Stock Strategy: What Will Mutual Funds Do In 2013?

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2013: A Look Back And Ahead

Mutual funds invested at home and abroad enjoyed a banner year in 2012 despite constant worries.

Topping the worry list were slower global economic growth, developed markets' sky-high government debts and unemployment rates, Japan and the eurozone falling back into recession, the year-end U.S. fiscal cliff debate and turmoil in the Middle East.

If Wall Street forecasters are correct, investors can expect high single-digit returns in 2013. Investment strategists at major investment houses expect the S&P 500 to return about 8% in 2013, citing studies of previous bull markets, low interest rates and consumer and corporate spending trends.

Most mutual fund categories across the board scored handsome double-digit gains. The only ones to lose money were those betting on bear-market strategies and commodity producers -- mainly precious metals and energy.

The average domestic stock mutual fund returned 13.87% vs. 17.69% for the average world stock funds, according to Lipper Inc. European and Pacific Region funds outpaced all world markets, returning 22.24% each.

"You don't need macro growth to generate good returns," said Stephen Goddard, founder of Richmond, Va.-based The London Company with $4.5 billion in assets under management and subadviser of Touchstone Mid Cap .

He believes the Federal Reserve juiced the market most in 2012 as rock-bottom interest rates allowed companies to borrow money cheaply to make acquisitions or buy back shares, which boosts earnings per share. But overall because of political uncertainties, companies hoarded cash instead of hiring more people or expanding capacity.

"A vast majority of companies have no debt and have more free cash flow than ever," said Goddard. "And they're trading at 30% to 40% below their private market value. The gap gets closed through buybacks and mergers. If valuations stay where they are, you will see more merger activity."

S&P 500 cash and marketable securities balances in the third quarter rose 5.8% year over year and 4.1% from Q2 to a record of $1.23 trillion, according to FactSet. Cash inflows from debt issuance rose a ninth quarter straight to $32 billion in the third quarter. But dividend payouts and stock repurchases dropped 17.5% year over year and 4% over the second quarter.

FactSet notes the "declines were primarily due to volatile share repurchase activity in prior periods."

Goddard's fund returned 19.5% in 2012. It gained an average annual 14.38% the past three years and 0.24% the past five years. The S&P 500 averaged 10.87% and 1.66% over the same periods.

Retailers and capital goods producers, or consumer discretionary, offer attractive values while consumer staples, trading double-digit earnings multiples, are overvalued, he said.

Goddard recommends avoiding real estate investment trusts, or REITs, and master limited partnerships because valuations are getting lofty. "Investors have bid them up because they want yield," he said.

The S&P 500 returned nearly 16% including dividends in 2012. It is trading at about 14 times earnings, a valuation that's typically seen when the benchmark 10-year Treasury note yield is about 6%. With the rate at 2%, the S&P should be trading at 20 times earnings at least, Goddard contends.

BofA Merrill Lynch Global Research projects the S&P 500 will rise to 1600 by year's end, up 12% from its 2012 close at 1426, and surpassing its prior high of 1576 from October 2007.

The price gains will come from S&P companies growing earnings by 7% to $110 a share, following 5% EPS growth in 2012.

The S&P is still relatively undervalued, trading at discount to its average price-to-earnings ratio of 16. Although S&P earnings soared to new highs in 2011, the S&P failed to do so, suggesting it should eventually catch up.

JPMorgan's investment strategists also see 12% upside in the S&P for similar reasons. Also helping will be political clarity out of Washington and Europe, and acceleration in durable goods spending. Earnings are seen rising to $117 a share by 2014.

Capital goods spending, now at 21% of U.S. gross domestic product, is at its lowest level since World War II, suggesting it has plenty of room to expand before getting to lofty levels. Corporate capital spending as a percentage of sales, currently 6.2%, is at the low end of its 16-year range of 5.1% to 8.1%.

The wealth effect from rising home values has lifted consumer confidence but overall debt levels remain high, while wages and incomes are barely growing in the face of relatively high unemployment, according to Baird.

Returns each of the four years of the current bull market followed the script of previous bull markets. If this pattern continues in 2013, the S&P should rise only about 8%, its historical average in the fifth year of bull markets, according to Randy Frederick, managing director of active trading and derivatives at Charles Schwab.

"The first year of a presidential term has been positive only eight of the last 15 times with an average return of 4.7%," Frederick wrote in a report. "Should (2013) follow this presidential pattern and the fifth-year cycle pattern, a return of somewhere between 5% and 8% seems likely for 2013."

Retail Investors Miss Out

Fund flow data shows investors favored the safety of bonds, despite record low interest rates, and shunned equities even though U.S. and foreign stock markets posted double-digit gains. Inflow into fixed-income mutual funds and ETFs shot up 115% in 2012 to $364 billion, according to TrimTabs Investment Research estimates. That's while equity funds saw outflow of $20 billion, following $68 billion in outflows in 2011.

Investors are rushing for safety although real Treasury yields are negative when adjusted for inflation.

"Unless Treasuries are held to maturity, their being 'risk-free' is a myth," Baird's strategist wrote in the firm's 2013 Economic & Stock Market Outlook. "A 10-year Treasury note purchased in 2012 could see a significant decline in principal value five years from now even if interest rates rise only modestly."

Fears of tax-loss selling appear overblown considering that investors funneled $7 billion into equity funds in December after pulling out $7 billion in November, said David Santschi, executive vice president at TrimTabs.

BofA Merrill's research found that higher dividend tax rates don't affect stock performance as much as earnings growth. High-dividend payers actually performed worse after the dividend tax rate was dropped to 15% following the Jobs and Growth Tax Relief Reconciliation Act of 2003. Perhaps it's because more than half of mutual fund assets are invested in tax-deferred or exempt accounts.

Sector Fund Performance

Funds investing in international real estate climbed a whopping 40.75%, outpacing all sector funds. Funds investing in precious metals and energy commodities lagged most, losing 9.36% and 7.56%, respectively.

BofA Merrill recommends overweighting the most economically sensitive, or cyclical, sectors heavy with foreign sales such as technology, energy and industrials. It advises underweighting overvalued, U.S.-focused sectors, utilities and telecom, on the expectation that overseas economic growth will top that of the U.S.

"S&P 500 stocks most correlated with U.S. GDP growth are currently trading at a discount to the benchmark, when they typically trade at a about a 5% premium," BofA Merrill equity and quant strategist Savita Subramanian and her colleagues wrote in a 2013 strategy report. "S&P 500 stocks with the highest foreign sales exposure could outperform in 2013 amid the improvement in global growth."

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

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

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Mutual Funds