U.S. Mutual Funds Up 3.39% in Oct.; Pullback Overdue?

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Mutual fund investors booked solid returns in October as the stock market scaled to new heights despite a 16-day government shutdown that threatened economic productivity. If history repeats this year, investors can relax in November, which kicks off the S&P 500 and Dow's best six months of the year historically.

The average U.S. diversified stock mutual fund rose 3.39% in October and 25.46% year to date. Large caps took the lead over small caps in the short run, but the latter remain in the lead for the year. Large-cap growth funds climbed 4.22% in October and 26.08% year to date, while small-cap value funds returned 3.26% and 28.76 over the same periods.

The S&P 500 jumped 4.5% in October and a juicy 25.2% year to date. The Nasdaq rose 3.9% in October, boosting year-to-date gains to a plump 31.1%. The Dow industrials added 2.8% for the month and 21.0% for the year.

The stock market has overheated and is due for at least a 3% to 5% pullback, says Mark Arbeter, chief technical strategist at S&P Capital IQ. The market's 15-day rate of change topped 7% as of Oct. 29 -- the fastest since January 2012.

"Over the past couple of years, whenever the 15-day rate of change has reached 5% or above, the market has either paused, pulled back or corrected," Arbeter wrote in his weekly technical report Friday. "I have to remind myself that markets never move in one direction forever, and to never ignore historical price action."

In addition, the Chicago Board Options Exchange put-to-call ratio, along with market sentiment surveys from Investors Intelligence and the National Association of Active Investment Managers, show overwhelming bullishness and very little bearishness. As contrarian indicators, they suggest the market will go against the crowd.

Record Earnings Season

With a little more than seven in 10 S&P 500 companies having reported third-quarter results, earnings have grown 4.2% year over year. Consumer discretionary companies grew profits most, up 10%, while the energy sector was the only one to see earnings drop, by 8%.

The index is on track to grow earnings 5.8% year over year for 2013. Nearly seven in 10 companies have eclipsed forecasts -- slightly better than the long-term average of 63%, according to Thomson Reuters.

But earnings beats may not carry much significance considering analysts have lowered expectations en masse.

About two in 10 companies have made negative pre-announcements. About half of the companies topped revenue estimates, which is much lower than the long-term average of 61%. Sales have increased 3.7% year over year, with eight of the 10 S&P sectors expecting growth.

The financials sector are dragging down sales growth as banks struggle to grow revenue in a low-interest-rate environment, Mark Litzerman, manager of proprietary equity strategies and research at Wells Fargo, wrote in a client note. At the same time, energy sector revenue fell because global demand has stagnated, while increased U.S. output has boosted supply.

Sector Fund Performance

Consumer goods funds rose 4.43% in October and 22.52% year to date.

Consumer staple companies are "recession-resistant and have lower volatility in earnings," said Paul Karos, a portfolio manager for Whitebox Mutual Funds, a Minneapolis-based alternative investment firm with $2.5 billion in assets under management. "It's much better to have cyclical industries leading the charge in a market run-up because it signals economic confidence."

This suggests institutional investors are favoring defensive sectors given the economic weakness, which was confirmed by the fact that the Federal Reserve announced it will continue to be "highly accommodative" in its monetary policies and it will scale back quantitative easing in 2014 at the earliest.

"Regardless of consistently overly optimistic forecasts by the Fed, the data paint a much more dismal, glass-half-empty view of the economy," Lindsey Piegza, managing director and chief economist at Sterne Agee, wrote in a commentary. "If you like a growing Fed balance sheet and continued accommodation for the foreseeable future, you are in luck."

JPMorgan's equity strategists say the Fed stance has mutual fund managers buying defensive stocks to protect gains, while hedge fund managers are doing the opposite and buying cyclicals.

"We believe this is likely the result of a need to improve relative performance (the HFRI Index was up 5.2% vs. 19.8% for the S&P 500 total return index through Sept. 30)," they wrote. "Consequently, we believe hedge funds will continue to add to cyclicals into year-end.

"Hedge fund buying will lift index levels, triggering mutual funds/long-only to move back towards a higher-beta position (reversing what we believe is a move towards more defensive stocks)," JPMorgan strategists added.

"Of course, we continue to see other supporting arguments as well, including: 1) improved economic visibility and 2) relative value, in addition to the risk of performance slippage."

They recommended overweighting such stocks asPeabody Energy ( BTU ),Whiting Petroleum ( WLL ),CA Technologies ( CA ),Schlumberger ( SLB ),EOG Resources ( EOG ),Delta Air Line s (DAL) andUDR (UDR).

The worst-performing major sector, precious metals funds, slipped 0.33%, leaving the year-to-date decline at 40.98%.

Gold bullion prices were nearly flat for the month, ending at $1,324 an ounce. The yellow metal failed to rally even after the Federal Reserve announced it's maintaining its easy money policies, defying widespread expectations that it would scale back bond purchases.

"The gold market perhaps is focusing on the eventual reduction in stimulus, rather than the immediate continuation of it," Adrian Day, founder of Adrian Day Asset Management in Annapolis, Md., with $125 million in client assets and manager of EuroPac Gold , said in an email.

"The Fed saying (again), 'we won't reduce bond buying (because the economy is not strong enough) but we will eventually' is a very gold-bullish statement to me. But the gold market focused only on those last few words."



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: BTU , CA , EOG , SLB , WLL

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