Mutual Fund Quarterly: Wall Street sails through disasters

Sky-high gasoline prices. One of the worst natural disasters in United States history. Plummeting consumer confidence. While these events may seem like a prescription for investor panic, that's not what happened in the third quarter.

Investors kept their cool and most equity mutual funds came out ahead of the game, especially if they had a stake in overseas markets. For the quarter, the average US diversified equity fund rose 4.7 percent, according to fund tracker Lipper, slightly more than the S&P 500's 3.5 percent gain.

To be sure, the stock market swooned a bit in September. But the psychological damage from double-barreled hurricane blows in the Gulf region was relatively minor. Investors pulled back from consumer-oriented stocks, fretting that the critical holiday season will find shoppers in a glum mood.

Yet energy stocks continued to forge ahead, as did healthcare and technology issues. With huge sums of federal aid targeted to rebuilding the Gulf states area, shares of engineering and construction, building materials, and machinery issues gained. Small- and mid-cap stocks, which many analysts had expected to falter after a lengthy stretch of outperformance, also held their ground.

"Wall Street is showing surprising resilience in the wake of the hurricanes, soaring energy prices, and the Fed's latest monetary-tightening moves," says Fred Dickson, market strategist at D.A. Davidson & Co., a brokerage firm in Great Falls, Mont.

Investors seem to be encouraged by stocks' reasonable valuation levels and the expectation of massive public- and private-sector outlays to rebuild the Gulf Coast infrastructure, he says.

In fact, the market's ability to snap back after major natural disasters is well documented, according to Ned Davis Research. The institutional invest- ment research firm studied the market's action following 18 hurricanes of a magnitude of Category 3 or higher since 1954. After six months, the S&P 500 rose an average of 10.3 percent. After 12 months, it rose an average of 15.1 percent.

The market's ability to shrug off bad news doesn't mean that investors are smiling. Judging by fund flows, 2005's choppy market has deterred investors from sticking their necks out too far. Fund inflows were unusually sluggish in August, according to fund tracker Lipper. As has been the case for over a year, large-cap US stock funds had the biggest drains. Investors siphoned some $11.6 billion from the large-cap category and funneled $5.3 billion into multi-cap funds, which have a more flexible investment mandate.

World equity funds, which include global, international, and emerging-market funds, had the lion's share of equity fund inflows. Investors tend to chase performance, notes Lipper senior analyst Don Cassidy, and "the relative attraction of investing outside US borders has increased, despite a stronger US dollar."

From a performance standpoint, all major categories of US stock funds scored positive returns in the quarter. Yet they lagged behind their international counterparts by a wide margin. The average world stock fund returned a hefty 11.5 percent, more than double the average gain of US equity funds. Emerging-market and Latin American funds were prominent pacesetters, advancing 17.5 and 29.3 percent, respectively. "Emerging markets hold out prospects for faster growth than the United States and, by most counts, they are not yet overvalued," Mr. Cassidy says.

Among sector funds, the natural resources group led the pack, rising 22.3 percent for the quarter. Energy-related stocks powered the sector's gain. With many oil and natural-gas stocks up more than 40 percent this year, some analysts say the stocks are due for a breather.

"The integrated oil stocks may be vulnerable if crude prices weaken from these elevated levels, as seems likely," says James Moltz, vice chairman of ISI Group, an economic research firm in New York.

Utility funds gained 8.1 percent, reflecting investor interest in stable, dividend-paying stocks. After a strong three-year run, such funds are now much less appealing, analysts say. The average utility fund yields only 1.5 percent, while the average balanced fund has a 1.7 percent payout.

Gold-sector funds, notorious for their volatility, surged 20.1 percent. "As an inflation hedge, gold is a good way to diversify a multiple-asset class portfolio," says Lester Satlow, portfolio manager for Cabot Money Management of Salem, Mass. "But you probably don't want gold to be more than 5 percent of your holdings," he adds.

Multi-cap growth funds topped all diversified US stock fund categories with a 6.7 percent gain. In a departure, large-cap growth funds also fared well.

Unexpected events like hurricane Katrina and the run-up in energy prices reemphasize the importance of a diversified portfolio. "You've got to go beyond US stocks and bonds and have a global perspective," says Mr. Satlow. Most globally diversified portfolios this year have outperformed the S&P 500 index, he notes.

One reason index fund investors aren't doing so well: Financial service stocks represent more than 20 percent of the S&P 500 index. With interest rates rising, many financial stocks face an earnings squeeze. Actively managed multi-cap funds, on the other hand, have had more flexibility to delve into energy, real estate, and healthcare stocks.

Equity strategists are cautiously optimistic about the fourth quarter, traditionally a strong one. Most agree that the three-year-old bull market is struggling to get its second wind. Locked in a narrow trading range for more than six months, it faces stiff headwinds - a steady rise in interest rates, an uptick in inflation, and lofty energy prices. Yet investors' worries, they say, are probably overdrawn.

"At this midway stage of the economic cycle, stocks and cash continue to have the edge over most bonds," says James Swanson, chief investment strategist for MFS, a mutual fund company in Boston.

"We wouldn't be surprised to see a 5 percent pullback over the next month, but don't see any major drop in the indices coming," says Dickson. He expects the market's action in the next few weeks to be heavily influenced by third-quarter earnings reports. Rising energy prices will produce some negative earnings surprises. Still, he says, reasonable price/earnings valuations and a lot of cash on the sidelines should attract value-conscious investors, mitigating any downswing.

Diversified-equity fund: A mutual fund invested in a wide range of stocks, as well as cash. Such funds do not usually include bonds or notes.

Exchange Traded Funds (ETFs): In effect, they are mutual funds that can be traded daily, like stocks. The shares represent a "basket" of securities. As the value of the securities in the basket fluctuates, so does the value of shares in the ETF.

Expense ratio: The percentage of a mutual fund's assets that is used to cover management fees and other operating expenses. Also known as "management expense ratio" (MER).

Index fund: A mutual fund that invests in the same stocks used to compute a particular stock-market index (the Dow, the S&P 500, etc.) in order to mirror the performance of that index.

Small-cap, mid-cap, large-cap: A shorthand way to indicate the size of a corporation. "Cap" stands for "market capitalization," the total value of all the stocks and bonds issued by a corporation. (See key at the bottom of the chart on page 15.)