Europe Mutual Funds Outdo U.S., Emerging In August

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European Central Bank President Mario Draghi's pledge to do "whatever it takes" to save the eurozone from collapse and dollar weakness propelled European markets and stock funds above all others in August.

That performance may prove to be a fluke, however, as the region faces a flurry of uncertainties from the upcoming political events in Europe, another Federal Reserve meeting midmonth and seasonal market weakness in September.

Europe stock funds surged 4.31% in August vs. 2.75% for the average U.S. stock fund, according to Lipper Inc.

The S&P 500 has rallied for three months straight to a four-year high during the month. It gained 1.97% in August and 10.55% year to date. It would be normal for traders to book profits after such a healthy run and especially in September, the market's historically worst month of the year.

"Once tans begin to fade and the new school year begins, fund managers tend to clean house as the end of the third quarter approaches," said Jeffrey Hirsch, chief market strategist at Magnet AE Fund in White Plains, N.Y. "Portfolios are restructured and weeded out in preparation for the fourth quarter and to improve performance numbers."

By some measures, the stock market is overvalued compared with historical averages. On a trailing 12-month earnings basis, the S&P trades at 16 times earnings vs. the long-term price-earnings ratio average of 14 times, said Zach Liggett, a portfolio manager at Kahului, Hawaii-based Financial & Investment Management Group with $600 million in assets under management. "Its dividend yield of 1.9% is well below the long-term average of 4.4%."

Russell Investments' strategists also believe the market will pull back from its August highs. In addition to high valuations, they see corporate profits succumbing to sluggish U.S. economic growth. Eventually profit growth has to align with nominal gross domestic product growth and that adjustment might be more abrupt than previously thought, they wrote in a "2012 Global Outlook." They believe the market got overly optimistic following Draghi's late-July comments that the ECB will do "whatever it takes" to save the euro.

Europe Leads Globe

European funds returned 9.69% year to date. Investors can expect a wild ride in September from the upcoming ECB policy decision, Dutch election, German Constitutional Court ruling on the eurozone bailout fund and myriad economic data releases. Scotiabank projects Europe's economy will contract 0.7% in 2012. Scotia lowered the European economic growth forecast to a mere 0.2% in 2013, down from 0.3% previously estimated. Contrarian fund managers say it's time to follow Warren Buffett's words of wisdom: Be greedy when others are fearful.

"I'm quite excited by the opportunities in Europe," said Andrew Sleeman, manager of Franklin Templeton Mutual International with $21 million in assets. "Global companies that happen to be domiciled in Europe are trading at discounts to their U.S. peers."

"Corporate balance sheets are a lot healthier than government balance sheets," Sleeman said. "With challenges come very interesting opportunities that will generate earnings through these markets."

His top holdings include Rexam, the largest beverage can maker in Europe and Brazil; REXLot Holdings, a lottery machines developer and producer; and Aozora Bank. His fund returned 7.20% year to date vs. 6.92% for the MSCI EAFE index for developed markets, according to Morningstar. It gained 1.94% in the past year vs. -0.04% for the benchmark.

Japan funds ticked up 0.16% in August and 0.93% year to date. A 0.38% loss in China for the month weighed on emerging markets, up 0.76%, which have underperformed foreign developed markets this year. Latin America added 0.60%.

Fund flow data indicate retail investors missed out of some of the solid stock fund performance in August by favoring bond funds. Investors pulled $15.5 billion out of U.S. stock mutual funds, while funneling $16.3 billion into bond funds in August, according to EPFR Global. Stock mutual funds globally disgorged $17.5 billion, while bond funds globally took in $22.7 billion.

"We fear this potentially parabolic move in equity markets in the short term may lure the retail investor back into the markets just before the beginning of the next cyclical bear begins," said Douglas Stewart, manager of the Sherwood Forest Alternative with $12 million in assets. "We are nearing the end of this cyclical bull rally (that began in early 2009) with a potential parabolic-type of melt up before entering the next cyclical bear market in the second quarter of 2013," Stewart said.

Stewart's top holdings includeProShares Short Russell 2000 ( RWM ),ProShares Short S&P 500 ( SH ) andiShares FTSE China 25 Index ( FXI ).

Sector Fund Performance

One of the worst performing sectors of the past year outpaced all sector funds. Precious metals funds rallied 10.18% amid expectations of more quantitative easing, a weakening dollar and seasonal demand. Jewelry makers tend to store supplies in late summer/early fall for increased demand during the Diwali holiday in India, India's wedding season and the year-end holidays in the West.

Technology funds climbed 4.42% asApple ( AAPL ) rallied 8.92% to become the world's most valuable company in history. Consumer services, 4.10%, were the third highest-gaining sector.

Utilities, down 1.33%, were the only sector to end the month in the red. Health care ticked up 2.13%.

Outperformance in sectors dependent on economic growth and underperformance in defensive sectors shows investors have a strong appetite for risk. Alec Young, global equity strategist at S&P Capital IQ, recommends overweighting consumer staples, energy and technology, while underweighting basic materials and utilities.

Consumer staples benefits from inelastic global demand and strong dividend growth. Energy trades at low valuations, while falling oil prices have prompted negative earnings revisions. Technology trades at low price-to-earnings growth rates and enjoys pent-up demand. Young is bearish on materials because slowing global growth will limit commodity prices. Utilities trade at high valuations with weak earnings prospects.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Mutual Funds

Referenced Stocks: AAPL , FXI , RWM , SH

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