Ouch, That Hurt
Mutual Funds Took a Beating Last Quarter, and Experts Disagree on When Healing Will Begin

By Tomoeh Murakami Tse
Washington Post Staff Writer
Sunday, April 6, 2008

NEW YORK -- Take shelter in large, stable companies? Forget about it. Flee to overseas stocks? Not a chance. How about the once red-hot Chinese market? That didn't work either.

From large-cap funds that invest in big, quality companies to international stock funds, which enjoyed years of consistent growth, to bond funds traditionally considered to be safe, there were few mutual fund categories that didn't bleed red in the first quarter as the credit crisis sent global investors running for cover.

"It was a rough quarter," said Craig Hester of Hester Capital Management. "There was no place to hide. . . . In hindsight, everybody should have been in 100 percent cash."

Many money managers say the credit crunch will produce more flare-ups and disappointments in the coming months. As debate turns from whether a recession is on the way to how deep it will be, the question becomes when the financial markets can start their long healing process, and how many more shocks investors have to stomach before that happens.

Some, like Hester, are hopeful that markets endured the worst of it in the first quarter and that the government interventions in recent months will soon induce a recovery.

But others are not hazarding a guess. Too often, the stock market's rallies have turned out to be short-lived.

"It makes it very difficult to find investments you can have confidence in when you have strong headwinds in the economy," said Ryan Jacob of the Jacob Internet Fund, which fell 16 percent in the first three months of the year. "In terms of what the rest of the year will bring, no one knows."

Investors will get a sense of how companies are holding up under slower consumer spending and reduced access to credit when they begin reporting earnings this week. Investors will pay particular attention in mid-April, when Citigroup, Merrill Lynch and Bank of America, three financial giants that have reported billions of dollars in write-downs, disclose their quarterly performances. Losses substantially larger than what Wall Street is expecting will probably further dent investor confidence and lead to another broad sell-off, analysts said.

One important measure of the economy came Friday, when the Labor Department said 80,000 jobs were lost in March, more than analysts anticipated. It was the third consecutive month of losses.

"The recession bell has rung for the U.S. economy," said Stuart Hoffman, chief economist at PNC Financial Services Group. "The loss of jobs is very widespread."

Nonetheless, Hoffman said he is still in the camp that believes the recession will be shallow. He predicted the economy will recover in the second half of the year as it begins to feel the effects of multiple Fed interest rate cuts and the stimulus package signed in February by President Bush, which should give consumers a shot in the arm. Consumers fuel two-thirds of the economy.

With more help from a slowing but healthier global economy and a housing market that may start to bottom out this fall as prices become more attractive for home buyers sitting on the sidelines, the U.S. economy will be on a path to slow growth, Hoffman said.

Though the downturn has not been sharp, FTN Financial's chief economist, Christopher Low, is not so sure the recession will be that mild. The stimulus package may help consumer spending temporarily, but it "won't do a whole lot in the grand scheme of things," he said. And the Fed, though it acted early and aggressively, faces big challenges in persuading banks to lend, he said.

"Unfortunately . . . the Fed is fighting a collapse of confidence in the credit market that is entirely justified," Low said, adding that with gloomy prospects for income and job growth, the only way consumers can increase spending is to borrow. "It's hard to imagine a great deal of credit being extended as long as default rates are hitting new highs. . . . I'm confident the second quarter will be worse than the first quarter."

The first quarter certainly wasn't pretty. It began with a sell-off as a series of worrying economic data came into focus: The unemployment rate jumped. Job growth ground to a near-halt. Retail sales were slowing, manufacturing activity was weakening. Commodity prices, such as oil, were soaring to record highs, feeding worries of stagflation -- a toxic mix of stagnant growth and inflation.

Meanwhile, Citigroup and Merrill Lynch reported the worst quarterly losses in their histories.

As investors lost confidence, parts of the credit market previously thought to be safe froze up. Municipal bond prices fell. So did high-quality mortgages backed by Freddie Mac and Fannie Mae. Funds failed, including one managed by District-based private-equity giant Carlyle Group. Last month, investment bank Bear Stearns was forced to sell itself to rival J.P. Morgan Chase to avoid bankruptcy.

The Standard & Poor's 500-stock index finished the quarter down 9.9 percent, its worst performance since 2002. The Dow Jones industrial average dropped 7.6 percent. The tech-heavy Nasdaq composite index declined 14.1 percent.

Every sector finished the quarter lower. Hardest hit were financials, telecom and technology shares, which all fell about 15 percent.

Most mutual funds that invest in stocks lost money, with diversified U.S. stock funds falling an average 10.1 percent, according to Lipper, a fund tracking data firm. World stock funds lost 9.6 percent; emerging-market funds fared worse, falling 11.7 percent. China region funds dropped a whopping 21.2 percent.

Investors pulled nearly $35 billion out of U.S.-based equity mutual funds in the first quarter, including 5.4 billion from those that invest in overseas stocks, according to preliminary data from AMG Data Services, which tracks fund flows. Taxable bond mutual funds had inflows of $40 billion, helped by money pouring into funds that invest in safe U.S. Treasurys and investment-grade corporate bonds and despite outflows from junk bonds.

In the United States, large-cap growth stock funds shed 11.6 percent, while small-cap growth funds fell 14.9 percent, Lipper said. Bear-market funds that short, or bet against, stocks rose 11.9 percent.

Of the sector-specific funds, real estate funds shed just 1.2 percent, reflecting some investor optimism that the beaten-down market may be hitting bottom. Natural resources funds, helped by rising commodity prices, also escaped relatively unscathed, losing 4.5 percent. Gold-oriented funds rose 5.2 percent.

With red just about everywhere, what's an individual investor to do?

Some market strategists caution against chasing commodities-related stocks, noting that commodity prices, which have pulled back from their mid-March highs, still look expensive.

"A lot of commodities have run up sharply, partly driven by speculative demand," said David Darst, chief investment strategist at Morgan Stanley Global Wealth Management, which is maintaining a 4 percent allocation to real assets such as timber, gold, oil and gas interests. "Longer term, we're fine with these. But on a short-term basis . . . they look a bit pricey."

At the same time, strategists said, investors should not panic and pull money out of battered sectors at what could be the low points.

Jacob said he has been repositioning his fund to have more exposure to smaller tech companies, which he said have been beaten down to the point where they are reflecting the most pessimistic of views. Investors bid up shares of large tech firms in the second half of 2007, but the sector has since fallen because of concern that profit growth will weaken in a slower economy.

"It's become clear that we're entering a recession or in one now," Jacob said. "It's hard to believe that these [large] companies will continue to grow as analysts expect."

Ginny Chong, senior portfolio manager at Laudus Mondrian Emerging Markets Fund, noted that many emerging markets, such as Taiwan, Thailand, Mexico and Egypt, posted healthy gains in the first quarter despite losses in places like China and India, which had seen speculative buying during the double-digit gains of recent years.

"Over the long term, we believe in the fundamentals of emerging markets," she said. "What we've seen is greed in the past and full expectations built in, and now we're seeing the opposite of that, which is fear."

Hester said he has been increasing exposure to multinational companies. Export growth, he said, has been one of the key factors that has held the economy together. The dollar, which has continued its downward trend for six years and hit fresh lows against the euro during the first quarter, has helped fuel that growth.

"They didn't do you a lot of good the first quarter because it was a global sell-off, but I think going forward, looking at where you want to be positioned when this market gets going again, I think it's going to be [in] quality" multinational companies, he said.

As he sorts through the chaos of the first quarter, Chad Deakins, portfolio manager at the RidgeWorth International Equity Fund, said his staff has been emphasizing the ability of companies to produce earnings. Valuation, or the relative price of stocks compared with earnings, is not as important right now in this period of contraction, in which high earnings expectations will ultimately be revised down, Deakins said. "We're looking more at earnings certainty," he said.