Equity Funds: Bad to Worse
Even Wall Street’s biggest bulls have a hard time sugar-coating the stock market’s performance of the last few months.
Beset by corporate financial scandals, doubts about the economic recovery and fears of a U.S.-Iraq war, share prices have continued to slide, extending the worst bear market in a generation.
How bad was it in the third quarter ended Sept. 30? The average domestic stock mutual fund lost 17.2%, one of the biggest quarterly losses ever, according to fund tracker Morningstar Inc.
At this stage of the downturn that began more than 30 months ago, there is almost no place to hide: Fewer than 1 in 100 stock funds gained ground in the quarter, and every equity fund category lost money, on average--even gold-oriented funds and real estate-related funds, which had been market stars in the first half of the year.
Indeed, investors last quarter began selling stocks that, until then, they had regarded as keepers. That knocked many “value”-oriented mutual funds into the red for the year.
The selling hasn’t stopped: On Friday, the Dow Jones industrial average closed at 7,528.40, nearly a five-year low. The technology-dominated Nasdaq composite index ended at a six-year low of 1,139.90.
Perhaps the most comforting fact left for investors who are trying to find a reason to be optimistic is simply that things are already so bad. Isn’t this the way it’s supposed to feel at the bottom?
The decline in blue-chip stocks, as measured by the Standard & Poor’s 500 index, equals the drop of 1973-74 at about 48% from the bull market peak. The ‘73-74 bear market had been the worst since the Depression years.
Unless the economy is going to reprise the 1930s experience, some Wall Street bulls say, why should share prices lose more than half their value?
The market’s bears have an answer: Stock valuations, using such classic measures as price-to-earnings ratios, aren’t nearly as cheap as they were at the end of 1974, when many big-name shares were valued at P/Es in single digits.
The S&P; 500 now is priced at 15 to 18 times this year’s estimated operating earnings, depending on whose earnings estimate is used.
Meanwhile, even though the Nasdaq composite index has plummeted 77% from its March 2000 peak, many technology stocks remain highly valued, even assuming a corporate profit recovery arrives in 2003.
Chip giant Intel Corp., for example, at $13.71 a share Friday, is priced at 18 times analysts’ average earnings estimate for 2003, according to Thomson Financial.
Some veteran money managers worry that even if the market is bottoming, the psychology will remain so negative toward stocks that share prices will do little more than move sideways for years.
John Bollinger, head of Bollinger Capital Management in Manhattan Beach, said the 1990s “cult of equities” has soured to the point where many investors may give up on the market entirely, just as they did after the mid-1970s slump.
“I fear we’re losing a generation of investors, many of whom may never come back,” Bollinger said.
Stock mutual funds have faced net withdrawals since June. Foreigners also have soured on U.S. assets. And U.S. corporate managers have lost their appetite for mergers, diminishing another key source of demand for stocks.
Over the last three years, the return on the average domestic stock fund is a negative 8.5% per year, according to Morningstar. The average fund also is negative for the last five years, with a loss of 2.2% per year.
But the gloomier the discussions get, the greater the likelihood that the bear market is nearing an end, some Wall Street veterans say. At least, that’s the way it has generally worked.
Oakmark Funds’ Bill Nygren, a well-known value stock manager whom Morningstar last year named its equity fund manager of the year, warns that investors who sell stocks now may be “making the same mistake they made three years ago when they sold value and bought growth”--basing their decision on recent returns rather than a thoughtful long-term asset allocation strategy.
For investors who are still daring to keep track of their stock fund portfolios, the third quarter produced some shifts that may have lasting significance.
Some of the third-quarter highlights:
* Growth beat value. Growth-oriented funds lost less than their value-style counterparts, reversing the recent pattern. Large-cap growth funds, for instance, fell 15.8% on average versus an 18.3% decline for the average large-cap value fund.
The financial sector’s woes were especially damaging to value funds, according to fund tracker Lipper Inc., as the bear market and investigations of Wall Street conflicts of interest weighed on major investment banking stocks such as J.P. Morgan Chase & Co. and Citigroup Inc. Those stocks long have been among value fund managers’ favorites.
Also, investors rushing to sell stocks and funds in the midsummer meltdown may have been taking profits in the few sectors in which they still had them--mainly value--said Don Cassidy, senior analyst at Lipper.
Real estate funds, big winners in the first half and a classic value sector, turned negative in the quarter but still held up better than most categories, falling 8.8% on average. They suffered another decline last week, pushing the average fund into the red for the year, according to Morningstar.
Growth funds’ relatively stronger showing didn’t spread to the technology sector. The average tech fund dropped 26.6% in the quarter and is down 51.4% for the year, after diving 38.3% in 2001.
* Big-cap beat small-cap. In general, smaller stocks had been performing better than bigger stocks since the bear market began in March 2000. That reversed in the third quarter.
The average small-cap growth fund’s 19.8% drop in the quarter was four percentage points worse than the average large-cap growth fund’s loss, Morningstar data show.
Large-cap “blend” funds, which hold a mix of growth and value stocks, fell 16% in the quarter, versus a loss of 19.1% for small-cap blend funds.
One reason smaller shares were hit harder may be that, with the drumbeat of war growing louder in Washington, investors felt more comfortable holding more liquid blue chip stocks, analysts said.
As with value stocks, profit-taking in previously strong-performing smaller stocks also may have been a factor.
* Foreign funds were in a world of hurt. Foreign stock funds had held up in the first half, helped in part by a weaker dollar.
But Wall Street’s summer sell-off hammered many foreign markets as well. And the dollar began to strengthen again versus the euro and the yen, so the currency benefit that U.S. owners of foreign shares had reaped in the first half was halted.
The average European stock fund slid 21.8% in the quarter, compared with the 17.2% drop in the average U.S. fund. Germany’s economy slowed to a crawl in summer, deepening concerns about the European economic outlook.
The average Japanese fund was down 13.4% in the quarter as the Nikkei-225 index fell to a 19-year low.
Latin American funds plummeted 23.4%, on average, in the quarter. That category was hurt by worries that a leftist candidate might win Brazil’s presidency, and by fears that the U.S. economy would fall back into recession, hurting Mexico.
Still, other emerging markets fared better: The average diversified emerging-markets fund was off 16.1% in the quarter and 13.3% in the nine months.
* Gold funds lost momentum. The average gold-stock fund fell 3.7%, as the metal’s price stalled out in June before rallying again in recent weeks.
Year to date, gold funds still rank as the top performer among all equity funds with a 44.9% gain, on average. The funds rose 20.2% last year.
* “Bear” funds rolled in the dough. The handful of stock funds that always follow a bearish strategy--using short-selling and other techniques to achieve returns in the opposite direction of indexes such as the Nasdaq 100 or the S&P; 500--naturally made money in the quarter.
ProFunds UltraBear, up 33.8%, was the best-performing fund of any type in the quarter. Its gain through the first nine months was 71.4%. The Prudent Bear fund rose 17.5% in the quarter and 73.8% in the nine months.
Investors who believe the bear market has longer to run may be tempted to look at these funds as a hedge against greater portfolio destruction. But analysts warn that if the market should rebound, these funds would instantly be among the worst performers.
