Gains amid gloom
BOSTON -- There’s not much good news for investors. The outlook for the global economy is worsening and U.S. corporate profits are starting to shrink.
Even so, the Standard & Poor’s 500 index climbed 5.8 percent in the latest quarter, while U.S. stock mutual funds returned an average 5.3 percent, according to fund tracker Lipper Inc.
The stock market is a leading indicator, which means that its movements generally anticipate changes in the economy around six months before they occur. So how to explain the recent gains for stocks, given the worsening outlook?
The answer is simple: Policymakers in the U.S., China and Europe have come to the rescue with new stimulus programs and financial support.
Although the global economic outlook didn’t improve, investor perceptions of what central banks were willing to do changed, says Tom Roseen, a mutual fund analyst with Lipper. "It looks like they’re willing to do whatever it takes to keep the markets rolling, and get employment back on track," he says.
That realization is pretty much the story behind the stock market’s recent strength, Roseen says.
Most notable was the Federal Reserve’s approval last month of a third round of bond-buying to stimulate the economy and stock market.
Stocks rallied throughout the summer in anticipation of the Fed’s move as investors tried not to be discouraged by the quarterly profit outlook. Earnings from July through September are expected to be about 1 percent lower, on average, than a year ago. It would the first such quarterly decline in three and a half years. Earlier this year, Wall Street analysts were forecasting third-quarter earnings would modestly grow rather than decline.
Meanwhile, the economy continues to grow slowly, although jobs gains last month are fueling modest optimism. Outlooks in China and Europe have worsened, and the International Monetary Fund has scaled back its global growth forecast.
Against such a backdrop, it was a strong third quarter for mutual fund investors:
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NEARLY EVERYTHING RISES: All but four of the 90 stock and stock-bond fund categories that Lipper tracks posted gains. The exceptions were niche categories, including "short" funds that profit by correctly betting that a stock will fall. Most of those bets ended up poorly in a rising market, and the funds lost an average 10.6 percent.
GOLD’S APPEAL GROWS: The Fed’s approach to fuel economic growth elevates the risk that inflation will eventually spike, eroding the earnings power of bonds and many lower-risk investments. Gold tends to increase in value when inflation fears rise. The top-performing sector funds were those investing in stocks of precious metals mining companies, an average 22.4 percent return; and funds that invest directly in precious metals by owning gold and silver, up 15.7 percent.
FOREIGN STOCKS COME BACK: Funds investing in U.S. stocks have done better than foreign stock funds most of the year, due to the relative strength of our economy. But stock funds investing primarily overseas returned an average 6.6 percent in the third quarter, compared with 5.3 percent for U.S. stock funds. A key reason for the overseas performance edge was investors’ growing confidence that European leaders can control their continent’s debt crisis.
ASIAN GIANTS TAKE DIFFERENT PATHS: Funds specializing in Indian stocks returned an average 13.7 percent in the third quarter,
best among the world stock fund categories. India’s outlook improved as its lawmakers approved a series of economic reforms. In contrast, China funds returned 3 percent, and Japanese funds lost 0.5 percent.
VALUE EDGES GROWTH: Growth-oriented stocks have outperformed value stocks for the better part of five years, but the growth advantage has worn thin lately. In fact, funds investing in value stocks had an edge in the third quarter, returning an average 5.8 percent to 5.6 percent for growth funds. Value stocks are considered cheap based on price-to-earnings ratios, while growth stocks are more expensive because investors expect they will generate above-average earnings and revenue growth.
LARGE BEATS SMALL: Funds specializing in stocks of large companies outperformed for the second straight quarter, with an average 6.2 percent return to 5.2 percent for small-cap funds. However, small-caps had an edge in September. That’s perhaps a result of investors becoming more willing to invest in riskier small stocks after the Fed’s latest stimulus program.
BONDS CHUG ALONG: Fund investors in higher-risk segments of the bond market were rewarded with larger returns than those choosing a safer path. Funds investing in emerging markets bonds returned an average 6.5 percent, while high-yield funds investing in companies with shaky credit ratings returned an average 4.3 percent.
On the lower-risk end of the scale, returns averaged less than 1 percent for funds specializing in intermediate-term Treasurys as well as those investing in short-term Treasurys.
As for the market’s next moves, Lipper’s Roseen believes performance will remain strong as long as global stimulus programs continue to fuel short-term optimism.
But beyond that, it’s hard to say. After next month’s election, the president and Congress must resolve differences over getting the nation’s debt problems under control. Failure to reach a deal could trigger broad tax increases and automatic budget cuts, possibly leading to another recession. Even if that obstacle is overcome, there’s the risk that the Fed may have gone too far with its latest stimulus.
"Over the long-term," Roseen says, "we could see some inflationary runs."
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