Mutual Funds: 3 Corners Of Stock Market Led July Dip


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Mutual fund investors may cringe when they open their July statements, especially if they were invested in the hardest-hit corners of the global market: small-caps, utilities and Europe.

High valuations, worries over the Federal Reserve raising interest rates sooner than expected, Argentina's default and war throughout the Middle East gave investors reasons as good as any to book profits after the market hit new highs. Mutual fund managers are positioning their portfolios defensively but recommend that investors buy during the dip, owing to strong earnings and sales growth.

"The plan is to wait for a correction, which may in fact be happening now," said Phil Orlando, chief equity strategist at Federated Investors. "The market will do fine into the end of the year, so we'll look for an opportunity to put more money into stocks later in the summer, early in the fall."

SPDR S&P 500 ( SPY ) snapped a five-month winning streak, slipping 1.3% in July. Small-cap growth funds dropped 5.79%, putting their year-to-date return in the hole by 5.37%, according to Lipper.

Large-cap growth outperformed all size and style categories by giving back the least, 1.27%. It pared its year-to-date return to 2.98%.

Small-caps likely sold off the most because they were most overvalued and remain so by some measures.

While SPY trades at 17 times earnings, the iShares Russell 2000 Index Fund ( IWM ), a benchmark for small-cap stocks, trades at nearly 21 times forward earnings, a level "consistent with sub-par forward returns," say Credit Suisse analysts Lori Calvasina and Sara Mahaffy.

They believe that large-cap outperformance over small caps will likely persist for the rest of the year because of the Fed's reducing its economic stimulus, known as quantitative easing, and the mergers and acquisitions favoring large caps in recent quarters.

"Small- and midcaps also lost their leadership vs. large as Operation Twist and QE2 came to an end," they wrote in a report released July 31. In Operation Twist, the Fed buys and sells short-term and long-term bonds. QE2 is the Fed's second round of quantitative easing. "Flows to small-cap funds have turned negative in 2014, reversing strong inflows seen in 2013, a strong underpinning of last year's rally."

Q2 Corporate Results

With three-fourths of S&P 500 companies having reported second-quarter results, corporate earnings are up an average 7.5% and sales 4.1%, according to FactSet. Nearly three in four firms eclipsed Wall Street earnings estimates; nearly seven in 10 beat sales forecasts.

"For Q3 2014 and Q4 2014, analysts are predicting earnings growth rates of 7.8% and 10.2%," FactSet wrote in a report Aug. 1. "For all of 2014, the projected earnings growth rate is 7.8%." Q3 and Q4 sales are expected to be nearly 4% with full-year revenue growth forecasts of 3.7%.

The telecom sector, down 0.88% in July, reported the largest earnings growth of the 10 S&P sectors at nearly 20%. Financials, down 2.71% in July, was the only sector to see a year-on-year slide in earnings at 0.1%. It will be the second quarter in a row of earnings declines.

As July's worst-performing sector, utility funds burned off 5.44%, cutting their year-to-date return to 9.89%. Consumer spending on utilities fell after the first quarter's spike in heating demand sparked by exceptionally cold weather across the U.S., according to IHS.

Natural resource funds lost 5.1% as commodities suffered their biggest sell-off since May 2012. Unleaded gasoline prices evaporated 8.1% in July as prices dipped four weeks in a row. U.S. refineries are producing at their highest rates since 2005, says the Energy Information Administration. Long-anticipated buildouts to refinery capacity in the Gulf Coast are also materializing. What's more, slower-than-expected economic growth in emerging markets has led to weaker demand than forecast.

Agricultural commodity funds fell 4.66% as ag prices hit their lowest level since July 2010, according to S&P Dow Jones Indices. Farmers have ideal weather conditions to thank for their record yields this summer, says Brian Hicks, a portfolio manager at U.S. Global Investors in San Antonio, Texas.

Federated's Orlando -- who oversees its Global Allocation Class A Fund , Managed Risk Class A Fund and Managed Tail Risk Fund II -- expects a midsummer correction and has positioned his portfolios defensively. He is heavy on health care, consumer staples, real estate investment trusts, utilities and telecom, and light on economically sensitive sectors such as technology, industrials, financials and consumer discretionary.

He recommends investors have a small allocation to hard assets such as energy and precious-metals stocks as a hedge against geopolitical risk in Israel, Iran, Iraq and Syria, "any one of which could be a tinderbox that results in significant problems," Orlando said. "There's no way of knowing that a company or an industry is going to be able to exist or function based on something that may happen. But if you've got oil or gold in hand, those are hard assets against something bad happening in the world."

Sanctions Hit Europe

European stock funds lagged all global markets in July, losing 4.32% on fears that new economic sanctions against Russia may ripple through the continent.

"When you are in a fragile recovery at the margin, anything that hurts your sales when the recovery is very slow is not going to be insignificant," said Bob Baur, chief global economist at Principal Global Investors, in Des Moines, Iowa. "Depending on what some countries import, if those costs rise because of retaliation, there could be some economic consequences."

The sanctions ban sales of arms, technology and energy-related equipment, and cut off financing to five major state-owned Russian banks. Russia's stock market plunged 11% in July and 16% year to date, according MSCI.

China funds, which were already lagging, bucked the global sell-off, rallying 4.24% in July, pushing their year-to-date rise to 3.12%.

The Hong Kong stock market rallied to multiyear highs as the government boosted spending on infrastructure, cut some taxes and reduced bank reserve requirements to spur lending, Peter Kohli, CEO of 2-year-old DMS Funds with $2 million in assets under management in Newton, Ma., said in an email.

"These measures have succeeded in helping boost the economy in the short term. They have also resulted in an increase in corporate debt," Kohli wrote. "But this is only temporary as the underlying problems of a soft real estate market and the shadow banking system have yet to be adequately addressed."

A professor at Peking University says that China could be overstating its gross domestic product tally by $1 trillion a year, so China's data don't add up.

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

This article appears in: Investing , Mutual Funds
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