Look who's moving the market

After enjoying more than a year of stellar returns, investors in US stock markets seemed to spend most of the first quarter of 2004 waiting. Waiting for an improvement in the jobs outlook. Waiting for decent earnings reports from some of the major bellwether companies. And most important, waiting to see who is most likely to win the White House.

Stocks tend to do well in presidential election years. And if history is any guide, the market should perform better in the second half of the year. But analysts warn against making big changes in your portfolio based on guesses of who will win. Politics, it turns out, is even more unpredictable than markets, they say.

For their part, the major stock market indexes struggled to reach positive territory during the past three months. Both the Standard & Poor's 500 and the Nasdaq Composite indexes moved up a little, down a little, then back up before ending the quarter virtually flat.

Investors, it seems, were stuck in waiting mode - a continuation of the cautious investment pattern in the fourth quarter of 2003.

Over the past three months, investors shied away from the more aggressive mutual funds in favor of value funds that look for undervalued stocks, balanced funds that combine stocks and bonds, or equity-income funds that invest in dividend-paying companies.

"We're seeing money flows into value rather than growth," says Donald Cassidy, senior research analyst at Lipper Inc. "We're still seeing flows into cautious kinds of funds like balanced, real estate, income, equity-income, convertibles. We're not seeing a lot of money flowing into sector funds, which tend to be fairly aggressive choices."

While there was some increased interest in technology funds in the fourth quarter, "that's kind of stopped now," Mr. Cassidy says.

At the same time, Cassidy notes, some people showed a somewhat contradictory streak by investing overseas, where risks would seem to be higher.

"There's an awful lot of money flowing to world equity funds," he says. "People are taking advantage of the lower dollar and the prospects that the dollar might go somewhat lower. But they're also chasing performance."

For example, funds that invest in Japan, the overall Pacific/Asian region, and emerging markets continued the strong performance they showed over the last year (see story).

Domestically, more money may have gone into more conservative options, but the best returns were found elsewhere. Funds that invest in small value companies managed average returns over 6 percent. Three categories of sector funds - telecommunications, natural resources, and financial services - all gained more than 5 percent. But real estate funds turned in the highest returns for the quarter. In fact, they have returned nearly 12 percent since the beginning of the year and more than 51 percent over the past 12 months, according to Lipper.

These gains were fueled in part by increased demand from investors who see real estate as a useful hedge against volatility in the broad stock market.

In the fixed-income universe, the low interest-rate environment continued to help long-term bond funds. These funds will be more volatile when interest rates rise but, these days, their yields are still better than short-term bond funds. According to Morningstar, long-term government bond funds returned approximately 4.7 percent during the quarter, while short-term corporate and short-term government funds each returned about 1.2 percent. When interest rates do rise, however, prices of longer-term bond funds could fall dramatically, Morningstar warns.

One group of funds did continue losing assets, no matter how they invested. Those were funds run by companies involved in either the late-trading or market-timing scandals that started coming to light last September.

"It's still very much an ongoing issue," says William Rocco, a senior analyst at Morningstar. Even as the first quarter came to a close, he notes, state and federal regulators were uncovering instances of unethical or illegal trading practices at fund companies. "A lot of fund companies got subpoenaed and facts are still coming out," Mr. Rocco says.

Until all the facts do come out, Rocco suggests investors avoid funds that have been touched by these scandals. While some people, such as those in 401(k) retirement plans, don't have a choice, others do. "To the extent you have a choice, try to stick with funds not involved in these abuses," he says.

While their focus has been on scandals, investors are starting to turn their attention to the presidential and congressional elections seven months from now. Analysts are already looking at possible outcomes.

Based on history, this presidential election year should be good for stocks, says Edward G. "Ned" Riley, chief investment strategist at State Street Global Advisors in Boston. The Dow Jones Industrial Average has advanced in 10 out of the last 13 presidential election years, he notes.

Further research shows that the second half of 2004 should be better than the first. According to Ned Davis Research, the first and second quarters of election years going back to 1900 have been the weakest, while the third and fourth quarters have been the strongest.

Mr. Riley expects that pattern to be repeated this year. "What we have had so far is the election dictating the market as opposed to the fundamentals dictating the market," he says.

Sen. John Kerry's quick victory over his Democratic challengers was one of the reasons the market paused over the past several weeks, he believes.

But now that the nominations for both parties are sewn up, Riley thinks investors will go back to focusing on the economy and the improving corporate outlook. "We have an economy that's very healthy and a mountain of liquidity on the side waiting to come in," he says.

No one should try to guess the outcome of this year's election now and change their fund portfolio based on that guess, says Cassidy at Lipper. But, he believes investors can start thinking about what might happen and prepare accordingly.

"Don't act on today's poll because that's going to change," he says. "But you don't want to wait until you wake up in the second week in November and say 'Oh, we've got change coming.' Because the market will already be factoring that in."

For example, Senator Kerry and other Democrats have talked about reducing the federal budget deficit. That might mean raising taxes on the highest-income taxpayers and letting some of the recent tax changes expire in 2010. So if a Kerry victory looks like a good possibility a few weeks before the election, investors in upper-income tax brackets might start looking for municipal-bond funds because of their tax advantages and consistent performance, Cassidy suggests.

A victory by President Bush, on the other hand, would be seen as more pro-business, he says. For example, he notes, financial services and communications companies might find it easier to continue the recent pattern of big mergers within their industries, while insurance companies might benefit by being more involved in servicing Medicare drug coverage.

But other experts believe investors should largely ignore the election.

"It's really too soon to tell what effect the election might have," Rocco at Morningstar says. "As always, you should have a plan and a portfolio that works for you and stick with that plan."