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Dow's year-end rise a pleasant surprise

Fourth-quarter surge comes with a caution about what may lie ahead.

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Mutual fund investors can toot their horns over the surprising success of 2006. An aging bull market that was supposed to eke out modest returns turned out to be a real winner. Major stock indexes hit highs not seen for six years. And unlike 2005, when the fattest gains were confined to a handful of narrow sectors, such as energy and emerging markets, Wall Street's bounty was widespread. Most stock funds chalked up double-digit gains in 2006, enjoying their best year since 2003.

Among 18 types of diversified US stock fund categories tracked by Lipper, only one – dedicated short bias funds – lost ground for the year. The average diversified fund rose a hefty 12.4 percent, the fourth upside year in a row. Fund portfolios packed with big multinational companies fared particularly well, as did those geared to foreign markets, where a weakening dollar boosted returns.

Investors who put their dollars in riskier sectors, such as emerging markets and small-cap growth stocks, experienced considerable volatility, but scored solid gains. While small-cap funds didn't fade, as many analysts had expected, mega-cap stocks – the top 100 companies in the capitalization-weighted S&P 500 index – rebounded in the second half of the year. Value stock funds again beat growth stock funds, a pattern that has persisted for more than five years. The chief laggards were large-cap growth funds, whose penchant for technology and healthcare were a drag on performance.

Almost half of the S&P 500 index's 16 percent rise in 2006 occurred in a robust fourth-quarter rally following August's pause in the Federal Reserve's long string of rate hikes. The rally was stoked by an easing of oil prices and inflationary pressures. Investor confidence was also buoyed by record corporate profits and a growing belief that a cooling economy would not sink into recession.

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