Stock mutual fund investors couldn't have asked for a smoother ride higher in the 12 months through March. But that just made the second-quarter market sell-off all the more jarring.
Most equity funds lost between 9% and 14% in the three months that ended June 30, halting a winning streak that had lifted the average U.S. stock fund nearly 50% over the previous four quarters.
It wasn't that investors were unprepared for a pullback. Everyone knew the stock market would "correct" at some point. But many thought the catalyst would be rising interest rates triggered by a V-shaped economic recovery.
Instead, the mood turned grim as a rapid pileup of bad news — the government-debt crisis in Europe, a shocking lack of job growth in the U.S., the Gulf of Mexico oil-spill catastrophe and more — fueled fresh doubts about the global economy's ability to sustain its recovery.
And by the end of June, equity investors had to contend with a chorus of well-known economists asserting that deflation and depression were becoming real risks again.
Princeton University economist Paul Krugman has become one of the loudest voices warning about depression. He contends that Europe, Japan and the U.S. should roll out more stimulus money to fill the void left by still-weak private-sector and local-government spending.
Instead, Europe and Japan are pledging to cut back on government outlays to pare their budget deficits, and pressure is rising on Congress to do the same. Policymakers, Krugman says, are repeating the mistakes of the 1930s.
In the Treasury bond market, a stampede of buying during the quarter showed that some people were taking the deflation/depression talk to heart, much as they did in late 2008.
Painting a dire picture of investors' fears, the benchmark 10-year T-note yield dived to 2.93% by the end of June from nearly 4% in early April as investors rushed for the perceived safety of U.S. bonds.
Given all that, the surprise may be that stocks didn't fare worse. Losses in most of the world's stock markets have stayed within the limits of a classic short-term correction, meaning a 10% to 20% drop from the highs reached in early spring. By Wall Street's traditional yardstick, it takes a decline of more than 20% to mark a new bear market.
The Standard & Poor's 500 index of big-name stocks dropped 16% from its second-quarter peak of 1,217.28 on April 23 to its recent low of 1,022.58 on July 2.
In the last week, the selling has abated. The S&P 500 rose 5.4% for the week. It's still up 59% from the 12-year low reached in March 2009.
Foreign stock funds, which on average fell more sharply than domestic funds in the second quarter because of Europe's government-debt woes and the dollar's strength, have been outperforming domestic funds over the last few weeks, thanks in part to a reversal in the dollar.
With the stock market's losses modest so far — certainly compared with the crash of 2008-09 — investors who fear the economy will crumble have time to rethink their tolerance for risk.
The good news is that basic portfolio diversification worked well in the first half. Bond mutual funds, which saw record inflows of cash in 2009 as many Americans sought to play it safer with their nest eggs, mostly scored total returns of 2.5% to 5% in the first six months, according to Morningstar Inc. If you owned bonds, your returns could have significantly offset the 4.7% loss on the average U.S. stock fund in the half.
Likewise, owning gold helped, as the metal surged to record highs. And funds that own smaller stocks lost less than those that own blue chips.
Could pessimism about the economy be overblown? Many analysts continue to downplay the risk of a "double-dip" recession in the U.S. — although, admittedly, most never saw the 2008 crash coming.
In a midyear survey of economists, Bloomberg News found that the median growth forecast for the U.S. over the next four quarters was 2.8%, down slightly from 2.9% a month earlier.
Yet some mutual fund managers are convinced that the U.S. economic recovery is about to run out of gas. John Hussman, an economics PhD who heads the $8.1-billion Hussman Funds group in Ellicott City, Md., believes that the rebound of the last year has been almost entirely a result of spending by governments worldwide and financial aid from central banks.
As that help winds down, "the U.S. economy appears headed into a second leg of an unusually challenging downturn," compounded by the ongoing need to reduce mountainous debt levels, Hussman said. He thinks stocks overall are headed sharply lower.
Even so, his strategy hasn't been to abandon equities. Rather, his Hussman Strategic Growth fund, which rose 5.2% in the half, uses a "long/short" approach: He buys stocks he thinks can do relatively well in a harsh economy, while hedging his bets by shorting major market indexes. A short position pays off if an investment falls in value.
Hussman said he believes that some stocks, such as big drug issues, already trade at "appropriate" levels for the risks they entail. His fund has owned drug stocks including Merck & Co., Abbott Laboratories and Pfizer Inc., each of which sells for less than 12 times the company's expected 2010 earnings per share.
Most stock fund managers, of course, have to stay largely invested in equities; they can't just flee the market even if they fear the economy will tank. Most also can't short the market as Hussman can. The best they can do is focus on stocks they expect to hold up better than average in any decline.
Tom Ognar, who manages the $1.8-billion Wells Fargo Growth stock fund, says the drop in share prices since April has left many of his stocks selling at what he regards as bargain levels relative to underlying earnings. He cites Hewlett-Packard Co., which at $45.25 on Friday was priced at about 10 times this year's expected earnings per share. By comparison, the S&P 500 index had a price-to-earnings ratio of about 13.
Ognar also likes Tractor Supply Co., a fast-growing retailer catering to small farmers and ranchers. The stock trades for 16 times its 2010 estimated earnings.
Even if the economy grows weakly overall, Ognar said, some companies obviously are going to fare much better than others. Despite fears of a double dip, "when we talk to our companies it's still pretty universal that they feel good about their businesses," he said.
The risk is that companies' optimism could quickly evaporate in the second half if their sales suddenly go south.
At the Forester Value fund in Lake Forest, Ill., manager Tom Forester said he has been putting some of the $104-million fund's cash holdings to work as stocks have slumped. Computer services giant IBM Corp. was one of the issues he picked up, with the shares trading for about 11 times estimated 2010 earnings.
Forester says he wants to stay conservative in the portfolio given the challenges the economy faces as federal stimulus wanes. "The economy is pretty much on its own now," he said. "Either it's at takeoff speed or it's not."
His focus on large, financially strong multinational firms with low price-to-earnings ratios — like Altria Group, Kimberly-Clark Corp. and Microsoft Corp. — may not be novel, and his fund has lagged behind the market in big rallies. But in the plummeting markets of 2000-02 and 2008, Forester's stock-picking protected his shareholders from deep losses if they hung on.
Nowadays, "if you have to be known for something, that's not a bad thing," Forester said.