Times Staff Writer

Stock markets worldwide in the second quarter tried to shake off the deep gloom that gripped them in the first three months of the year. They succeeded -- for a while. ¶ But as the quarter drew to a close a major issue that had spooked investors in winter was looming large again: the financial system’s fractured state in the wake of the housing market’s crash. ¶ As if that weren’t enough, investors were forced to focus more sharply on the fearsome threat of rising inflation, as prices of oil and many other raw materials continued to streak higher. ¶ Given all of that, the surprise for many stock mutual fund investors may be that their portfolios didn’t fare worse in the three months ended June 30. The average U.S. diversified stock fund eked out a 0.1% gain in the quarter, after diving 10.6% in the first quarter, according to Morningstar Inc. ¶ Positive returns in energy, utility, technology and healthcare funds, as well as in portfolios that target stocks of small and mid-size firms, helped offset losses in financial, real estate and blue-chip-oriented funds.

Foreign stock funds had a rougher go of it. They lost 1.8%, on average, in the second period, as many foreign markets -- particularly the emerging-market stars of the last few years -- quickly reversed after an early-spring rebound.

All in all, the mixed results were a classic argument for being well-diversified with funds, said Paul Merriman, a principal at financial advisor Merriman Berkman Next in Seattle.

At a time like this, he says, “I think it’s better to just stay the course if you have the right portfolio allocation.”


Even investors whose funds were in the black in the second quarter haven’t had much time to savor their gains. As worries mounted in June about the economy, the financial system and soaring commodity prices, stock markets suffered broad declines.

By last week, the Dow Jones industrial average fell into an official bear market, meaning a drop of at least 20% from its recent high. The Dow is down 20.3% from its peak in October. The last bear market was in 2000-02, amid the tech bust.

Investors’ upbeat view in April and May, as stocks revived, was that the financial system, at least, was on the mend.

But as warnings continued from financial companies about more loan write-offs, Wall Street’s optimism faded.


And the wild run-up in oil has only deepened concerns about the financial health of consumers.

The credit markets’ woes and the pain of sky-high energy prices “are two shocks that are just going to keep rippling,” said Russ Kinnel, director of fund research at Morningstar in Chicago.

What’s more, those shocks are being felt worldwide. Energy- and food-driven inflation has spurred central banks in India, China, Mexico and Europe, among other places, to tighten credit in recent months. Investors, expecting economic growth to slow as interest rates rise, have bailed out of many once highflying foreign markets.

Whether the U.S. economy is in an actual recession or just suffering a period of very weak growth, some market pros say they aren’t betting on a broad-based revival of U.S. consumer spending any time soon.


“I think the consumer is going to be stressed for a while,” said John Osterweis, at the Osterweis Fund in San Francisco.

But as a bargain-hunter, Osterweis says he’s finding more to like in the market as prices slide. Echoing other fund managers, Osterweis said he can only stick with his stock-picking discipline in this tough period and hope his investors will be patient. His fund was up 3.4% in the second quarter.

“We are finding an increasing number of interesting stocks. I can’t tell you if they’ll be higher in six months, but I think they will be in two to three years,” Osterweis said.

One of his holdings: Life insurance giant Prudential Financial, which has plunged 34% this year. The stock now is priced at eight times expected 2008 earnings per share, less than half the price-to-earnings multiple of the market overall.


Prudential is in part a long-term play on Asia’s economic rise, Osterweis said. “They’re seeing terrific growth in Korea, Japan and Taiwan,” he said.

Not surprisingly, many stock funds that performed better than their peers in the second quarter could thank their energy holdings.

The Dallas-based Westwood Equity Fund, managed by Susan Byrne, slipped 0.9% in the quarter, compared with a 4% drop for the average large-cap “value” fund. Some of the fund’s big winners in the period included exploration company Murphy Oil and oil-services firm McDermott International.

Byrne said she has “stress tested” her energy holdings to judge whether the investments would still make sense, on their business fundamentals, even if oil were to fall back to $75 a barrel. Her conclusion: “Even at those lower price levels the companies wouldn’t be overvalued.”


At the same time, Byrne said she’s happy to stay with blue-chip stocks such as Walt Disney Co.

“Disney is doing fabulously well and is getting absolutely no credit for it,” she said. The stock is priced at about 13 times this year’s estimated earnings per share.

Big-name stocks in general were a disappointment in the quarter. If investors needed to sell something, they seemed to target blue-chips first.

On the flip side, the quarter saw strong performance by shares of mid-size companies. The average mid-cap growth fund was up 4.3% in the period.


In general, growth stocks -- shares of companies whose earnings are expected to grow faster than average -- fared better than value stocks, shares of firms that usually are slower-growing but less expensive relative to earnings.

In a struggling economy, more investors probably are hunting for true growth stories, said Chris McHugh, manager of the Turner Midcap Growth fund in Berwyn, Pa. The fund was up 4.5% in the quarter.

Mid-size companies, McHugh said, offer investors the potential for faster growth than larger firms. At the same time, he said, “These companies are a little more seasoned in their management teams than smaller companies.”

McHugh is favoring retailers including Urban Outfitters and Guess Inc., which he said are bucking the general trend in retail sales.


He also likes Omniture Inc. -- which helps companies manage their online business operations -- even though the stock has been hammered.

The challenge in a down market, McHugh notes, is to stay with one’s convictions. “From a sentiment standpoint it always feels ugliest and hardest at these points in time,” he said.