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QUARTERLY MUTUAL FUND REPORT

Stocks' Slide Shows Value of a Good Defense

After four periods of gain, the average U.S. fund's 3.4% fall may be a hint to focus on risk.

July 11, 2006|Tom Petruno | Times Staff Writer

Stock mutual fund investors suffered a scare in the second quarter, as worries about rising interest rates and higher inflation triggered a global market sell-off in May and early June.

Was it a mere blip -- or a warning to fund investors to rework their portfolios for a dicier environment?

Some analysts say investors should take the hint. "It's a decent time to play defense," said Russ Kinnel, director of fund research at investment firm Morningstar Inc. in Chicago.

That doesn't mean bailing out of all higher-risk investments, he said. But it does mean looking closely at your mix of stock funds to make sure you aren't too heavily invested in any one sector -- and that you have enough diversification so that weakness in some funds could be offset by strength in others.

The average domestic stock fund slid 3.4% in the three months ended June 30, after four straight quarters of gains, according to Morningstar.

For the first half of the year, however, most stock fund categories still were solidly in the black, thanks to global equity markets' sharp rally in the first quarter. The average domestic fund was up 3.1% for the half. The average foreign stock fund was up 8.3% after losing 1.7% in the second quarter.

In the giddy first quarter, U.S. investors seemed highly confident in the "Goldilocks" scenario for the economy: The expectation was that nearly two years of credit-tightening by the Federal Reserve would slow the economy enough to allow the Fed to stop raising interest rates, but not enough to threaten recession.

But the central bank threw investors a curve early in May, when Fed officials sounded fresh warnings about rising inflation pressures. Instead of pausing at their May 10 meeting, policymakers raised their key short-term rate for the 16th time since mid-2004 -- then followed that with a 17th increase, from 5% to 5.25%, at their June 29 gathering.

Amid growing fears that rising interest rates could lead to an economic accident, some investors decided to cut back on stock market sectors that have historically been considered above average in risk.

For the quarter overall:

* Small and mid-size stocks generally fared worse than large-company issues. The average fund that owns small-capitalization "growth" stocks dropped 7% in the three months, according to Morningstar. By contrast, the average large-capitalization growth stock fund lost 4.8%.

All figures are for total return, meaning principal change plus any dividend or interest income.

* Growth stocks -- typically shares of companies whose earnings are expected to grow faster than the market average -- fell more than "value" stocks. Value issues tend to be slower-growing companies, but the prices of their stocks often are lower, relative to earnings, to reflect that.

The average fund that owns mid-size growth stocks lost 5.6% in the quarter, compared with a 1.4% drop for mid-size-value funds.

* Emerging-market stock funds, which own shares of companies in fast-growing economies of the developing world, slid 5% in the quarter, on average.

* Technology stock funds were the quarter's worst performers among major sectors. They lost 9.7%, on average, hurt by worries about the economy and by a widening investigation by federal regulators into tech companies' stock-option accounting practices.

For tech, the second-quarter decline added insult to injury: The sector remains one of the worst-performing of all fund groups over the last five years.

The big question on Wall Street is whether the weak performance of sectors such as emerging markets and small stocks in the quarter was the start of a trend, or just some needed profit taking after the heady gains of recent years.

Emerging-market stock funds have trounced U.S. funds over the last five years. The average emerging-market fund has gained 20.2% a year in that period, compared with 3.9% for the average U.S. fund.

Measured by Standard & Poor's indexes, smaller U.S. stocks have beaten big-name issues every year since 2000. Although bigger stocks fared better in the second quarter, they're still trailing year to date.

Bill Nygren believes that big-name U.S. stocks are in the process of taking the lead from their smaller brethren.

He's got a vested interest in saying so: His Chicago-based Oakmark Select fund is heavily invested in such U.S. blue chips as Time Warner Inc., Intel Corp. and Bristol-Myers Squibb Co. The fund slipped 0.8% in the second quarter, holding its ground better than most equity funds.

Nygren expects investors to gain a new appreciation for large-company stocks if the economy slows and earnings growth becomes tougher for companies in general.

Many U.S. stocks are priced right around the same level relative to underlying earnings per share -- about 15 to 16 times estimated 2006 earnings, Nygren said. That suggests "there's no premium for large-cap stocks versus small- and mid-cap stocks," he said.

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