Stocks Point to Economic Rebound

08/11/2009 6:45 am EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, says if markets anticipate the economy, there’s good news ahead in the coming months.

[In July,] many indices enjoyed their best monthly gains in years: 8.9% for the Dow Jones Industrial Average, 7.6% for the Standard & Poor’s 500 index, 7.8% for the Nasdaq Composite index, and 9.6% for the Russell 2000. The broad market S & P 500 has surged nearly 50% from its March low and is now up 11% [this year], a decent annual return. But the broad market remains about 35% below its all-time high in 2007.

Upturns in the stock market typically lead the economy by about four months. If March marked the market’s bear market lows, we would expect the economy to turn up soon. Indeed, vital signs in the economy continue to improve, furthering the notion that the recovery has started. Sentiment is improving as most believe the worst of the economic downturn is over.

Markets tend to overreact on both the up side and the down side. The large amount of cash sitting on the sidelines and the relative attractiveness of stocks may be fueling the current rally. Cash reserves in money market funds are estimated to be as much as $3.5 trillion. Interest on cash in many countries remains virtually zero.

True to historical recovery patterns, small- and mid-cap funds outperformed large-cap funds in July. Value funds as a group outperformed growth funds last month, but if history is a guide, growth funds are likely to lead in the post-recession period.

Among sectors, materials, consumer discretionary, financials, and technology funds continued strong. Real estate funds led last month as share prices of real estate investment trusts (REITs} surged after hitting an 18-year low in March.

Foreign funds outpaced their US counterparts last month. Latin America and emerging markets, which tend to be economically sensitive, led. Diversified emerging market funds gained 11% on average, although Europe was not far behind.

It can be dangerous to make big allocation moves, particularly in volatile markets. Mutual fund money flows suggest that, once again, investor experience (i.e., selling out and buying back in) has been even worse than the horrible market experience this past year.

The peak outflows came in February and March during the worst weeks of the decline. Then, $136 billion flowed back into mutual funds in April, May, and June, according to Strategic Insight, a New York-based research group. That’s the biggest flow since the first quarter of 2007, and it occurred after the market had come off its low.

A recent study in the Journal of Banking and Finance by professors Geoffrey Friesen and Travis Sapp traced fund flows for individuals over a 14-year period. They concluded that investors lost an average of 1.56% annually due to poor timing decisions. That 1.56%, experienced by a great many investors over many years, adds up to a whole lot of money.

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