Fund investors last month were spared from the seasonal weakness in the stock market known as "sell in May and go away."
The market shrugged off news that U.S. gross domestic product shrank 1% in the first quarter. The S&P 500 added 2% for the month and 4% year to date as it eclipsed the psychologically significant round milestone of 1900. Stocks were more appealing, given a persistent slide in interest rates. Yields on benchmark 10-year Treasuries fell 21 basis points from 2.67% to 2.46% at month's end. They've fallen 54 basis points since Jan. 1.
"Everyone was bearish on rates," said Ari Sass, a portfolio manager at MD Sass in New York City, with $6 billion in assets. "Usually when everyone is thinking one thing, usually the opposite happens."
The average U.S. diversified stock mutual fund returned 1.69% in May and 1.87% year to date, according to Lipper Inc. World equity funds did better, rising 2.22% and 3.03% in the same periods. With inflation at 2%, investors have better opportunities for growth in dividend-paying stocks than Treasuries as dividends tend to increase with earnings, says an email from Timothy Malloy, vice president at Birch Hill Investment Advisors in Boston, with $1.2 billion in assets under management.
But earnings growth has been driven more by "financial engineering" rather than demand, as companies are buying back shares at record levels, making acquisitions and using aggressive tax strategies, says Charlie Smith, chief investment officer at Fort Pitt Capital Group in Pittsburgh, which oversees $1.3 billion in assets.
"We remain cautious due to the amount of artifice in the system, whether as a result of ongoing Federal Reserve interest-rate suppression or the aforementioned financial engineering," Smith wrote in an email. "The economic weakness seen in Q1 2014 will linger for much of the year, meaning revenue growth will continue to be difficult to come by."
The S&P 500 ended the month at 1923.50, just a hair below Smith's fair value estimate at 1938, which represents a price-earnings ratio of 17 on $114 a share in earnings estimated for 2014.
Most economists expect the economy to improve in the second quarter, but that factor may already be priced into stocks, says Damon Barglow, co-manager of Bright Rock Quality Large Cap and Bright Rock Mid Cap Growth , with $206 million in assets combined.
"Investors appear to be getting more aggressive on equities just as valuations are getting richer," Barglow said in an email. "Equity price inflation driven by demand in the absence of improving fundamentals is not sustainable."
Volume fell deep below average, which means the uptrend may be growing tired. But the VIX volatility index -- the so-called "fear gauge" -- fell to a seven-year low, suggesting that investors are not anticipating a correction by hedging their positions.
"They bought tons of put protection last year, and the market has done nothing but go up, so investors are protection-fatigued and are now underhedged," Miranda Davis, portfolio manager of BPV Core Diversification , with $47.9 million in assets in Knoxville, Tenn., said in an email. "When this happens, it tends to exacerbate small downward market movements, which is a concern."
Gold Resumes Meltdown
All major sector funds enjoyed gains except for precious-metals funds. They fell 6.26% in May, cutting their year-to-date return to 7.85%. Precious metals and miners resumed their multiyear meltdown after a short countertrend rally at the beginning of the year. Gold bullion prices, as tracked bySPDR Gold Trust ( GLD ), fell 3% in May, clipping its year-to-date gain to 3.71%. The U.S. dollar -- which tends to move opposite gold -- appreciated nearly 1% against a basket of widely traded foreign currencies tracked by PowerShares DB U.S.Dollar Index Bullish ( UUP ). It is unchanged year to date.
Gold is melting down under the threat of global deflation because the yellow metal is a hedge against inflation, says Davis. Gold has become undervalued compared with stocks, which are "no longer cheap," says Adrian Day, manager of EuroPac Gold , with $33 million in assets under management.
"The Fed's tapering is not as bad as feared, and the possibility of higher rates is viewed as being far off," Day said in an email. "China's gold demand continues to be robust as the possibility of a withdrawal of Indian restrictions comes to the fore and the Ukraine situation is clearly not over. So gold is set to move higher now."
The markets will increasingly expect a recession, which in turn will weaken the dollar and strengthen gold, says John Williams, founder of Shadow Government Statistics. He expects second-quarter GDP to contract as it did in first quarter.
"Intensifying weakness in the U.S. dollar will place upside pressure on oil prices and other commodities, boosting inflation and inflation fears," Williams wrote in a commentary May 29. "Resulting higher inflation should boost the prices of gold and silver, the primary hedge against the pending inflation and financial crises."
New Hope For India
India funds led all global markets as investors bet on new Indian Prime Minister Narendra Modi, who leads the business-friendly Bharatiya Janata Party, to turn around the economy.
"NaMo has become the economic hope for this country," Peter Kohli, CEO of DMS Funds, with $2 million in assets under management in Newton, Ma., wrote in a client note. "He has halted India from continuing down the path of socialism, and within eight days of his election has managed to turn it towards capitalism and prosperity."
India funds rose 12.48% in May, lifting their year-to-date gain to 23.58. Other gains in May by funds focused on regions included Japan 3.87%, emerging markets 3.52%, China 3.36%, Latin America 0.98% and Europe 0.71%.
Wasif Latif, head of global multi-assets at San Antonio, Texas-based USAA Investments, with more than $62 billion in assets, has overweighted foreign developed and emerging markets because of their lower valuations.
Emerging markets, as tracked by iSharesMSCI Emerging Markets ( EEM ), trades at 10.8 times forward earnings, 1.3 times book value and 0.94 times sales, according to Morningstar. Developed foreign markets, measured by iSharesMSCI EAFE ( EFA ), have a P/E ratio of 14.7, P/B of 1.5 and P/S of 0.94. The SPDR S&P 500 ( SPY ) trades nearly 17 times earnings, 2.3 times book and 1.6 times sales.