U.S. Funds Lose Early Q2 Gains During May And June Sell-Off

Posted 07 8 2008 3:33PM

Domestic stock funds endured a month of extreme highs and lows in June, which left most categories down for the month, quarter and first half of 2008.

Oil soared to a high past $143 a barrel. Financials plunged to new lows. Inflation rose. Interest rates stayed the same.

For the month, U.S. diversified stock funds fell 7.24%, according to Lipper Inc. It was the biggest one-month drop since September 2002. After a promising start in March, the June decline left stocks nearly where they began the second quarter, up a mere 0.13%. They're down 10.09% year to date.

Growth trumped value in all size categories in Q2 and the first half, thanks to less exposure to financials.

Large-cap growth eked out 1.62% in Q2. Large-cap value -- the worst-performing category -- fell 3.94% due to its heavy weighting in financials. They've lost 10.14% and 13.02%, respectively, year to date.

Midcap growth gained 4.99% in Q2. Midcap value was unchanged. They're down 8.53% and 9.36%, respectively, year to date.

Small-cap growth funds rose 3.56% in Q2, while small-cap value shed 1.75%. They're down 11.83% and 8.57%, respectively, year to date.

Asset managers' bullishness on large-cap growth stocks declined by 7 points to 57% between Q1 and Q2, according to Russell Investments' quarterly survey of investment managers. Bullishness on midcaps remained the same, at 49%. Bullishness on small caps increased from 36% in Q1 to 40% in Q2.

Too Optimistic

"Sentiment was too favorable for large caps," said Will Nasgovitz, manager of Heartland Select Value (NASDAQ:HRSVX - News), with $339 million in assets. "Once the dust is cleared, small and midcaps outperform large. Coming out of periods of economic weakness, this is the place to be."

Nasgovitz and co-manager David Fondrie expect continued market weakness and disappointing earnings reports this summer. But as contrarians, they believe it poses a good chance to buy bargains, especially in health care, home builders and housing-related companies.

"There's some $3.5 trillion in money market accounts and $13.7 trillion in stock market valuation," Fondrie said. "The outflow of funds from U.S. equities to international has slowed. If that money comes back to the U.S., we could be setting up for a very strong market in the latter part of the year."

Sam Dedio of Artio Global Investors, formerly Julius Baer, also expects more weakness as earnings season gets under way.

"Higher input costs are now starting to move from the balance sheet to the income statement," Dedio said. "Companies can raise prices in some instances, but competitive pressures and record margins we've seen for the last two years or so give way to gross margin compression."

Financials led the June sell-off, plunging 16%. The Dow tumbled 10.2%. The S&P 500 slid 8.6%. It was the worst one-month plunge for both since September 2002, when they fell 12.4% and 11%, respectively. The Nasdaq sank 9.1%.

In Q2, the Dow fell 7.4%. The S&P lost 3.2% and nearly touched its March low of 1256. Both indexes closed the first half of the year 20% below their October highs, signaling a bear market. The Nasdaq edged up 0.6% but sits 19% below its high. Year to date, the Dow was off 14.4%, the S&P 500 12.8% and the Nasdaq 13.5%.

Large-cap fund managers were unfazed by financials' weakness.

"Our investment process is driven by fundamentals, and our outlook is always long-term, which leads to very low turnover," said Adriana Posada, manager of American Beacon Large Cap Value (NASDAQ:AAGPX - News), with $8.5 billion in assets. She maintained the same sector weightings in the second quarter as in the first.

Cruising For The Bruised

Posada sees the best buying opportunities in the most-battered market sectors, financials and health care. That contrarian view has led American Beacon Large Cap Value to overweight financial services. It makes up 23% of fund assets. As a result, the fund has underperformed the S&P 500 by 5% in the past year. It has beaten it the last five and 10 years.

"There is further downside to financials as these institutions continue to write down bad loans," said Jason Votruba, manager of the UMB Scout Small Cap (NASDAQ:UMBHX - News), with almost $700 million in assets. "Consumers still face a number of head winds and have yet to fully adjust their spending to rising food and energy prices, increasing unemployment, continued deterioration in the housing market and increasing interest costs."

During Q2, Votruba underweighted his fund in financials and consumer discretionary and overweighted energy, industrials and technology. "We are in a secular global industrialization trend for the 3billion people outside the U.S.," said Votruba.

He does anticipate some profit-taking along the way. "We could see a correction in the leading issues, energy, steel and ag, entering the third quarter, but by the end of the year these groups should finish strong," Votruba said.

Bob Doll, vice chairman and director of BlackRock, sees reasons for bullishness.

"Many industries are still well below their first-quarter lows and appear oversold, and bearish sentiment is extremely high and is at the level that often coincides with market bottoms," Doll wrote in his weekly investment commentary.