This bear market has defeated professional stockpickers of all persuasions. So far this year, the Dow Jones industrial average has lost 20.3%, and the Standard & Poor's 500-stock index has shed 26.4%. Fund managers haven't done much better: The average U.S. diversified-equity fund has lost 25% this year, more than half of it in the three months through Sept. 20. Some sector funds, including technology, utility, and financial services, fared worse in the third quarter, falling between 15% and 22%, making for 28% to 48% losses so far this year. Foreign stocks were no refuge: Funds investing in them lost 17.6% in the past three months. "Everyone who has been trying to catch the bottom of this market has been smoked," says John Lekas, president of Leader Capital, an investment firm in Portland, Ore.
Lekas, whose high-minimum Technical Portfolio Management fund is up 16%, is one of an elite group of equity-fund managers to make money this year. Once a close watcher of balance sheets, he now either takes short positions in stocks based on technical indicators--such as 200-day moving averages of prices or ratios of sell orders to buy orders--or he's fully in cash. Lekas embraced this investing religion two years ago, after losing faith in Corporate America--and 30% of his clients' money. The trigger: One of his favorites, Corning, cut its 2000 earnings-per-share forecast five times, to 20 cents from $2.20. "You need to know when to say you're not going down with the ship," he says. "Those are damned hard decisions to make because you're already looking at red ink."
Conservative strategies will likely continue to perform best, so investors should keep their expectations in check, say money managers. Despite low interest rates and low inflation, many big-picture strategists don't foresee a recovery until late next year. Even then, they say, it will be unspectacular. The main culprit: weak profits. Earnings growth, notes Merrill Lynch chief strategist Richard Bernstein, is the least predictable it has been in more than 60 years. Add the fear of war with Iraq and uncertainty about consumer spending, and the outlook through early 2003 is grim indeed.
It's a climate in which bear funds and those using hedge-fund techniques flourish. The handful of market-neutral funds that use such hedging strategies as short-selling, options, and arbitrage have made money. Recovery skeptics Martin Weiner and Charles Minter of Comstock Partners, a unit of Gabelli Asset Management, have an enviable record: Comstock Partners Capital Value Fund is up 44% so far this year, vs. a 23% fall for its peer group, according to fund tracker Morningstar. Most of its money is in short positions on individual stocks and S&P futures, with the rest in U.S. Treasury bonds and euros. "We're definitely not perma-bears," says Weiner. "I can assure you we will turn bullish as soon as the conditions are warranted."
The bearish mood bodes well for gold. Funds that invest in precious metals seem poised to beat the market and general equity-fund managers for the third year in a row. Industry fundamentals have improved greatly: Mining companies are controlling costs, and the dwindling supply of gold is boosting prices. Fear of war and rising oil prices are helping, too. "It's a safe haven," says Frank Holmes, CEO of U.S. Global Investors. "It shines when everything else falls apart." Holmes runs two of the best performers out of more than 8,000 equity funds of all types. U.S. Global Gold Shares is up 70.3%, and U.S. Global World Precious Metals has gained 68.7%, year to date. Holmes thinks some gold shares, such as Placer Dome and Goldcorp, could double by next year, especially if gold hits his estimate of $375 an ounce, up from $325 now.
Although most of this year's winning funds use exotic strategies, those following tried-and-true techniques--such as nitty-gritty company analysis--have at least limited their losses. The $500 million FPA Capital Fund, run by Los Angeles-based First Pacific Advisors, with $4 billion under management, is down 9.7% for 2002, but its mid-cap value peers have fallen 17.4%. Lead manager Robert Rodriguez, a long-term investor, bought one of his largest holdings, Thor Industries, which makes and sells recreational vehicles, in 1995 for an average of about 12; the stock hit an all-time high of 37 on Sept. 16. Many of his largest positions, such as Ross Stores, based in Newark, Calif., and specialty retailer Michaels Stores, have been in the fund since the mid-1990s. They are up about 50% and 150% respectively in the past 12 months. Still, Rodriguez is circumspect about such returns. "Any investor who is looking for the fastest, latest, greatest stock in the market is doomed to fail," he warns.
Indeed, their own optimism is the biggest obstacle many managers face. Collectively, a meager 5% of their assets are in cash--half the level in other bear markets since World War II. Why? Fear they'll miss the next upturn. But those with heavy cash holdings have trounced their peers. Longleaf Partners Fund, which has beaten the S&P since its start in 1987, has held as much as 18% cash. Its managers couldn't find stocks that meet their strict price criterion: a 40% or more discount to their estimates of value. Third Avenue Small-Cap Value and Clipper Fund have both had big cash stakes at some point this year and have both beaten the market so far this year.
Excessive optimism is still the tech sector's biggest problem as well. Despite the 76% fall in the NASDAQ Composite Index since its March, 2000, peak, the tech bear market still has legs, say observers. As of Aug. 1, the 16 tech stocks (excluding Yahoo!) that make up a third of the NASDAQ's market cap had an estimated price-earnings ratio of 39, says Fred Hickey, editor of the newsletter High-Tech Strategist. In contrast, in the 1990 bear market, the top third of the NASDAQ had an average p-e of 16.6. Worse, forward earnings estimates don't take into account the cost of options. "That means they are at least three times overvalued on bear-market lows," says Hickey. "And 1990 was a minor bear market."
It's no surprise, then, that the average tech fund is down 50% this year. Both T. Rowe Price Media/Telecomm Fund and its Global Technology Fund have lost 36.3% and 37.9%, respectively--yet they rank in the top 10% of the category. Portfolio manager Robert Gensler's strategy for the two funds is to lean toward industry blue chips--Cisco Systems (CSCO
), Microsoft (MSFT
), and AT&T (T
). "It's a Darwinian market: Only the strongest and largest will survive," he says. "If you manage for a very muted recovery over the next two years, you'll have a chance to make some decent returns."
While bond funds have outpaced stock funds for two years, the gap is narrowing. With government-bond yields at their lowest in 40 years, the question is, how long can the outperformance last? Some managers say investors should tip their portfolios away from Treasuries and emerging-market bonds toward corporate bonds to grab better returns--next year. Joseph Portera, who manages MainStay Global High Yield fund, has had a big stake in emerging markets, such as Mexico, Russia, and Brazil. His fund is up 1.3% so far this year, but he's getting more bullish on U.S. corporate bonds, including high-yield issues from Qwest Communications (Q
) and AOL Time Warner (AOL
). Portera says today's market reminds him of the early 1990s, when corporates yielded 10 percentage points more than Treasuries, a war loomed, and a recession persisted. "It's actually never been cheaper," he says. "The corporate-bond market has been beaten up so badly that people really should start looking."
Still, neither bond nor equity funds are likely to see any sun for a while. Investors' best bet: Hunker down and wait for a break in the clouds. By Mara Der Hovanesian