In 2006, investors scaled market's `wall of worry'

economists see `soft landing' on the other side

Many happy returns

Mutual funds show large gains in 2006

Year-end mutuals

January 07, 2007|By Laura Smitherman | Laura Smitherman,Sun reporter

At the dawn of 2006, investors confronted the proverbial "wall of worry" and an old adage that bull markets need to overcome uncertainties to continue a rally.

They worried about the Federal Reserve's campaign to fight inflation by cooling the economy, about corporate earnings, oil prices, the housing market. And for the next 12 months they scaled that wall, with much of the year's market gains coming during the fourth quarter.

For mutual fund investors, that meant huge returns after a tame 2005. The average stock fund rose 7.4 percent in the fourth quarter and about 15 percent in 2006, according to Lipper Inc. Bond funds also had a decent showing in the an average 1.3 percent in the quarter and 4.5 percent for the year.

Among 275 Maryland-based mutual funds, 96 percent posted positive returns for the year, according to a review by Bloomberg Funds. Many of the best performers for the fourth quarter and the year were international funds, including T. Rowe Price's Latin America and New Asia funds, and Legg Mason's Emerging Markets Trust. Funds that invest in commodities, telecommunications and utilities often led among sector funds.

"I don't think anybody at the beginning of '06 was expecting the gains that we did get," said Kent Croft, president of Croft-Leominster Inc. and manager of the Baltimore firm's Value Fund, up 18 percent for the year.

As for 2007, many economists are predicting a "soft landing," a scenario under which the Fed succeeds in slowing the economy through higher interest rates, though not so much as to precipitate a recession. That would be a relief for investors, and the steep market climb in recent months reflects the optimism.

But with every market upswing comes speculation about the downside. Some investors fear there may not be much room left for expansion, especially if an unexpected event throws markets into a tailspin, such as a Middle East crisis that causes oil prices to spike again or a financial meltdown, possibly at a hedge fund.

"Markets are expecting a very favorable environment and that has contributed to the recent strength, so there's little room left for a negative surprise," said Daniel F. Dent, whose DF Dent Premier Growth Fund in Baltimore gained 9.4 percent last year.

Bondholders already have tempered their enthusiasm, as the fixed-income market declined in December, partly because investors began to doubt that the Fed would cut interest rates in the first quarter as hoped. Many now believe the policymaking body won't cut rates until the second or third quarter.

"The market got ahead of itself with expectations that the Fed would ease in March," said James Hannan, who manages the fixed-income group at MTB Investment Advisors in Baltimore.

Hannan said the Fed would still want to see lower inflation and sure signs that the economy has slowed, including an unemployment rate closer to 5 percent and a gross domestic product that continues to grow in the 2 percent to 2.5 percent range.

High-yield funds, which invest in junk bonds with higher interest rates than Treasuries but more risk of default, have had outsized returns. Legg Mason's High Yield Portfolio, which holds lower-quality company bonds, rose 13 percent last year. Funds that invest overseas also did well, including T. Rowe Price's Emerging Markets Bond fund, which was up 11 percent for the year.

On the equity side, funds that invested in the China region rose an average 62 percent for the year, and Latin American funds increased 44 percent.

Telecom funds were up 23 percent for the year, as the sector was buoyed by AT&T Inc.'s $85 billion acquisition of BellSouth Corp. Real estate funds were up 34 percent, followed by utility funds at 26 percent, financial services funds at 17 percent and natural resources funds at 15 percent.

A surge of mergers and acquisitions contributed to higher stock prices in the past year, including buyouts that reached a record of $700 billion globally as private equity firms paid a premium to snap up public companies. The hedge fund industry also brought more liquidity to the markets, and companies in the Standard & Poor's 500 index spent more than $400 billion on buybacks.

A factor that bodes well for the new year: Stocks are considered reasonably priced by historical comparisons. S&P 500 stocks are selling at about 15 times expected earnings for 2007, or roughly half the price-to-earnings ratio at the height of the late '90s bull market.

Nagging worries do persist, however, including housing market woes. It is unclear how much farther the market will fall, and how the decline would affect consumer spending, which accounts for nearly three-fourths of the nation's economic output. Many consumers had used home-equity loans to fund their spending.

David Ross, senior portfolio manager at U.S. Trust in Washington, said investors are likely to see more volatility. A strong employment report, for instance, could stoke anxiety about the economy running too hot. "You'll see more volatility as more questions are raised during the year as to whether we'll make that soft landing," he said.

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