The bull takes a breather

You can't blame mutual fund investors for feeling a bit confused. After a strong first quarter, the bull market appeared poised to carry that momentum into the second quarter. An expanding economy kept adding more jobs in the United States every month, and corporate profits were rising. A vigilant Federal Reserve acted preemptively to nip inflation in the bud, with no recession in sight.

But for some reason, the ride came to a halt. Most US stock fund portfolios have shrunk in value lately, especially those with large chunks of small-cap and technology issues. Even international diversification hasn't helped much in recent months.

Why the apparent disconnect? The explanation, some analysts say, lies in investors' heightened anxiety over the risks that come with strong growth. They include commodity-driven price increases, the potential for rising inflation, and a tightening of Fed monetary policy.

"We've had a repricing of risk in the capital markets across asset classes," says Jack LaPorte, manager of the T. Rowe Price New Horizons fund. "Globally, markets hit a major inflection point in May when investors went from embracing risk to avoiding risk."

Investors were spoiled by the gains of a three-year bull market with only minor pullbacks. In retrospect, they were far too complacent, Mr. LaPorte says.

Led by big slides in emerging markets, many global stock markets dropped by 5 percent or more between early May and mid-June. As a result, almost all domestic and international stock fund portfolios were in the red for the second quarter. US diversified stock funds had a negative return of 3.3 percent last quarter, erasing half of the gains from a strong first quarter, according to fund-tracker Lipper Inc. Among sector equity funds, only natural resources and utilities bucked the downtrend. World equity funds fared slightly better than their domestic counterparts, but still slipped 1.6 percent on average.

Going forward, investors should be prepared to batten down the hatches, many strategists say. The threat of higher inflation, tighter credit, and prospects for slower economic growth in the second half of this year are the major culprits. Add to that the traditional summer market doldrums and what's certain to be a high-pitched Congressional election period, and "you don't have much incentive to raise stock exposure," says Fred Dickson, chief strategist at D.A. Davidson, a brokerage firm in Great Falls, Mont. "We'll probably see a Ping-Pong ball market response to a string of conflicting economic data for quite a while."

The odds for equities are poor in an aging bull market facing an adverse monetary climate and a buildup of inflationary pressures, says James Stack, editor of Investech Research, an investment advisory service.

Over the past two years, the Fed has boosted the federal funds rate 17 times, most recently to 5.25 percent. Wall Street is now counting on the Fed to end its long string of rate boosts sometime this fall. But even if it does, the end of the tightening cycle "is not necessarily favorable for stocks," Mr. Stack says.

Since 1929, in 10 out of 14 cases, stock prices were lower six months after the Fed stopped hiking rates. History shows that the Fed often overshoots on the side of restraint, causing a lot of financial stress to the economy, he contends.

Declining inflows into stock funds indicate that many investors have already adopted a more defensive stance, according to Don Cassidy, senior research analyst at Lipper Inc. From record levels earlier in the year, net flows into domestic equity funds fell sharply in May.

Mixed-asset type funds, which are popular among many corporate 401(k) retirement plans, accounted for the bulk of new money. Although investors continued to pour cash into diversified international funds, emerging-market offerings witnessed almost a $1 billion drain. Meanwhile, money-market funds captured $45 billion, the largest monthly total in more than three years.

From a performance standpoint, there were no standout categories in the quarter. Bear funds, designed to excel in a declining market, fared best, rising 5.7 percent. Value funds eclipsed growth, and small-cap funds lagged their large-cap rivals. Still, for the year to date, small-cap stocks have the edge and may keep alive their six-year winning streak against large-caps.

Small-caps have seen their best days, possibly for several years, LaPorte says. "But, importantly, that doesn't mean they will decline substantially. It just means that they are not likely to do as well as large-cap stocks, which are historically undervalued compared to smaller companies."

In the overseas arena, the biggest losers were funds that had scored the fattest gains in recent years. Emerging-market funds and Latin American funds, each of which advanced by more than 30 percent annually in the past three years, fell 5 percent and 3.4 percent, respectively.

"As in the US, spreading inflation fears are causing other central bankers to become more hawkish, and that's bound to take some of the steam out of foreign markets," says Stack.

Historically, stocks in foreign markets haven't closely tracked the US market. Achieving greater diversification has been a popular rationale for investing abroad.

But May's global downdraft has led some to question whether that low correlation is a thing of the past.

Under the impact of globalization, "US and foreign markets are much more closely synchronized than they were a decade ago," says Stack.

Like most advisers, Stack recommends spreading investments across various fund types and adjusting the mix according to an individual's risk tolerance.

A strong advocate of "safety first" strategies, Stack recommends that no more than half of one's portfolio be in equity funds, with an emphasis on value, natural resources, and equity-income funds. Short-term US Treasury bills, now yielding above 5 percent, are his first choice for protection against higher interest rates.

Portfolios managed by Proctor Financial of Wellesley, Mass., have shifted from small-cap growth issues in favor of those holding large-cap stocks paying steady dividends, says president Tony Proctor.

"We've also scaled back the risk meter by adding long-short funds," Mr. Proctor says. Such funds employ sophisticated hedging strategies geared to preserving capital in weak markets.

A well-diversified portfolio won't be immune to market downswings, but it will soften the pain. To sleep easier at night, you should raise cash reserves, some investment advisers say. "With yields on taxable money-market funds nearing 5 percent, you can afford to sit out a choppy market," says Mr. Cassidy.