Investors may feel relief but no joy in 2009 market recovery
For mutual fund investors, a year of harrowing losses in 2008 gave way to a year of spectacular recovery in 2009.
Now, what’s that noise you don’t hear? Maybe the sound of one hand clapping.
At best, most investors are likely to feel relief at stock and bond markets’ comeback last year, but hardly joy. Not after the pain they suffered in the collapse triggered by the financial system’s explosion in 2008.
What’s more, as the new year begins, uncertainty remains extraordinarily high about the economy and the direction of interest rates, the two issues that matter most to markets.
No wonder financial advisors like Jim Berliner, president of Westmount Asset Management in Century City, say that although clients were happy with their portfolios in 2009, “Not too many are confident it will last.”
That’s exactly what stock market optimists want to hear. The old line about how bull markets climb a wall of worry aptly describes the last nine months of ’09.
Even as the U.S. economy showed tentative signs of recovery last spring, many investors didn’t buy it. The banking system was badly damaged, corporate earnings remained severely depressed and unemployment was soaring.
Yet the rebound in share prices that began in March has rolled along since then with few setbacks, and none serious. The rally has continued in the new year, with the Dow industrial average hitting a new 52-week high of 10,618.19 on Friday.
And the bulls had it right about the economy: Growth resumed in the third quarter after four straight quarters of declines.
The reward for investors who stayed put: 30%-plus gains for many stock fund categories in 2009. The average domestic fund scored a return of 29.9% for the year, according to Morningstar Inc. The average foreign fund surged 40.1%.
The stock sectors hit the hardest in 2008 generally roared back the fastest last year. At the top of the performance charts were Latin American stock funds, which rocketed 113% for the year after plummeting 59% in 2008.
Emerging-market funds in general were stars last year, reflecting renewed faith in those economies’ prospects. “We really believe they’re the engines of global growth,” Berliner said. “I think the financial crisis has accelerated that trend.”
Many foreign funds also got a boost from the dollar’s weakness for much of 2009, although the U.S. currency has bounced up over the last month.
Among domestic funds last year, those that own stocks of small and mid-size firms mostly beat the gains of funds that focus on large-capitalization stocks. But in the fourth quarter the momentum shifted to the large-cap funds, suggesting that investors were hunting for companies that might hold up better if the economic recovery slowed.
As good as the 2009 stock fund performance numbers were, they fell far short of recouping what most investors lost in the crash of 2008.
Case in point: The biggest U.S. stock fund, Growth Fund of America, rose 34.5% for the year, its best performance since 1999. But that followed a stunning loss of 39% in ’08.
The way the math works, the fund’s share price would have to rise a further 32% from its year-end level just to get shareholders back to their peak asset value in 2007.
A surprising number of stock fund investors last year seemed to decide that things were as good as they’d get. Even as the market continued to move higher, domestic stock funds saw more money leave, from investors cashing out, than come in from new buyers.
Through November, domestic stock funds as a group suffered net redemptions of $19 billion for the year, according to Morningstar. That was tiny relative to the funds’ $3.2 trillion in assets, but it made the point: Many investors saw the market turnaround as a signal to get out, not in.
Instead, what the public wanted in 2009 was bond mutual funds -- in amounts never seen before.
The net cash inflow to bond funds was an unprecedented $348 billion through November, pushing total industry assets to more than $2.2 trillion.
The primary appeal of bonds, of course, is the interest income they pay. With the Federal Reserve holding short-term interest rates near zero, investors and savers have been starved for yield. Bonds -- government, corporate and municipal -- offer annualized yields at least in the low- to mid-single digits.
Bonds also provide relative safety compared with stock investments.
But the trillion-dollar question is whether the newbie wave of investors understand that it’s possible to lose money in bonds, at least temporarily.
“There’s probably a lot more risk in the bond market than the average investor is prepared for,” says Eric Jacobson, a bond fund analyst at Morningstar in Chicago.
One way to lose in fixed-income securities is if the issuer defaults, meaning it fails to make interest payments as promised.
But that’s usually a modest concern for most diversified bond funds. The more crucial issue is interest rate risk: If market rates rise, older bonds issued at lower fixed rates are devalued. The flip side is that older bonds rise in value if market rates fall.
For much of last year, most market interest rates were declining as fear of another financial-system meltdown subsided. The slide in rates drove up the value of many outstanding corporate and municipal bonds in particular.
Bond mutual fund gains or losses are measured in terms of “total return” -- meaning interest income earned, plus or minus the net change in the principal value of the bonds in the portfolio.
The average total return of funds that buy “junk” corporate bonds (those rated below investment grade) was a huge 46.2% last year, according to Morningstar. The majority of that return came from principal appreciation of the bonds, which in turn drove up the funds’ share prices.
Falling market yields also boosted the value of most funds that own tax-free California municipal bonds. The average total return of funds that focus on long-term California muni issues was 17.4% last year.
But what happens if market interest rates rise in 2010, perhaps because economic growth is stronger than expected?
“It’s a mathematical certainty that if interest rates rise you take a principal hit on bonds,” says Gus Sauter, chief investment officer at fund titan Vanguard Group.
To simplify it: If an existing bond pays 4% but new bonds of the same term are paying 5%, nobody would pay face value for that 4% bond. So its market price drops.
Last year, one segment of the bond fund market demonstrated how total returns can go negative. Funds that own long-term U.S. Treasury bonds lost 18% for the year, on average, as market rates on Treasuries surged and principal losses far exceeded interest earned.
The 30-year T-bond yield jumped to 4.64% by year’s end from 2.68% at the end of 2008.
Bill Gross, the Newport Beach bond guru who manages the world’s biggest bond fund -- Pimco Total Return -- has been a prime beneficiary of America’s new love affair with bonds. His fund, which now holds $202 billion in assets, took in more than $47 billion in fresh cash through the first 11 months.
For the year, the Pimco fund posted a total return of 13.3%.
But Gross admits he worries that that double-digit return could mislead new investors, who might expect that kind of performance on a regular basis.
“I do fear Mom and Pop are buying in for the wrong reason,” he said.
With the average interest yield on a broad index of high-quality bonds now a mere 3.5%, Gross said, double-digit returns are out of the realm of possibility in 2010. Although he expects the economy to remain weak and the Fed to hold its key short-term rate near zero for the entire year, he doesn’t expect a new dive in longer-term interest rates that would boost existing bonds’ principal values.
Investors in his fund, Gross said, shouldn’t count on earning more than about 3.5% this year.
For bond investors in general, the best way to lessen risk of principal loss if rates rise is to own funds that focus on short- or intermediate-term bonds. The shorter a bond’s term, or maturity, the smaller its price decline if market rates rise.
In fact, most bond fund investors favored short- and intermediate-term funds in last year’s buying binge.
Kurt Brouwer, head of financial advisory firm Brouwer & Janachowski in Tiburon, Calif., says that though bonds have a place in most investors’ portfolios, he views the tidal wave of cash flowing into bond funds last year -- while domestic stock funds saw cash flow out -- as a classic “contrarian” market signal.
“All of the money going into bonds to me is a good sign that the equity market rally isn’t over,” Brouwer said.
