By Jonathan Burton
Mutual fund and exchange-traded fund investors embraced U.S.
stocks again in the opening weeks of the year, only to be reminded
of why they'd fled.
Black swans, those unexpected market-moving events, appeared in
several places at once. Upheaval in the Middle East and North
Africa, Japan's devastation, and doubts about the strength of the
U.S. economic recovery had shareholders mobbing the corner of Wall
Street and Worry Street for several harried weeks in the first
quarter.
The uncertainty fed market volatility and sacked the broad U.S.
market. The benchmark Standard & Poor's 500-stock index slid
more than 6% from mid-February until the day after the ides of
March.
By then, many retail investors had seen enough. Too bad they
didn't hang around to capture the S&P 500's best first-quarter
since 1998.
After pumping almost $22 billion into domestic stock funds in
January and February, shareholders pulled about $8.5 billion from
these investments in subsequent weeks through March 23, according
to the Investment Company Institute, a fund industry trade
group.
Indeed, stock-buying sentiment in mid-March was lower than at
any time since last August, the American Association of Individual
Investors reported, and the percentage of bulls in its March 23
survey, though higher, remained below-average.
Yet, as is often the case, panicky sellers exited just as U.S.
stocks found their footing. Diversified U.S. stock funds gained
6.6% on average in the quarter through March 30. Every stock-fund
category that investment researcher Morningstar Inc. tracks
finished the period in positive territory -- though there was a
10-point spread between leader energy funds (up 12.6%) and laggard
consumer staples funds (up 2.5%).
The S&P 500, meanwhile, posted a 5.4% quarterly return, not
including dividends, thanks largely to soaring energy shares and a
late March rally, according to preliminary Morningstar data. The
Dow Jones Industrial Average weighed in with a 6.4% advance, its
best first-quarter result since 1999. A representative
exchange-traded fund, SPDR Dow Jones Industrial Average, mirrored
that performance.
The U.S. market's showing trumped returns for diversified
international stock funds, which gained 2.6% on average.
"The first quarter was a relatively good investment quarter for
most," said Jim Tierney, chief investment officer at investment
manager W.P. Stewart. "The fact that the market has held in is
remarkable, and positive."
Change From A Quarter
Indeed, the first 13 weeks of the year wound up being generous
to fund and ETF investors, regardless of whether they favored
small-cap, midcap or large-cap portfolios.
Small-cap growth funds led the pack with an average gain of
8.8%, while their midcap rivals added 7.6%, and large-cap growth
measured a 5.5% advance, Morningstar reports.
Among stock funds with a value discipline, midcap products rose
7% on average, followed by small-cap value funds' 6.5% return and
large-cap value funds' 6.2% gain.
The best diversified mutual fund of all: Integrity Williston
Basin/Mid-North America Stock Fund (ICPAX), up 20.5% in the
quarter. Sizable positions in energy stocks including National
Oilwell Varco Inc. (NOV), Baker Hughes Inc. (BHI) and Hess Corp.
(HES) spurred this midcap growth fund forward.
The biggest U.S. stock funds reflected the broad-market
returns.
Vanguard 500 Index Fund (VFINX), which tracks the S&P 500,
rose 6.1% including reinvested dividends. Actively managed American
Funds Growth Fund of America (AGTHX) added 5.3%, Fidelity
Contrafund (FCNTX) was up 4.9%, and Dodge & Cox Stock Fund
(DODGX) gained 6.3%.
Funds dedicated to energy companies were the biggest sector
winners, posting a 12.6% average gain, and portfolios invested
natural resources added 7.6% on average. Fifteen of the quarter's
20-best ETF performers were tied to energy and commodities,
Morningstar data show.
The top-performing ETF was the 300% leveraged Direxion Daily
Energy Bull 3X Shares (ERX), which rose 54.4%. Other ETF standouts:
iPath DJ-UBS Cotton TR Sub-Index ETN (BAL), up 38.1%, and
PowerShares S&P SmallCap Energy (PSCE), up 24%.
But surprisingly strong results came from health-care-related
funds, up 7.2%, and real estate funds, up 5.3% in the period. And
precious-metals stock funds were surprisingly weak, losing 3.4% on
average.
Technology funds, meanwhile, rose 5.9%, which doesn't fully
reflect the enthusiasm many fund managers have for the sector.
"Technology has these big waves of investing every 10 years or
so," said Bob Turner, chief investment officer at Turner Investment
Partners and manager of the tech -- heavy Turner Large Growth
Investor Fund (TCGFX), which gained 7% in the quarter.
Turner is especially keen on predictions of rapid growth for
mobile computing--smartphones and tablets--and so-called "cloud"
computing. Companies he expects to ride the mobile wave include
Apple Inc. (AAPL), Cisco Systems Inc. (CSCO), while he sees
Salesforce.com Inc. (CRM) taking a leading role in cloud
computing.
Get Up, Stand Up
Now comes the hard part.
The first quarter came in like a bull and went out like a bull.
U.S. stock funds and ETFs weathered the exogenous shocks of Japan
and the Mideast; the market absorbed oil spurting above $100 a
barrel and an ounce of gold fetching record prices.
Investors have whistled past a graveyard of deflating housing
prices, a weak U.S. dollar, shaky consumer confidence and rising
food and other commodity prices.
Bulls are encouraged that U.S. corporations are in reasonably
good financial shape. S&P 500 company earnings for the first
quarter are expected to be fairly robust -- up 14% year over year,
according to Thomson Reuters, with the materials, industrials and
energy sectors posting the strongest showing. S&P analysts, in
fact, recommend that investors emphasize those three sectors, in
addition to technology.
"The easy money off the bottom has been made," Turner said, "but
we have a safety net beneath the market: solid corporate earnings,
record levels of cash, free cash flow, and cash on the sidelines."
He looks for the S&P 500 to "grind higher" and finish the year
at around 1,400 -- about 6% above its March 31 close of 1,326.
But what if this is as good as it gets? Analysts at S&P have
a target of 1,400 for the S&P 500 as well -- they just see it
hitting 1,400 by May, tumbling 10% to 20% in a full-fledged
correction that bottoms in the third quarter, and then climbing
back to 1,400 in 12 months.
Many fund investors and portfolio managers are proceeding with
caution.
"I'm ambivalent about the markets," said Jerry Jordan, manager
of Jordan Opportunity Fund (JORDX), which gained 4.4% in the
quarter. While optimistic about U.S. companies' ability to compete
globally in coming years, he said: "I don't think you have to chase
anything."
There's growing concern about the after-effects on the economy
if the Fed ends its so-called QE2 stimulus at the end of June as
planned, and indeed, if the central bank moves to raise interest
rates.
"You have to have some way of hedging yourself if things get
worse, but participate as things recover," added Ed Peters, who
runs Managers AMG FQ Global Essentials Fund (MMAVX), which gained
1.8% in the quarter.
To that end, many fund managers are laser-focused on companies,
especially large- and mid-sized enterprises, with cash on hand and
pricing power for their goods or services -- or as W.P. Stewart's
Tierney put it, businesses that "have their own motor."
The biggest problem, as Tierney sees it, is that rising energy,
commodity and materials costs will keep pressure on margins, so
companies that can't readily pass along higher costs to customers
will have a tougher road.
"Keep an eye out on corporate margins," he said. To thrive in
this new economic climate, he added, companies will need
"significant revenue growth or significant free cash flow," he
said.
"Pricing power will be a much more important characteristic for
a company to have in the next five years," added Larry Pitkowsky,
founder of GoodHaven Capital Management in Miami.
Considering all of the open questions about the economy's
strength, it's hardly consensus that this patient can walk
unassisted come June. Yet, precisely because those fears may be
overblown, investors are likely to remain on edge -- and it's here
that savvy buyers can find opportunities.
David Rosenberg, chief economist and strategist at Toronto-based
investment manager Gluskin Sheff, advised clients in a quarter-end
research note to favor higher-quality companies, specifically
"cash-flow generators with strong balance sheets that pay out a
reliable dividend stream." He's also upbeat on energy and
commodities, as well as precious metals.
"We fully expect another roller coaster ride in the markets this
year," Rosenberg said. Accordingly, he added, "We must be very well
prepared to take advantage of the stepped up volatility."
(Jonathan Burton is MarketWatch's investments editor, based in
San Francisco. He can be reached at 415-439-6400 or by email at
AskNewswires@dowjones.com.)