Investors have had plenty to agonize about in the past three months. The tension between good and bad news -- between more jobs and continuing terrorist attacks, between healthy profits and rising interest rates -- seemed to paralyze even professional money managers.
All of that unpredictability meant a certain amount of volatility, but in the end it added up to a tepid quarterly performance for mutual funds. On average, U.S. stock funds barely budged in the three months ended June 30, rising just 0.09 percent.
The problem, according to analysts, was that investors were stuck trying to decipher a market that was not headed in any obvious direction. By contrast, last year stocks outperformed bonds, cyclical stocks that mirror the economy did better than steady performers, foreign markets proved sweeter than the U.S. market, small companies beat large companies, and technology shares led the way.
James W. Paulsen, chief investment strategist for Wells Capital Management, described the 2003 market as "compiled by trends."
"You were either on the right side or the wrong side," Paulsen said. But this year, he said, "none of those trends are clear at all."
Several analysts traced the indecision holding the market hostage back to the heady days of the technology bubble. At that time, they said, even an amateur could have studied a few charts and concluded that technology stocks were grossly overvalued and that stocks of smaller companies with steady profits were equally undervalued. The countermove was clear: Sell off the expensive stuff, buy up the cheap and neglected, and watch your portfolio swell.
As technology shares fell out of favor, their prices fell and no longer seemed so exorbitant relative to their earnings. As investors bid up the stocks of smaller companies overlooked during the dot-com craze, those shares became less of a bargain.
The result was a market more fairly valued overall -- and drained of bargains. Small-cap value funds have returned 11.2 percent over the past three years, while large-cap growth funds fell 5 percent and the overall market dipped 0.1 percent.
"There are no more 'gimmes' in the market," said Marian Pardo, one of three managers of Credit Suisse Asset Management's $100 million small-cap growth fund.
Pardo's sentiment is reflected in the returns of the major mutual fund categories. No matter how the data are sliced, average returns for diversified stock funds stayed within a narrow band of plus or minus 1 percent.
Faced with a riddle of a stock market, investors added only $35 billion to mutual funds in the past quarter, down from an inflow of $89 billion in the first three months of 2004, estimates Robert L. Adler, president of research firm AMG Data Services. That's the smallest contribution since the first quarter of 2003, when investors actually pulled $5.9 billion out of mutual funds. The quarterly number also masks the extreme caution investors displayed in May, when the Federal Reserve signaled for the first time that it would begin raising interest rates soon. Investors responded by taking $6.1 billion out of bond funds during the month, the first outflow since August 2003, and putting only $334 million into mutual funds.
"People don't know what's happening next, so they're sitting still," said Jeff Tjornehoj, a research analyst with fund research company Lipper Inc. "The longer [this static market] goes, the more people are concerned that they could make a mistake. They're not going to take a bold position."
Barely breathing markets like this one require a lot of digging to find stocks with some upside left, Pardo said. One example: Guitar Center Inc., a California-based chain selling guitars, amplifiers, drums and high-end recording equipment. The stock, which makes up 1.7 percent of the Credit Suisse small-cap fund, leaped 20 percent in the second quarter. Jumps like that helped the fund essentially break even, compared with an average loss of 2.38 percent for small-cap growth funds overall.
But the fund category that performed the best overall didn't require painstaking analysis from its managers. Natural resource funds, dominated by energy stocks, posted a 4.31 percent rise during the second quarter on the strength of oil and natural gas prices. The most successful was the Energy UltraSector ProFund, which tracks stocks in the Dow Jones Energy Sector index. The fund reported a 12.10 percent gain for the second quarter, the third-highest among all funds, because it is designed to amplify gains and losses. A $100 rise in the energy index, for example, leads to a $150 rise in the fund.
Other managers chased high returns and won by betting on some of the riskiest stocks. The Amerindo Technology Fund, which holds big-name Internet stocks such as Amazon.com Inc., eBay Inc. and Yahoo Inc., trounced every other mutual fund with a quarterly return of 22.16 percent. The fund performed spectacularly for the same reason that several mutual fund analysts said they wouldn't recommend it; the fund holds only 18 stocks, and 87 percent of its assets are in its top 10 holdings.
"We take concentrated positions early and hold them," fund manager Alberto W. Vilar said. "Yahoo is 10 percent of the fund. If you didn't own the right stocks in [a large enough quantity], you would have been up very nicely but you would have been up half [our return]."
In this flat market, those were the kinds of daring strategies that yielded big returns. But most people aren't willing to try volatile energy or tech-heavy funds, which guarantee big wins or big losses and little in between. (The Amerindo Technology Fund, for example, lost 13.98 percent over the past five years and plunged 90.7 percent during the market's slide from April 1, 2000, to Sept. 30, 2002.)
"It's not unusual for people to look at a sideways market and say, 'This is a stock picker's market,' " said Tjornehoj. He and other analysts, though, said that a diversified portfolio becomes even more important in a market that nobody feels ready to call.
Some fund managers, such as Robert L. Rodriguez, chief executive of First Pacific Advisors Inc., are dealing with a dull market by holding chunks of fund assets in cash. But most are trying to predict the next big thing. That's harder because some of the old rules no longer seem to apply. Wells Capital's Paulsen, for example, is torn between placing a bet on small or large companies. Historically, small companies do better as the economy heats up and inflation accelerates, but they have already outpaced large companies for the past three years.
"They sort of did well when they weren't supposed to," Paulsen said. "One wonders if they won't do well when they're supposed to."