Fund Outlook For 2nd Half: What Managers Are Buying

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The mattress proved the only refuge in June. All global markets, bonds and commodities sold off as the Federal Reserve signaled an end to economic life support.

And interest rates soared to two-year highs, threatening the housing recovery and corporate growth.

Overseas, the sun set on Japan, emerging market currencies plunged and a credit crunch roiled China. Investment strategists say the June swoon was long overdue and left undervalued and oversold markets that will eventually come back to normal.


The average U.S. mutual fund lost 1.13% in June, paring its second-quarter return to 2.29% and year to date 12.79%. The average foreign fund fell 3.73% in July, lost 2.18% in Q2 and left it with a 1.71% year-to- date gain. Domestic taxable bond funds lost 2.29% in July, 2.43% in Q2 and 1.17% year to date.

Yields on benchmark 10-year government bonds climbed 36 basis points in June to 2.52% -- the highest rate since August 2011.

The S&P 500 dipped 2.44% in June, while rising 2.9% in Q2 and 13.23% year to date.

A study of rolling 12-month periods going back to 1926 found that the stock market corrects 15% every 12 months and 30% every 36 months, according to independent investment advisory firm Gerstein Fisher, based in New York.

"Market corrections happen all the time," said Gregg Fisher, president of Gerstein Fisher, with more than $2 billion in assets under management, and manager of Gerstein-Fisher Multi-Factor Growth Equity and Gerstein-Fisher Multi-Factor International Growth Equity .

It seems the market has reason to sell off regardless of what the Fed does. Continuing QE would suggest "the economy and earnings are not getting better and you will see significant misses of optimistic second-half analyst estimates," Brian Frank, manager of Frank Value , with $18 million in assets, said in an email. "Should investors try to front-run a Fed tapering of bond buying, the ensuing price declines in the bond market could certainly scare equity investors."

Rising interest rates should help boost stock prices and the housing recovery because that would prompt potential buyers to buy before rates rise further, says Phil Orlando. He manages Federated Global Allocation Fund , with $400 million in assets, and is chief equity market strategist at Federated, with $380 billion in assets.

The resulting wealth effect from rising home values will spur consumer spending, thereby lifting corporate sales and earnings.

In addition, fixed-income investors will flock to stocks -- which Orlando believes are undervalued -- for fear of losing money from falling bond prices.

"The S&P 500 (at 1580) is trading at less than 15 times 2013 earnings and less than 14 times next year earnings," Orlando said. "In an environment in which the 10-year yield is 5% and core inflation is at 2%, we can expect stocks to trade at 18 times earnings."

Orlando has overweighted his portfolios in economically sensitive sectors such as financials and consumer discretionary. He's most bearish on Treasuries and defensive sectors such as utilities, telecom and health care, which he believes are overvalued.

Serena Perin Vinton, co-manager of Franklin Growth and a bottom-up stock picker, is most bullish on industrials and technology, in particular aerospace, cloud computing, search engines and software-as-a-service.

"The aerospace industry is in the midst of a multiyear growth phase, driven by technological advances that improve fuel efficiency and safety," Vinton, whose fund has $7.85 billion in assets, said in an email. "This is a wide-ranging, long-cycle theme that we expect will positively impact the industry's supply chain from megacap airplane manufacturers to the small-, mid-, and large-cap companies that produce their parts and materials."

Search engines draw advertising while expanding into mobile devices. And the advent of cloud computing or data virtualization -- combining many data sources into one -- alleviated companies from having to buy their own computers, networking equipment and servers. That's "disrupting established technologies," she added.

Foreign Funds

Latin America dragged down emerging market funds most. EM funds declined 6.45% in June, 7.33% in Q2 and 7.43% year to date.

Stock markets of the four largest emerging markets -- Brazil, Russia, India and China (the BRICs) -- have tumbled into bear markets or more than 20% from their recent highs.

Emerging markets sold off hardest since May 22 when Bernanke first hinted of tapering bond purchases because they benefited most from easy money policies in developed markets, says Alec Young, global equity strategist at S&P Capital IQ. Foreign investors borrowed in low-yielding currencies such as the greenback, yen and euro to buy higher-yielding emerging market stocks, bonds and currencies.

Fed Tapering Overhang

"The open-ended nature of the Fed tapering overhang will continue to limit rallies and fuel continued emerging market underperformance over the coming months," Young wrote in a June report. "After all, U.S. interest rates -- while up sharply from mid-May -- remain historically low, leaving plenty of room for additional rate increases to further undermine already fragile investor sentiment."

China, India, Indonesia, Mexico, Russia, Poland, Peru and Chile are expected to experience slower economic growth this year compared with last year, owing to falling earnings, high inflation, widening trade deficits and social unrest, Young adds.

Bank of America Merrill Lynch recommends buying the five most undervalued areas of the market: BRIC natural resource producers, developed market banks, the eurozone, Japan and China. These are trading 0.9 to 1.3 times book value, while everything else is trading at three times, BofAML investing strategists wrote in a report released June 27.

The BofAML Global Breadth Rule also shows that markets are oversold. It calls for investing when 88% of the markets in the MSCI All Country World Index are trading below their 50- and 200-day moving indicators. That indicator currently shows a reading of 89%.

"This argues for near-term contrarian trading rallies in China and BRIC resources, as these are among the most out-of-favor and inexpensive areas of the market," they wrote.



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

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