Stock funds struggle in 2007 as leadership shifts

SAN FRANCISCO (MarketWatch) -- It's said that the stock market climbs a wall of worry. Mutual-fund investors smacked into that wall in 2007, and still have good reason to worry.
Uncertainty about the strength of the U.S. economy and corporate earnings had been building all year, and the dam finally burst in the fourth quarter. The housing downturn and the subprime-induced credit crunch ravaged the financial-services and homebuilding industries, and investors began 2008 with serious concerns about the potential for damage to the broader economy.

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The biggest unknown is whether consumers will cut back on their spending when confronted with declining home values and rising prices for food, energy and other essentials. Many investment strategists surmise that belt-tightening by consumers could tip an already battered U.S. economy into recession, and accordingly they recommend that investors move to protect several years of robust stock-market gains.
"You have to build your defenses," said Hugh Johnson, chief investment officer at investment manager Johnson Illington Advisors LLC, who like many of his peers is committing more assets to the relative predictability of large-cap multinational stocks. "You have to think about preserving capital, not increasing capital, now that the risks are higher."
Without a stable foundation, stock funds struggled to find footing in 2007. Diversified U.S. stock funds rose 6.4% on average for the year, buckling under a 3.1% fourth-quarter slide, according to preliminary data from fund-tracker Lipper Inc.
The annual harvest was the barest since 2002 and well-below the U.S. market's 10.4% historical average gain, but this year's top fund groups and sectors suggest that investors would do well to recognize that a new crop of market leaders is taking root.
Shifting sands
When profits are scarce and credit is tight, the market favors companies in fit financial shape that can deliver solid earnings, boost dividend payouts, and have minimal borrowing needs. These businesses come in all sectors and sizes, but they tend to be larger, established operators that ideally have a global footprint.
Stock funds in 2007 reflected this sentiment. Growth-oriented strategies and sectors soared, while bigger companies were generally better investments than smaller rivals. The year's best-performing group: Midcap growth funds, up 16.4%, with a 1% quarterly loss. Large-cap growth portfolios rose 14.2% for the year and ended the calendar's final 13 weeks with a flat finish. One surprise standout: Fidelity Magellan Fund (FMAGX:Fidelity Magellan Fund
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Last: 92.56-1.31-1.40%

6:06pm 01/02/2008

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FMAGX 92.56, -1.31, -1.4%) , which many investors had dismissed, turned in a striking 18.8% return.
By comparison, small-cap growth funds managed a gain of 8.8% on the year against a sharp 3.2% quarterly decline. Small-cap stocks had been the market's darling for the past seven years, but nowadays small is decidedly not beautiful. In a slumping economy where credit is both tougher and more expensive to obtain, small businesses -- most of which are domestically driven -- suffer the most. In 2007 small-cap value stock funds, heavily exposed to financial services and consumer-related stocks, were hit hardest of any major category -- down 5.5% on the year after a massive 6.7% drubbing in the quarter.
"We're in the late innings" for U.S. small-cap stocks, said Richard Bernstein, chief investment strategist at Merrill Lynch & Co. "As volatility picks up and economic conditions change, the old leadership is unlikely to continue."
Indeed, value seekers trailed their growth counterparts in 2007 for the first time in several years. Large-cap value funds squeaked out a 2.2% annual gain after a 4.7% quarterly loss, while midcap value funds finished the year up 2% against a 5% tumble in the quarter.
Specialized sector offerings showed clearly why companies with growing earnings and rising dividends are having their day. Funds dedicated to natural-resources companies -- many of which are commanding fixtures on the global stage -- surged 40.4% on the back of a quarterly 7.2% advance. Utility funds tallied a 19.8% annual gain and rose 5.1% in the year's final 13 weeks. Technology funds -- which also tend to invest in companies with global operations -- staged an impressive rally, up 15.4% on the year against a 1.9% decline in the quarter, and health-care funds added 8.9% for the year and slipped 0.9% in the quarter.
On the downside, the subprime debacle sacked real-estate funds for a 14.8% annual loss after a 12.1% quarterly hit. Financial-services funds fared only slightly better, down 13.3% on the year and losing 9.6% in the quarter.
The bear market for financials took a big bite out of U.S. stock-fund returns in 2007. Without the financial sector, the Standard & Poor's 500 Index (SPX:S&P 500 Index
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Seeds of growth
Volatile and uncertain conditions that favor growth stocks are likely to persist well into 2008 and perhaps longer, market strategists contend.
"We're pretty cautious going into the beginning of the year," said Mike Avery, chief investment officer at Waddell & Reed Investment Management Co. "The crisis in the credit markets has been much worse than we would have thought."
Still, Avery says the U.S. economy can limp along without a recession. "But we're not sure about that, and I don't think we'll be sure until we get through the first quarter" of 2008.