Bulls still in command as stocks shake off uncertainty

Chalk up another win for investors who had the guts to stay put in the stock market -- and for those who held on for no better reason than inertia.

Most stock mutual fund categories scored gains in the three months ended March 31, the fourth straight quarterly advance after the meltdown of 2008 and early 2009.

The average U.S. equity fund posted a total return of 5.1% in the quarter, lifting the 12-month return to 49.4%, according to data firm Morningstar Inc.

Continuing the trend of the previous three quarters, the rally in stocks was broad-based and global. Of 44 categories of domestic and foreign funds tracked by Morningstar, 40 were higher in the first quarter.

Investors undoubtedly will have differing views on whether a mid-single-digit gain on stocks for a three-month period was worth the risk. Still, it beat the 2% average return of bond mutual funds and the near-zero average yield on money market funds.

But the ride wasn’t a smooth one. In fact, stocks worldwide faced their biggest test since the new bull market began in March 2009.

After rallying at the start of the year, most world markets slumped beginning in mid-January amid a raft of troubling news. China’s government signaled that it wanted to slow that economy’s torrid pace; the Greek government’s financial woes raised the risk of a fresh credit crisis in Europe; and some U.S. economic data suggested that the recovery was losing steam.

It all was enough to drive most U.S. market indexes to their steepest losses in nearly a year. The Standard & Poor’s 500 index slid 8.1% from Jan. 19 to Feb. 8. Some foreign markets fell more than 10%.

But then the sell-off abruptly ended. U.S. stocks turned higher on Feb. 9 and have climbed steadily since, and most other world markets have come along for the ride. Last week key stock indexes in the U.S., Germany, Japan, South Korea, Brazil and many other markets were at their highest levels in at least 17 months.

The 12-month-old bull run has been agonizing for people who’ve been sitting on the sidelines. It’s also making some financial advisors nervous.

Jim Freeman, who manages about $85 million at advisory firm Financial Alternatives in La Jolla, said he began trimming back on some clients’ stock holdings in September.

“Now we’re at the point where we’re looking to reduce equity exposure again,” he said.

Judging by mutual fund net cash inflows and outflows, plenty of other investors have had the same idea for much of the last year. U.S. stock funds overall still are facing net redemptions, meaning more cash is going out as investors sell than is coming in from purchases.

Instead, Americans continue to pump record sums into bond mutual funds.

David Kelly, strategist at JPMorgan Funds in New York, believes that investors will come to regret their caution. With bond yields low, and therefore unappealing, while corporate earnings are rising, “the bond market still looks too expensive and the stock market still looks cheap,” he said.

Indeed, despite the public’s lack of support, many investment pros are reluctant to turn bearish on equities for one basic reason: U.S. economic growth looks more sustainable now than it did a few months ago, which implies a continuing rebound in earnings to underpin stocks.

“I’m a believer that the economy is recovering and will continue to recover, because that’s what our companies are telling us,” said Charles McQuaid, co-manager of the Columbia Acorn fund, a $15.5-billion portfolio that invests mostly in stocks of small and mid-size companies. The fund’s Class A shares gained 7.2% in the first quarter after rallying 39% last year.

Market bulls concede that stocks aren’t the giveaways they were a year ago. The average U.S. blue-chip issue sells for about 15 times estimated 2010 operating earnings per share, according to Standard & Poor’s.

Historically, that isn’t an outrageously expensive price-to-earnings ratio -- though it assumes robust profit gains this year.

Still, even if the U.S. economic recovery stays on track, trouble overseas could hit Wall Street again. Worries that Greece would default on its debt riled European credit markets again last week and threatened more instability in that economy.

Asia, meanwhile, has the opposite problem: fear that the easy-money policies that governments instituted amid the credit crisis now are fueling asset bubbles.

Despite China’s efforts to restrain bank lending this year in a bid to slow its economy, real estate prices have continued to soar. In India and Australia hot real estate markets helped push the countries’ central banks to raise short-term interest rates this year.

China, India and Australia “are definitely stepping on the brakes,” said Robert Horrocks, chief investment officer of San Francisco-based Matthews International Capital Management, which manages 11 Asian-market-focused mutual funds. China’s main stock index lost 5.1% last quarter.

Asian efforts to tighten credit also are a reminder of the risks U.S. markets face as the Federal Reserve seeks to pull back on the trillions of dollars in ultra-cheap money it has pumped into the financial system.

The biggest question for many investors: When does the Fed begin raising its key short-term rate from current near-zero levels?

Although most economists don’t expect the Fed to boost rates before autumn, at the earliest, the debate will only grow louder for markets in the next few months.

All of this poses a different set of challenges for investors from what they faced a year ago, when simply surviving was the main goal.

Is it time to rethink your portfolio? Here are three considerations:

If you can’t shake the fear that a big pullback in stocks is imminent, it’s easy to take some money off the table. But do it in the context of “rebalancing”: Decide what percentage of your assets you can risk in stocks and compare that to where your portfolio stands now.

If your target is to keep stocks at 50% of your asset mix, and the recent rally has lifted them to 65%, rebalancing would call for selling stocks to get back to that 50% weighting. You would invest the proceeds in other assets to bring them back to your target weightings.

Financial advisors typically rebalance clients’ portfolios once or twice a year. The concept “is simple, but it’s not easy” for many investors, said Paul Merriman of financial advisory firm Merriman Inc. in Seattle.

“People’s emotions are so much stronger than their intellect,” he said -- meaning, they know what they should do, but when the time comes the mood of the market can ruin their discipline.

There’s another lesson in that observation: If you’re waiting to buy stocks when prices drop, will you have the guts to jump in when the pullback finally comes?

If the surprise this year continues to be that the U.S. economic recovery is stronger than expected, do you own funds that could benefit? That environment might call for a shift toward “growth” funds, which focus on stocks of companies whose earnings are expected to grow faster than average.

Over the last 12 months, value funds -- which own shares believed to be undervalued relative to a company’s earnings or assets -- generally have held a wide performance edge over growth funds.

“But for a second leg of the recovery, growth might prove to be a good place to be,” said Russ Kinnel, director of fund research at Morningstar in Chicago.

One of the Acorn fund’s favorite growth bets is the industrial sector. Over the last decade, McQuaid said, “U.S. manufacturers’ costs have been cut to the bone. Their efficiencies are very high.” That’s a recipe for powerful profit growth, he said.

If interest rates are going up, many investors’ assumptions about being safe in bonds will be tested. At the same time, if rates are rising because of a healthier economy, that could be a plus for many stocks.

Rising rates mean the principal value of older, lower-yielding bonds declines. The damage could be minimal depending on the kinds of bonds you own: The shorter their term, the smaller the principal loss if market rates go up.

Still, Financial Alternatives’ Freeman says that as he trims clients’ stock market holdings after the run-up of the last year, bonds aren’t his favorite idea for new investment. Instead, he’s looking to shift money into assets that offer modest appreciation potential while also protecting against wild market volatility.

One such option, he said, is the Merger Fund, which buys stocks of companies involved in publicly announced mergers. The idea is to take advantage of merger arbitrage, such as the return to be had by holding a takeover stock until the deal is consummated. The fund gained 8.5% last year.

Kinnel suggests that investors whose portfolios are bond-heavy should consider adding a commodity-focused fund, such as Pimco Commodity Real Return, as a hedge against the risk of higher inflation in a better economy.

Inflation, he noted, is the silent enemy of bond investors, eroding their fixed returns. “The more you have in bonds, the more you should fear inflation,” Kinnel said.