Risks Mutual Fund Investors Must Brace For In Q4

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The stock market  took mutual fund investors on a turbulent ride in the third quarter but in the end rewarded risk takers for hanging on.

Investors had best brace for more volatility in the final quarter of 2013 as the market confronts another Fed meeting, third-quarter corporate results and an Oct. 17 debt-ceiling deadline.

The average U.S. stock fund tracked by Lipper Inc. rose 4% in September and 7% in the third quarter -- a period rocked by fears over Fed tapering, war with Syria and political gridlock on Capitol Hill. But more worrisome were slower corporate earnings growth and a threat to the housing recovery from vaulting interest rates.

SPDR S&P 500 ( SPY ) added 3% and 5% over the same periods, booking gains for a third straight quarter.

S&P 500 companies are forecast to grow Q3 earnings a mere 4.6% year over year, the slowest pace in four quarters, according to Thomson Reuters. Earnings growth is expected to accelerate to 11% in Q4.

The benchmark index currently trades at a trailing price/earnings ratio of 16, about average compared with its historical P/E. But on a forward price-earnings basis, it trades at a slight discount of 15.

The average taxable bond fund rose 1.1% in Q3 as the benchmark 10-year Treasury yield sped nearly 100 basis points from a historic low of 1.66% in May and nearly breached 3% in September before settling at 2.64% at month's end.

Interest rates will continue to tick higher over the next few years but that's a healthy development for the economy and the stock market, says Mike Levine, manager of Oppenheimer Equity Income with $5 billion in assets.

It will signal stronger economic growth and rising employment rates, thereby leading to earnings growth, Levine said. He expects the Fed to start tapering its stimulus program within the next six months. "Delaying it will just cause more pain down the road or more dislocation," he said.

During the summer sell-offs, he added to his stakes in homebuilders, noting that the country is still in the early stages of a housing recovery. Levine also added to positions in real estate investment trusts, commercial mortgage REITs and consumer discretionary stocks, which he believes sold off indiscriminately on fears of rising rates.

"Interest rates and mortgages are still at historically attractive levels, and combined with a gradually improving employment picture, housing can continue to do well going forward even if rates rise from here," Levine said. "The government is going to do everything they can to get the housing market back on its feet."

Buying REITs

Morningstar data show during July and August Oppenheimer Equity Income boughtWeyerhaeuser ( WY ), a REIT that produces lumber, andAmerican Homes 4 Rent ( AMH ), a REIT that buys and rents houses. It added toDigital Realty Trust ( DLR ), a REIT that specializes in tech-related real estate, and homebuildersStandard Pacific ( SPF ) andBeazer Homes (BZH).

Oppenheimer Equity Income returned nearly 4% in Q3 and 20% year to date, on par with the S&P 500. Rising interest rates, which go hand in hand with falling bond prices, are expected to increase demand for stocks as investors shun bonds in search of yield income in dividend-paying stocks.

"The spell under which the bond market has kept investors, large and small, for some years now has been broken, and it is likely that there will be continued, if uneven, reallocation of portfolios into equities," John Carey, portfolio manager at Pioneer Investments with $220 billion in assets under management in Boston, said in an email. "Demand for equities is likely to support share prices for the next several years."

He's most intrigued now by this year's underperforming sectors: technology, basic materials, utilities and energy. "Many of the large tech companies are selling at almost deep-value levels, deservedly or undeservedly," Carey wrote.

Carey's mutual fund, Pioneer , with $5 billion in assets, returned 6% in Q3 and 21% year to date. The low-turnover fund bought only two stocks this year: search-engine blue chipYahoo (YHOO) and Ireland-based drugmakerMallinckrodt (MNK), according to Morningstar.

Precious Metals Funds Tarnish

Precious metals were the only sector funds to lose value in September, falling 9%, despite a weakening dollar, which usually moves opposite gold. That pared their third-quarter return to 10%.

The price of gold jumped 19% off of a three-year low at $1,192 an ounce in late June to a three-month high of $1,419 an ounce in late August. It fell back into a downtrend for most of September. It spiked 4% Sept. 18 after Fed Chairman Ben Bernanke announced holding on to the central bank's current bond-buying spree because inflation and unemployment haven't reached Fed targets.

That turned out to be just a countertrend rally, because gold resumed its downtrend right after, ending the month at $1,327.

Bank of America Merrill Lynch set its year-end gold price target at $1,200 an ounce. "Even a dovish Fed will ultimately tighten monetary policy, and higher opportunity costs means head winds to gold prevail," BofA Merrill's strategists wrote in metals report Sept. 19.

"The business cycle puts gold in an uncomfortable position. Higher growth, rising nominal yields and subdued inflationary pressure have all limited investor buying," they added.

Gold loses appeal when interest rates rise because investors opt for yield income in bonds whereas gold pays nothings. Gold would likely rally in the unlikely event that lawmakers fail to raise the debt ceiling, says Russ Koesterich, chief investment strategist for BlackRock.



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: AMH , DLR , SPF , SPY , WY

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