Rude Awakening
Stocks Took a Surprising Dive, And More Jolts May Be Coming

By Tomoeh Murakami Tse
Washington Post Staff Writer
Sunday, April 8, 2007

NEW YORK

Buckle up, investors: Turbulence is back in the stock market, and analysts say it's going to stick around for a while.

The ongoing turmoil arrived abruptly in late February, when a sell-off in the Chinese stock market jolted investors around the world, triggering the biggest one-day drop in the Dow Jones industrial average in four years and ending several months of steady gains.

Since then, stocks have seesawed sharply, as investors sift through mixed signals on the economy. Mortgage industry problems, a sputtering housing market and uncertainty about the direction of interest rates are all fueling market jitters. However, while economic growth has slowed considerably, unemployment remains low and corporate dealmaking continues at a record pace.

"If you're really just looking to make a call on the macro-economic factors, your visibility is pretty poor right now," said Brian Angerame, a portfolio manager at ClearBridge Advisors, which is owned by Legg Mason. He noted that other wildcards are lurking, such as the recent rise in oil prices and ongoing geopolitical tensions in the Middle East.

By the end of the first quarter, stocks had climbed back close to where they began the year. The Dow finished down nearly 1 percent, but the blue-chip index had been off as much as 3 percent in early March. The broader Standard & Poor's 500-stock index gained 0.2 percent, while the Nasdaq composite index rose 0.3 percent. The Russell 2000 index of small companies fared better, gaining 1.7 percent.

Most market watchers do not expect stocks to take off in the second quarter. Robert Doll, global chief investment officer of equities at BlackRock, said he anticipates that the economic slowdown will crimp corporate earnings and that this might make share prices less stable.

"We're in a period of growth scare for the U.S. economy," he said. "We're going to have more volatility in both directions."

Doll thinks profit growth, which had been in the double digits for the past four years, will slow to 5 percent this year. He said the broader stock market can still return up to 10 percent for the year -- provided inflationary pressures ease and the Federal Reserve lowers interest rates.

"It'll be a bumpier ride to get there," he said.

In recent weeks, the Federal Reserve has sent mixed messages about where its benchmark short-term interest rate is headed. After a monetary policy meeting March 21, the central bank issued a statement omitting language it had previously used to indicate the likelihood of interest rate increases. Investors pounced on the change as a sign of a pending rate cut and sent stocks soaring.

But a week later, in testimony to Congress, Fed Chairman Ben S. Bernanke said fighting inflation was still a priority, dousing Wall Street's hopes for a rate cut. Stocks tumbled on the news.

Many investors have been rooting for a break on interest rates to help snap the housing market out of its prolonged slump and spark broader economic growth. A recent survey of investment managers by the Russell Investment Group showed that their concern about the housing market rose after stocks plunged Feb. 27, joining inflation as a chief risk factor.

Worries about the real estate slowdown have been heightened by mounting troubles in the mortgage industry, where a recent spike in defaults on subprime loans has put more than two dozen lending companies out of business. Last week, New Century Financial, the nation's second-largest issuer of high-risk mortgages, filed for bankruptcy protection, the largest such lender to fall so far.

The subprime turmoil has dragged down many financial stocks, analysts say. Of the S&P 500's 10 sectors, financials was the worst performer in the quarter, losing 3.4 percent. Companies in that sector's thrift and mortgage category suffered particularly, dropping 10.8 percent, according to S&P.

"Just about anybody who was in the finance industry got crushed," said Tom Roseen, senior research analyst at Lipper, a fund-research firm.

The S&P's best performers in the first quarter were utilities and materials, which both rose more than 8 percent, and telecommunications, which gained more than 6 percent.

Not surprisingly, mutual fund performance slipped compared with the first quarter last year, with all fund types generating single-digit returns, according to Lipper.

Funds that invest mostly in mid-size companies gained more than 4 percent on average, while those specializing in small companies returned about 3 percent, according to Lipper. Funds that focus on large companies were once again the laggards, with an average gain of less than 1 percent.

Once-lofty emerging-market funds were hit by the global sell-off, returning an average of 2.2 percent for the quarter, compared with 12.2 percent a year ago. Funds focused on Latin America gained an average 4.8 percent, compared with a 16.7 percent gain a year ago.

"There is a large and rapid decline in some of the riskier assets," said Duncan W. Richardson, chief equity investment officer at Eaton Vance.

Investment strategists say this may be a good time for individual investors to readjust their portfolios, particularly for those who had a good run betting on somewhat riskier, smaller-company or emerging-market stocks, strategists say.

Doll recommends investing in large, multinational corporations with significant exposure to overseas markets, where the economic outlook remains stronger than in the United States. He said his firm has been increasing its funds' stakes in Hewlett-Packard and Cisco Systems in the technology sector, Pfizer and Merck in health care, and Exxon Mobil and Chevron in the energy arena in the past year.

Craig Hester, chief investment officer of Hester Capital Management, said large-cap stocks represent 75 percent of the equities it manages for clients, compared with 50 percent three years ago. The firm, which has $1.45 billion under management, has pared its holdings of smaller companies to 1 percent from 15 percent.

Among the large companies it holds, Hester said, are U.S. Bancorp, which gets a chunk of its earnings through fees, and Joy Global, a mining-equipment manufacturer that derives about half its revenue abroad. "Our portfolios today have a more quality bias -- companies with strong cash flows, strong balance sheets," he said, adding that they hold up better in market downturns.

But the key, money managers said, is diversification. Angerame of ClearBridge, who manages mid-cap funds, said the investing environment remains favorable to mid-size companies, in part because they are often targets for corporate acquisitions.

"Mid-caps make tasty little morsels for private-equity shops to acquire," he said. Angerame noted that two firms in his portfolio -- ServiceMaster, a lawn care and pest control company, and Spirit Finance, a real estate investment trust -- recently accepted takeover bids from buyout firms that offered a premium over their current stock prices.

An unrelenting stream of mergers and acquisitions has helped boost U.S. stocks, analysts say. According to Thomson Financial, $451 billion in corporate deals were announced during the first three months of the year, up 35 percent from a year ago. Leveraged buyouts led by private-equity firms accounted for a quarter of the deal volume.

To some on Wall Street, those corporate deals say a lot about how investors are handling the latest stretch of market volatility.

"Clearly, some risk aversion has crept back into the market," Angerame said. "I don't get the feeling that investors have completely changed their mind-sets, though. I think we woke up one morning and heard that a foreign market had sold off . . . and not many people knew how to interpret it."