full-blown global credit crisis. A mild economic slowdown, once thought to be over by early next year, now threatens to morph into a more prolonged economic contraction. Several large financial institutions have been forced to merge after wiping out shareholders. And the outlook for corporate profits has deteriorated as many companies retrench because lenders are tightening their fists.
These disturbing developments have taken a heavy toll on stock-fund portfolios and curbed investors' zeal for risky investments.
As the scope of the credit crisis in the United States widened, global stock markets tumbled in virtually the same fashion during the third quarter. With several venerable Wall Street financial institutions collapsing or merging with stronger players and major banks requiring life support from the federal government, investors fled from stocks. But other than Treasury securities and cash, there were few havens. Even money-market funds, normally a secure place to park cash, gave investors a scare. In September, some fund families temporarily halted redemptions in order to safeguard $1-a-share asset values. Meanwhile, stocks, as measured by the S&P 500 index, plunged deeply into bear territory. September's 12 percent drop was that index's worst monthly decline in 10 years.
"The unwinding of excessive leverage in the financial services sector is painful and still has a ways to go," says Milton Ezrati, chief strategist for Lord Abbett & Co., an investment firm in Jersey City, N.J. The government mortgage rescue package should remove some of the uncertainty, but it won't stop the deleveraging effect from hurting the economy and eroding consumer wealth, he says.
"We're entering a period of credit contraction and investors aren't sure how severe it will be," he adds. "We'll have to see signs of home prices stabilizing before investor confidence is restored."
Among the various stock-fund categories tracked by Morningstar, only two showed positive returns last quarter: Bear funds, which profit when stocks fall in price, gained an average of 7.2 percent, and real estate funds, up 2.1 percent. Meanwhile, the average US stock fund fell 10.5 percent, erasing three years of gains.
Nor did international stock funds fare any better. These funds have garnered the lion's share of stock-fund inflows over the past five years as investors sought to stabilize their portfolios during market downturns at home. But last quarter's 20.5 percent drop, the worst quarter in more than 30 years, was a rude awakening, says Tom Roseen, senior analyst at Lipper in Denver.
"The honeymoon may well be over for foreign funds," he says. "The turmoil in global markets now has many investors ducking for cover."
Going forward, investors should be braced for more turbulence, at least until early next year, analysts say. Rising joblessness and cutbacks in credit availability for households will continue to weigh heavily on investor psychology.
The banking system needs to raise huge sums of capital to replenish its coffers, says Charles Lieberman, president of Advisors Capital Management in Paramus, N.J., and the task won't be easy. "At a minimum, the healthy functioning of the credit markets must be restored if the stock market is to stage a significant recovery," he says.
Prudent investors shouldn't dump stocks indiscriminately, but should be "playing defense at least until after the election," says Nicholes Michas, chief strategist for Alexandros Partners LLC. "Maintain ample cash reserves and stick with high-quality fixed income securities with shorter maturities."
With a drop in oil and commodity prices, inflationary risks have eased and bonds look more attractive, Mr. Michas says. He believes that high quality growth stocks in such sectors as healthcare, consumer staples, and technology can weather a recession better than retailers or other consumer discretionary stocks.
Roller-coaster markets often dissuade investors from sticking with a disciplined asset allocation plan. Yet a large body of academic studies shows that investors who maintain their asset allocations and investment strategies fare better over the longer term than those who pull back in times of trouble.
Often that may require having a cool-headed adviser at your side. "Investors who have access to registered investment advisers are apt to fare better during volatile markets than self-directed investors," says Robert Huebscher, president of Advisor Perspectives in Lexington, Mass. "They help clients avoid acting on emotional impulses or making short-sighted decisions."
His firm tracks how financial advisers allocate the assets of high-net-worth individuals. Its latest data shows that they have 61 percent of their portfolios in equities, 12 percent in cash, and 27 percent in bonds. About one-fifth of the equity portion is devoted to non-US markets. Although cash holdings have risen over the past year, Mr. Huebscher says, "we've seen no dramatic shifts by advisers onto the sidelines in recent weeks."
Still, some advisers have sharply trimmed their stock allocations in recent months. "Capital preservation is the key goal now," says Dean Barber, president of Barber Financial Group in Lenexa, Kan. His "conservative growth" portfolios, geared toward retirees, currently hold 35 percent in bonds, 22 percent in US stocks, 7 percent in commodities, 5 percent in foreign stocks, and 31 percent in cash equivalents (mainly money-market funds backed by large financial institutions and short-term government bond funds). A portfolio so defensively tilted, he says, has lost less than 3 percent of its value in the past month.
One of the sturdiest performers has been San Francisco-based Permanent Portfolio fund, which holds precious metals, Treasury securities, and stable foreign currencies such as the Swiss franc. "It's a kind of one-stop shop for hedging against a resurgence of inflation," Barber says.
Will the November's presidential election have an impact on the market?
From a historical standpoint, which party wins the election doesn't really matter all that much, says Eric Bjorgen, senior analyst at the Leuthold Group in Minneapolis. Measured over the entire term of each presidency from 1944 to date, the Dow Jones Industrial Average rose at an annual compound rate of 6.7 percent under five Democratic presidents and 7.5 percent under six Republican presidents. "What really counts are secular forces of the market cycle, the economy, and the longer-term effects of policies put in place by prior administrations.
"If Obama wins, the prospect of a higher capital-gains levy would put an additional damper on the market," says Mr. Barber.
Although Mr. Ezrati agrees that a capital-gains boost could induce a "one-time sell-off" before the end of 2009, the troubled economy may cause a Democratic administration to "backpedal on tax hikes until things improve."
Regardless of who is president, bear markets usually end in one of two ways, capitulation or exhaustion, says Maureen Busby Oster, chief investment officer of MBOCleary Advisors. "Capitulation is short, severe, and dramatic, like [after the] October 1987 [crash]. Exhaustion is more prolonged with an end that is difficult to discern, such as 1973-74 and 2000-2002," she says.
Bear markets of the past 50 years, defined as a 20 percent drop from a prior high, have been as short as four months and as long as 41 months. Because the process of financial deleveraging and bank balance sheet rebuilding will drag on well into next year while the economy languishes, "this bear market could last for some time," she says.