Stock mutual fund investors couldn't have asked for a smoother ride higher in the 12 months through March. But that just made the second-quarter market sell-off all the more jarring.
Most equity funds lost between 9% and 14% in the three months that ended June 30, halting a winning streak that had lifted the average U.S. stock fund nearly 50% over the previous four quarters.
It wasn't that investors were unprepared for a pullback. Everyone knew the stock market would "correct" at some point. But many thought the catalyst would be rising interest rates triggered by a V-shaped economic recovery.
Instead, the mood turned grim as a rapid pileup of bad news — the government-debt crisis in Europe, a shocking lack of job growth in the U.S., the Gulf of Mexico oil-spill catastrophe and more — fueled fresh doubts about the global economy's ability to sustain its recovery.
And by the end of June, equity investors had to contend with a chorus of well-known economists asserting that deflation and depression were becoming real risks again.
Princeton University economist Paul Krugman has become one of the loudest voices warning about depression. He contends that Europe, Japan and the U.S. should roll out more stimulus money to fill the void left by still-weak private-sector and local-government spending.
Instead, Europe and Japan are pledging to cut back on government outlays to pare their budget deficits, and pressure is rising on Congress to do the same. Policymakers, Krugman says, are repeating the mistakes of the 1930s.
In the Treasury bond market, a stampede of buying during the quarter showed that some people were taking the deflation/depression talk to heart, much as they did in late 2008.
Painting a dire picture of investors' fears, the benchmark 10-year T-note yield dived to 2.93% by the end of June from nearly 4% in early April as investors rushed for the perceived safety of U.S. bonds.
Given all that, the surprise may be that stocks didn't fare worse. Losses in most of the world's stock markets have stayed within the limits of a classic short-term correction, meaning a 10% to 20% drop from the highs reached in early spring. By Wall Street's traditional yardstick, it takes a decline of more than 20% to mark a new bear market.
The Standard & Poor's 500 index of big-name stocks dropped 16% from its second-quarter peak of 1,217.28 on April 23 to its recent low of 1,022.58 on July 2.
In the last week, the selling has abated. The S&P 500 rose 5.4% for the week. It's still up 59% from the 12-year low reached in March 2009.
Foreign stock funds, which on average fell more sharply than domestic funds in the second quarter because of Europe's government-debt woes and the dollar's strength, have been outperforming domestic funds over the last few weeks, thanks in part to a reversal in the dollar.
With the stock market's losses modest so far — certainly compared with the crash of 2008-09 — investors who fear the economy will crumble have time to rethink their tolerance for risk.
The good news is that basic portfolio diversification worked well in the first half. Bond mutual funds, which saw record inflows of cash in 2009 as many Americans sought to play it safer with their nest eggs, mostly scored total returns of 2.5% to 5% in the first six months, according to Morningstar Inc. If you owned bonds, your returns could have significantly offset the 4.7% loss on the average U.S. stock fund in the half.
Likewise, owning gold helped, as the metal surged to record highs. And funds that own smaller stocks lost less than those that own blue chips.
Could pessimism about the economy be overblown? Many analysts continue to downplay the risk of a "double-dip" recession in the U.S. — although, admittedly, most never saw the 2008 crash coming.
In a midyear survey of economists, Bloomberg News found that the median growth forecast for the U.S. over the next four quarters was 2.8%, down slightly from 2.9% a month earlier.
Yet some mutual fund managers are convinced that the U.S. economic recovery is about to run out of gas. John Hussman, an economics PhD who heads the $8.1-billion Hussman Funds group in Ellicott City, Md., believes that the rebound of the last year has been almost entirely a result of spending by governments worldwide and financial aid from central banks.
As that help winds down, "the U.S. economy appears headed into a second leg of an unusually challenging downturn," compounded by the ongoing need to reduce mountainous debt levels, Hussman said. He thinks stocks overall are headed sharply lower.
Even so, his strategy hasn't been to abandon equities. Rather, his Hussman Strategic Growth fund, which rose 5.2% in the half, uses a "long/short" approach: He buys stocks he thinks can do relatively well in a harsh economy, while hedging his bets by shorting major market indexes. A short position pays off if an investment falls in value.