Broad Rally Lifts All Boats

For the first time in four years, stock mutual fund investors actually can look forward to opening the midyear account statements from their fund companies.

The second-quarter market rally lifted every major stock fund category and left them all solidly in the black for the first half.

By any measure, it was a spectacular advance. The average domestic stock fund posted a total return (price appreciation plus dividend income) of 17% in the quarter ended June 30, according to fund tracker Morningstar Inc. in Chicago. That was the biggest gain since the fourth quarter of 1999, in the waning days of the last bull market.

Data firm Lipper Inc. in Denver said it counted more double-digit returns among stock fund categories than in any quarter in 15 years.

“The rally is really impressive for how broad it was,” said Russ Kinnel, director of fund analysis at Morningstar.

Year to date as of June 30, the average U.S. stock fund was up 13.1%. That barely made a dent in the losses many investors have suffered over the last three years, but it held out hope of more gains to come -- if the economy rebounds in the second half and the market plays along with the script.

But the end of the bear market, if in fact it has ended, would bring new challenges for fund investors. Is it time to clean house in your portfolio? Should you invest more in stocks, or just ride with what you have? Which fund sectors offer the best potential if the market is going higher?

There is, of course, a risk that stocks’ surge in the second quarter was another short-term rally within a continuing bear market. Wall Street bulls say the breadth of the turnaround argues against that. The market, they say, wasn’t merely responding to the relatively quick end to the major hostilities in the Iraq war; it also was foretelling a marked upturn in the global economy.

“Markets are picking up the scent” of a recovery, said James Glassman, economist at J.P. Morgan Chase & Co.

If the economy accelerates, many companies could see that translate into rising earnings. That is the basic reason stocks would be expected to attract more investors’ dollars.

Bearish analysts say recent evidence doesn’t back up the idea of an economic revival and leaves little justification for a rally that has lifted the big-stock Standard & Poor’s 500 index 23% from its 2003 low reached on March 11.

“Convinced that all of the bad economic numbers are backward-looking, the bulls maintain that the best indicator is the market itself ... and its recent strength is anticipating future growth,” said Peter Schiff, president of Euro Pacific Capital in Newport Beach. “It seems to me that the recent rise in the stock market is better viewed as a contrary indicator, reflective of too much investor optimism for a rebound in earnings and the economy.”

Still, stock market rallies can become self-fulfilling by raising consumer and corporate confidence, analysts say.

Stocks also could benefit if more capital flees two main alternative investments: money market accounts and bonds.

The Federal Reserve, which cut its key short-term interest rate to a 45-year low of 1% on June 25, has all but pledged to keep short rates low indefinitely.

Many economists doubt the Fed would tighten credit before mid-2004 at the earliest. That would mean no relief is in sight for investors who are earning a record low average yield of 0.58% on money market mutual funds, as calculated by IMoneyNet Inc. in Westborough, Mass.

Meanwhile, if more signs emerge that business activity is firming, investors would be likely to push long-term interest rates up from their recent generational lows. Bond yields have been rising since mid-June, and if that continues it could drive more big investors, such as pension funds, to shift assets from bonds to stocks.

Already this year, stocks are beating bonds for the first time since 1999.

Standard & Poor’s Outlook newsletter for individual investors last week advised subscribers to reduce their bond allocation from 15% of assets to 10%, while keeping 65% in stocks and raising cash from 20% to 25%.

The relatively high cash recommendation, S&P; said, reflects the expectation that stock prices could pull back soon after the second-quarter rally, giving investors an opportunity to put money to work at lower prices.

That possibility is a good reason investors shouldn’t feel rushed to jump into the market solely because of the big numbers stocks racked up in the second quarter, said Alan Skrainka, market strategist at brokerage Edward Jones & Co. in St. Louis.

Investors who want to make portfolio shifts should go slow, he said: “Do it in a way that you can sleep at night,” rather than taking on a high degree of risk all at once.

Warnings against chasing hot stocks and hot funds dominate the advice many financial pros are giving today. That’s not surprising, given the losses investors suffered in the bear market by overpaying for shares.

The average price-to-earnings ratio of blue-chip stocks is between 18 and 40 based on earnings estimates for this year, depending on which measure of earnings is used. In any case, stocks aren’t cheap, historically, most pros agree.

Big investors’ fears of paying too much could make the market prone to seesawing in a “trading range” in the near term and possibly even longer term, many experts say.

Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Irvington, N.Y., said he believes the latest rally is a bull market within a longer-term bear market. “I think this rally will probably go to the end of 2004 and maybe into 2005,” he said. But it may well be that buy-and-hold investors will find that, 10 years from now, the market is no higher than today, he said.

If a trading-range market is what’s ahead, it could present huge challenges for stock fund managers who came into the business in the 1990s, when the market seemed to know only one direction: up.

That’s why fund investors should take a much closer look at their portfolios overall, and at the individual funds they own, Morningstar’s Kinnel said.

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Portfolio Changes

After the worst bear market in a generation, investors may find that their funds “have changed quite a bit,” he said.

A key issue is whether a fund has become much more conservative in its strategy and in the type of stocks it owns. That may have been a logical move given the long market decline, but if an investor was counting on a fund to be an aggressive holding within his or her portfolio, a shift to conservatism may mean the fund no longer fills that aggressive niche.

“Investors should ask, ‘Am I still diversified?’ ” in terms of the mix of funds owned and in terms of the stocks inside individual funds, Kinnel said. (Funds typically disclose their major holdings in midyear reports to shareholders. Some also update that information more frequently on their Web sites.)

Another issue, Kinnel said, is whether a fund shrank so significantly in the bear market that its operating costs are eating up much more of its returns. To check that, investors should look at a fund’s expense ratio, or annual operating costs as a percentage of assets.

A simpler question is whether a fund is managed by the same person, or people, who were in charge before the bear market.

Bad markets have a way of shaking people out of the money management business. A change at the top could be good or bad for shareholders, depending on the situation, Kinnel said.

He warned investors not to rush to judgment about a fund based solely on its performance in this year’s market comeback. If a fund has been lagging this year, he said, an investor should first ask whether the portfolio performed better than its average peer during the bear market.

However, if a fund has been lagging in the recovery, and also performed worse than its average peer in the bear market, an investor should at least take that as a sign to study the portfolio in more depth, Kinnel said.

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Sector Clues

As for individual fund sectors, the broad nature of the second-quarter rally may vex some investors who were hoping to get stronger clues about which sectors might lead for the rest of the year and into 2004.

The deeply depressed technology stock fund sector was the biggest sector winner of the quarter and the first half, scoring average gains of 24.6% and 24.1%, respectively, according to Morningstar.

Yet returns in 12 other major fund sectors -- from mid-capitalization value-stock funds to Latin American stock funds -- fell within a narrow range of 18% to 21.7% in the quarter.

In the small-cap fund sector, the subgroups of “growth” and “value” scored the same total return in the quarter: 21.5%.

For the first half, however, growth-oriented funds generally beat value-oriented funds. Growth funds typically own shares of faster-growing firms; value funds tend to focus on companies that are slower-growing but whose stocks sell at lower price-to-earnings ratios.

Some Wall Street pros believe growth stocks are the natural choice to lead in a stronger economy, because as optimism rises investors usually become more willing to pay for firms that promise faster earnings growth.

“The most important call is to bet on the stock market,” said Ed Keon, a market strategist at Prudential Securities in New York. “But beyond that, my advice is to tilt toward growth, and to tilt toward smaller rather than larger stocks.”

Others see the value sector, which held up far better than growth throughout the bear market, as a good bet to continue leading.

“Investors remain keenly aware of the damage their retirement plans took in the bear market led by growth stocks and funds,” said Don Cassidy, senior research analyst at Lipper Inc. in Denver. He thinks that will make investors more conservative in getting back into the market, which would favor value shares.

At the same time, Cassidy agrees with Keon’s tilt toward smaller stocks.

Shares of smaller companies often have led the first stage of new bull markets. The Russell 2,000 index of smaller shares had a total return of 23.4% in the second quarter, its biggest gain since the first quarter of 1991 -- the start of the 1990s bull market.

By contrast, the S&P; 500 index had a total return of 15.4% in the recent quarter.

But Philip Orlando, senior portfolio manager at Federated Investors in New York, argues that big-name stocks would be the easiest way for investors to quickly get back into the market if the economy improves. He particularly favors the largest tech companies, such as Microsoft Corp. and Intel Corp., on the expectation that many companies are on the verge of upgrading their tech equipment.

To many market pros, the debate over which sector to favor threatens to obscure a more important message: Mutual fund investors should seek to maintain a diversified portfolio that includes all major sectors -- stocks and bonds, growth and value, big-cap and small-cap, and U.S. and foreign.

If more investors had followed that strategy in 1999, their portfolios might have come through the bear market in far better shape.

After the market turnaround in the first half, said Skrainka of Edward Jones, an investor should study his or her fund lineup in the context of long-term balance, and “if there are gaps in your portfolio, start filling them in.”