The Market's Leadership Changes

12/09/2009 11:48 am EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, says different stock groups are leading the market now than in the months after the March lows.

The nearly nine-month rally in the stock market continued in November with the Dow Jones Industrial Average jumping 6.5%, its best monthly gain since July. The broad market Standard & Poor’s 500 index tacked on 6% and is now up 58% from a 12-year low in March. The small-cap Russell 2000 rose 3.1% last month, while the tech-oriented Nasdaq Composite index gained 4.9%.

Economic reports remain mixed, but point to a strength­ening trend. Recent reports show signs of stability in three cornerstones of the economy: housing, manufacturing, and construction. Some are concerned that a large part of the growth we’ve had was driven by government spending. In addition to low benchmark rates, the Federal Reserve has been buying as much as $1.2 trillion in mortgage-backed securities to keep rates from rising.

True to previous patterns, stocks bottomed before the economy and earnings growth. But the volatility has been extraordinarily high and [has] taken a toll. Smart investors stay put and maintain a long-term focus, especially because stock investors typically earn higher investment returns after periods of sharp losses. A bull market typically produces its greatest gains at its beginning.

Different funds tend to thrive in dif­ferent periods of a bull market. In the early stages, the top performers tend to be riskier funds—those funds holding com­panies that are most vulnerable to an eco­nomic downturn. Stocks that lost the most tend to regain ground first when the market turns around. True to form, small-cap funds led large-cap funds off the most recent bottom.

But as bull markets mature, leadership typically shifts to larger, higher qual­ity funds, and recently large-caps have moved up the ranks. Multinationals are best positioned to take advantage of glob­al growth. Among the US benchmarks, the Dow 30 is most leveraged to global economic growth—these multinational companies are capable of capitalizing on a weaker dollar, and economic strength outside the US. Conversely, smaller com­panies rely more heavily on domestic economic strength, and raging emerging economies do little for most small caps. 

It’s been a good year for fixed income, but not all bond funds are created equally. This year to date, for example, the iShares Barclays 7-10 year US Treasury Fund (NYSEArca: IEF) is down 2.8%, while high-yield bonds surged more than 30%, but also suffered gut-wrenching volatility last year and into the March 2009 lows. As with stock funds, the key is to stay alert to changing leadership. And because fixed income is supposed to dampen volatility, we advise only limited exposure to riskier funds.

Over the long term, stocks have provided the best returns. Money that will stay invested for 20 years should be predominantly in stocks. Bonds offer consider­ably less upside potential over the long term, but offer a useful cushion in downturns and, when used as a part of an active strategy, provide a compelling alternative to low yielding cash.

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