Stock Market: Q2 Outlook For Mutual Fund Investing

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The stock market took mutual fund investors on a bumpy ride in the first quarter and more jostling is expected in the second quarter as the stock market enters its seasonally weakest six months of the year, between May and October.

Several mutual fund managers said they welcome the recent market pullback to work off high valuations in some sectors. But they expect stocks to press higher, driven by corporate earnings growth, low interest rates and the Federal Reserve's confidence in the economy in scaling back stimulus.

The stock market typically loses momentum in April, the last month of the market's "Best Six Months," according to "The Stock Trader's Almanac."

"In midterm-election years like 2014, there have been more declines during the (seasonally) 'Worst Months' than there have been gains and the average Dow Jones Industrial Average loss expands to 2.5%," Christopher Mistal wrote in "The Stock Trader's Almanac." He likens investing during the stock market's worst six months to going on a Gulf Coast or Caribbean vacation during hurricane season.

"Sure, you might find a great bargain and have a great trip, but it could just as easily turn out to be a real disaster," he wrote.

The average U.S. diversified stock mutual fund gained 1.33% in Q1, while world equity funds added 0.4%, according to Lipper Inc. The U.S. stock market , as measured by the S&P 500 index, skidded 4% in January and rallied back just as quickly in February and March to end the quarter ahead 1.3% at 1872.34.

Charlie Smith, manager of Fort Pitt Capital Total Return and founder of Fort Pitt Capital Group with $1.3 billion in assets under management in Pittsburgh, Pa., has set a price target for the S&P 500 at 1938, up 3.5% from its Q1 close. That's 17 times projected earnings for 2014 of $114 a share.

The consensus of analysts forecast S&P earnings to grow about 7%-8% year over year.

"If price-earnings multiples stay the same, we can expect the S&P 500 to perform in the range of 9%-10% for the year, including dividends," Shawn Blau, a portfolio manager at Westport Resources in Westport, Conn., said in an email. "Some positive factors we see include rising inflows of new investments into stock mutual funds, gradually improving housing data, steady declines in unemployment, easing credit conditions in the U.S., which tend to precede uptrends in the stock market, and rising activity in mergers and acquisitions."

Blau favors buying stocks in capital goods, diversified financials, semiconductors, software, technology, real estate, and utilities. He dislikes automakers, consumer services, consumer durables, pharmaceuticals, biotech, health care, retail, media and telecom.

Large-Cap Growth Trailed

Large-cap growth funds, down 0.02%, lagged all size and style funds while mid-cap value, up 3.23%, outpaced its peers.

Megacap stocks, valued at $40 billion or more, are trading at the cheapest valuations compared with small- and midcap stocks, which implies the market expects significant earnings and economic growth, says James Abate. He manages Centre American Select Equity and Centre Multi-Asset Real Return , with combined assets of $191 million.

"We're at the early/midcycle stage of the business cycle, not in the fifth year of recovery as we actually are," Abate said in an email. He believes megacaps will outperform smaller companies the rest of the year because earnings estimates are too high for most stocks, and as a result they will fail to meet expectations.

"Without a pickup in top-line revenue growth, we may have seen the peak in profit margins and returns on capital for this business cycle," Abate wrote. "As a result, 2014-2016 earnings estimates appear at risk."

Precious metals funds, up 12.21% in Q1, outperformed all sector equity funds as gold and silver regained their luster. Gold prices rebounded 6% to $1,284 an ounce in the first quarter after melting 28% last year. Silver prices lifted 2% to end Q1 at $19.75 an ounce after 36% slumping last year.

"Geopolitical concerns were the major catalyst for the rise this year," Tom Cahill, portfolio Strategist at Ventura Wealth Management in Ewing, N.J., with $200 million in assets under management, wrote in an email. "Gold is probably fairly valued around $1,200 an ounce, given the cost of production and the fact that the Fed is becoming less accommodative."

Precious metals funds remain the most battered sector in the past year, with a 31% loss. Outperformance in last year's most beaten-down areas of the market shows investors are rotating into value plays, while selling out of "frothy parts" such as biotechnology, social media and Internet stocks, said Russ Koesterich, chief investment strategist for BlackRock.

Mutual funds investing in real estate, up 9.03%, and utilities, 7.45%, benefited from interest rates unexpectedly falling in the first quarter despite the Federal Reserve's move to scale back its monthly bond purchasing program. The Fed's move was expected to lift interest rates.

General bond funds on average rose 2.7% in Q1 as the benchmark 10-year Treasury bond yield fell 27 basis points to 2.73% at quarter's end. Yields and prices move in opposite directions.

As the Federal Reserve reduces stimulus and raises interest rates as early as 2015 in response to the improving economy, real estate and utilities will continue to underperform the market as they did last year, said Jeff Vancavage, co-manager of Eagle Growth & Income in St. Petersburg, Fla.

His $584 million mutual fund has underweighted real estate relative to its benchmark and has no exposure to utilities. With the expectation that U.S. gross domestic product will expand 3% this year, Vancavage has overweighted his portfolio in industrials and technology names because they are "more levered to GDP growth."

Economy In Transition

"We're transitioning from stimulus-driven economy to a fundamentally driven economy," Vancavage said.

However, rising interest rates would significantly increase the U.S. government's borrowing costs and increase the budget deficit. At the same time, monetary stimulus will be necessary for the foreseeable future to make up for decreased productivity that coincides with an aging population across the developed markets, contends Abate of Centre Asset Management. His New York-based firm has $1 billion in client assets.

"This leaves the Federal Reserve trapped in keeping its short-term policy rate lower for a longer period, and monetary policy may contribute to an increase in market volatility, just when expectations are the exact opposite," Abate 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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