Rough climb for market

3rd-quarter turmoil leaves bonds up 1.4% on average

stocks rise 2%

Quarterly Mutual Funds

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

Watching the stock market rally that pushed the Dow Jones industrial average to a new high last week, it's hard to believe that August marked a time of profound financial turmoil in the housing sector, one of the nation's bedrock industries.

For mutual fund investors, the third-quarter roller-coaster ride that ended on an upswing meant stock funds eked out an average 2 percent gain and bond funds advanced 1.4 percent on average from July through September, according to Lipper Inc. Funds betting on large, fast-growing companies rose 6.2 percent during the quarter, while funds investing in China shot up 29 percent. Funds focused on financial services dropped 4.1 percent.

"It was probably one of the most volatile quarters I have seen in the past 40 years," said William Dwyer, chief investment officer at MTB Investment Advisors in Baltimore. "A lot of emotion and a lot of fear came into the marketplace. You could have gotten lost and traded yourself right out of the market."

About three-fifths of 215 Maryland-based stock funds managed to break even or post positive returns for the quarter, according to a Bloomberg Funds review. All but one of 55 bond funds were in the black.

Just two months ago, markets were swooning on three housing-related downers: the real estate markets slumped, subprime mortgages went into default at higher rates and credit became increasingly harder to come by. Then markets sharply rebounded in September when the Federal Reserve cut two key interest rates, including the closely watched federal funds rate, by an unexpected one-half percentage point.

While many analysts say the subprime morass has been "priced into" the market, meaning current stock prices reflect all those downsides, other worries continue to weigh on the economy. Oil prices are rising. Inflation remains a concern, and the falling dollar could stoke inflationary worries by making imports more expensive.

Hold on investors, the bumpy ride may have only just begun.

Money manager John P. Hussman compared the recent buoyancy in the market to the run-up in dot-com stocks when analysts reasoned that the risks were well known and therefore factored into market prices. Then the bust came in 2000. He expects problems in the subprime market will worsen as many adjustable-rate mortgages reset for the first time during the next year, leading to more loan defaults and home foreclosures.

"One interpretation is that all of this is already in the numbers," Hussman said. "The other is that investors are in denial because they have placed so much faith in the Federal Reserve, and incorrectly believe that the Fed is actually adding meaningful amounts of liquidity to the system."

Hussman's Strategic Total Return fund, run out of Ellicott City, had one of the best returns among fixed-income funds in the most recent quarter with a 6.7 percent gain. His fund, which can invest up to 30 percent of its assets in stocks, was positioned to take advantage of an investor flight to gold stocks. Barrick Gold Corp. and Newmont Mining Corp. are among its top holdings.

Funds that invest in the mining industry ranked among the best performers out of sector-based stock funds, including Bethesda-based ProFunds' Precious Metals UltraSector, which jumped 38 percent, and Rockville-based Rydex Investments' Precious Metals fund that was up more than 17 percent.

Legg Mason Inc.'s Robert Hagstrom brushes aside worries about worsening economic conditions. As manager of the Growth Trust, he is in the running for Morningstar Inc.'s Domestic Stock Manager of the Year, a major industry award, and this quarter he ranked near the top of Maryland funds with a 7.1 percent return. He says he plays the odds, and many forecasters put the odds of no recession at 2 to 1.

"My sense is there is always something to worry about, and you need to think about it probabilistically," Hagstrom said. He said the economy, currently in a "mid-cycle slowdown," will pick up the pace with more interest rate cuts by the Fed, and "we are likely to see a very strong market for the next two to three years."

Funds in the large-cap growth category, meaning they seek to invest in big companies with above-average earnings growth, took the lead among U.S. diversified stock funds for the first time in eight years, since the height of the dot-com bubble, according to Lipper.

Besides the Growth Trust, T. Rowe Price Group Inc.'s New America Growth and Blue Chip Growth funds also did well in that category with 5.8 percent and 5.6 percent gains, respectively. The DF Dent Premier Growth fund, which is based in Baltimore and invests in mid-cap stocks, posted a 6.9 percent return.

Investor perceptions of growth stocks have evolved since the late 1990s when technology companies were expected to expand rapidly, said John Coumarianos, a Morningstar analyst. Popular stocks in that category now include established companies like Google Inc. and eBay Inc. as well as General Electric Co.

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