Mutual Funds Dragged Down by Global Unease

By Conrad De Aenlle, New York Times

INVESTORS are supposed to hate uncertainty, but they lived with it fairly comfortably for two years after the last recession ended.

Then, in the third quarter, the weight of many unanswered questions, mainly about the economic recovery’s staying power and the soundness of Europe’s financial system, dragged stocks sharply lower.

The 14.3 percent decline in the Standard & Poor’s 500-stock index in the three months through September was the worst quarterly loss since 2008 and left the index down 10 percent since the start of 2011. Treasury Bonds, often a haven in difficult times, went in the opposite direction, recording double-digit gains and pushing yields on 10-year instruments as low as 1.7 percent.

The catalyst for both moves, an ironic one at that, appeared to be S.& P.’s downgrade of Treasury debt in early August after a rancorous debate in Congress over federal spending left no clear path to long-term deficit reduction. The deterioration of Europe's debt crisis added to the downward momentum, as a resolution of Greece’s problems remained elusive, raising fears of default.

Perhaps even more unsettling to investors was the prospect of contagion in Europe — a wider destabilization of treasuries and banks in the region resulting from anticipation of just such a calamity. In this picture, investors spooked by events in Greece would sell bonds elsewhere, driving up interest rates and adding to debtors’ stress.

The chance that these economic woes will derail an already fragile global economic recovery, spread alarm in the stock market. Yet there was more. Political stability in pockets of the Middle East and North Africa remained in doubt, as did China’s ability to maintain strong economic growth while controlling inflation. And supply-chain disruptions for manufacturers in certain industries, a remnant of the March tsunami in Japan, continued to cause concern.

“There are crisis situations all over the world,” said David Marcus, chief investment officer of Evermore Global Advisors. “Investors have been in panic mode, selling indiscriminately without regard to value. They want out at any price.”

When assets are sold at any price, they become cheap. And that has indeed happened to stocks, some investment advisers contend, which were trading at about 12 times earnings as the quarter ended, compared with a long-run average of closer to 15. Buying now may not make for a peaceful night’s sleep, but it could result in healthy gains for the long term, they say.

“There is an absolute fear of having money exposed to anything that can fluctuate in value,” said David Steinberg, managing partner of DLS Capital Management. Investors who take a chance now “are going to be rewarded once the dust clears,” he predicted. “There is a very high probability of high returns and a low probability of losing a lot on a long-term basis.”

In the short term, though, fund investors have lost a lot. The average domestic stock fund in Morningstar’s database fell 16.2 percent in the third quarter.

Funds focusing on cyclical industrial companies, financial services and natural resources were among the weakest performers. Those with concentrations in consumer-oriented companies and utilities lost ground, but less than average.

International stock funds, down 18.3 percent, fared worse than domestic ones and were dragged down by a 23.7 percent decline in Europe portfolios.

Taken as a whole, bond funds were little changed in the quarter, down 0.6 percent, but there were exceptions. The persistent appetite for the perceived safety of Treasury bonds sent long-term government bond funds to an average gain of 26.9 percent.

Conditions may improve for the long haul, but ponderous progress on major issues could bring more pain in the short run. Rick Rieder, chief investment officer for actively managed fixed-income portfolios at BlackRock, says, for example, that he foresees no immediate end to Europe’s crisis.

And as much as that might unnerve investors, however, it wouldn’t be such a bad thing, in Mr. Rieder’s view. Keeping Greece on the brink as a financial zombie could give governments, central banks and commercial banks time to arrange credit lines to keep financial systems going and institutions solvent.

Time is also a factor in the quandary over the federal deficit. The clock is ticking toward the November deadline for a bipartisan panel to find more than $1 trillion in spending cuts that Congress must approve; if it doesn’t do so, automatic cuts are to be imposed.

Time can be an ally to investors in another way. With valuations so low on stocks but uncertainty too great to push them higher, Mr. Rieder encouraged anyone who could commit capital for several years to consider buying stocks with high dividend yields. Then they could wait out the unsettling present until a brighter future emerged. “Nobody doubts that if you take a long-term perspective, they are attractive,” he said.