Market takes investors on a wild ride

Mutual fund investors may be excused if their knees are knocking a bit.

While the year didn't begin with high hopes on Wall Street, the first quarter's roller-coaster markets gave investors a jolt. After a smooth ride for nearly two months, a dramatic plunge in the inflated Shanghai stock market sent shivers through world equity markets, pulling down riskier assets leveraged with debt. In the United States, the sell-off was amplified by investor fears that the troubles in the subprime residential mortgage market would aggravate a home-building slump that appears far from over.

Financial stocks were hit especially hard, reflecting concern that rising mortgage delinquencies and deterioration in credit quality might spread to other types of lending. While stocks partially recovered in March, the major market indexes struggled to stay in positive territory.

The increased market volatility is "a wake-up call for investors who had become notably complacent about investment risks," says James Stack, editor of Investech Research, an investment advisory service. A five-year bull market that hasn't had so much as a 10 percent setback should furrow brows among prudent investors, he says.

With an economic slowdown looming, oil prices rising, and a Federal Reserve that has not softened its anti-inflationary stance, investors should focus more on preserving capital than reaching for short-term gains, Mr. Stack says.

Despite wide day-to-day price swings, all major fund categories scored modest gains for the quarter (see PDF or Flash chart). US diversified stock funds rose an average of 2.1 percent, according to fund-tracker Lipper. While value and growth styles ran neck and neck in the first quarter, mid-cap funds – which hold mostly companies with market capitalizations in the $3 billion to $15 billion range – were the cream of the crop. Mid-cap value funds rose 4.4 percent, while small-cap value counterparts rose 2.6 percent. Large-cap growth funds, market laggards since the Internet bubble burst seven years ago, eked out a 1 percent rise, slightly better than large-cap value funds.

Continuing strength in overseas markets gave the popular world equity funds category a 3.3 percent boost.

Among sector funds, utility funds led the pack, rising 7.7 percent.

Ron Sorenson, chief investment officer of W.H. Reaves & Co., credits the utilities sector's strong performance over the past three years to investors' quest for higher-yielding stocks. Though dividend yields are now below 3.5 percent for most gas and electric utilities, these asset-intensive companies have steadily upped their payouts and are expanding their power and transmission infrastructure under supportive regulatory oversight. Financial-services funds, hit by the fallout from real estate woes, were the only sector to finish the quarter in the red.

Investor awareness of elevated risk is reflected in the way money has flown into mutual funds, says Lipper senior analyst Jeff Tjornehoj. Money has been pouring into high-grade bond funds lately as well as into the more conservative equity income and asset allocation funds. Enthusiasm for world equity funds remains higher than that for their domestic counterparts, he notes, but the once torrid pace of flows into emerging markets has ebbed considerably.

Among pure stock funds, multi-caps have been "king of inflows" says Mr. Tjornehoj. People prefer the "go anywhere" nature of multi-caps, he says.

The five-year-long performance disparity between large- and small-cap stocks has many analysts scratching their heads. Large-cap stocks typically outdo small-cap stocks in the later stages of a cyclical bull market, but large-cap stocks have yet to strut their stuff. During the quarter, large-cap core funds rose 0.5 percent, trailing small-cap core funds' 2.8 percent rise. "It's still a tug of war between the large and small caps," says S&P analyst Massimo Santicchia. With good credit conditions, hedge funds with an appetite for risk, and brisk merger activity, many small company stocks can prosper, he says.

With profits growth sputtering, the best long-term values are in the large-cap arena, says Michael Maubousin, chief strategist for Legg Mason Capital Management. Companies such as General Electric and United Technologies have greater exposure to global growth and pricing power than small companies do, he says. They also benefit from an upswing in US exports, aided by a weaker US dollar. Large-cap growth stocks are "statistically cheap when compared to large-cap value stocks," agrees Eric Bjorgen, senior analyst with Leuthold Group in Minneapolis. "But you need to see more positive sentiment toward the healthcare and technology sectors before growth funds forge ahead."

Investors need to keep a sharp eye on the financial-services sector, which is close to 25 percent of the total market capitalization of the S&P 500, analysts say. "Banks face their toughest environment in five years," says Lester Satlow, portfolio manager with Cabot Money Management. "Consumer loan growth has peaked, lending standards on mortgages are tightening, and credit quality is deteriorating. In 2006, the financial sector provided more than one-third of the S&P 500's earnings growth. It won't be nearly "the same kind of earnings engine" this year, he says.

The bull market that began in 2003 may be struggling, but don't expect its demise anytime soon. An economic slowdown, coupled with sluggish profits growth, are by themselves not likely to trigger a bear market, analysts say. The traditional warning signs – a severe narrowing in stock-market breadth, rampant optimism, and extended valuations – are not evident, says Leuthold's Bjorgen. The more likely result is a choppier market with a shift in leadership away from cyclical industrial stocks toward higher quality, dividend-paying stocks in more stable industries.

Adam Bold, chief investment officer for the Mutual Funds Store, a chain of mutual fund advisory offices based in Kansas City, Kan., agrees. "You're seeing a healthy correction in progress, but not the beginning of a bear market," he says. Investors need to be more alert to managing downside risks, he says, but not react emotionally by retreating. In recent months, client portfolios have reduced small-cap and international funds holdings in favor of funds emphasizing large-cap, multinational companies. An investor nearing retirement may well have more than 50 percent of his or her portfolio in equities, but it should be properly diversified, he says. "We always determine the appropriate asset allocation first, and then pick funds with proven track records. Too many investors do it the other way around."

Market strategists enter the second quarter in a wary mood. "I'm looking for a modest spring rally with some speed bumps along the way," says Fred Dickson, market strategist for D.A. Davidson. Consumers may be stretched financially, he says, but job and income growth continue to buoy spending. While the housing slump is likely to continue to be a drag on the economy, GDP growth will probably still exceed 2 percent for the year. Another positive factor: Equity shrinkage of 5 percent in 2006, the upshot of record stock buyback activity, has put lots of money on the sidelines, waiting. Over the next few weeks, he expects market action to be heavily influenced by first-quarter earnings reports, which may well contain some negative surprises.

Income-oriented investors, meanwhile, should stick to high-grade, short to intermediate bond funds, bond experts say. Don't buy long-dated bonds, since these could lose value quickly if inflation numbers sour. "High-yield bond funds have had a good run," says Jason Brady, bond fund manager with Thornburg Investment Management in Santa Fe, N.M., "but you're not being paid for the added risk at this point in the cycle."