A so-so year
A fourth-quarter rally leaves investors with average returns
Call it the Goldilocks market. Last year, mutual fund investors witnessed something that they haven't seen in more than a decade: a stock market that was neither too cold nor too hot but rather just right.
The average domestic stock fund generated total returns of about 11.9 percent in 2004, thanks in large part to a fourth-quarter rally that sent fund shares up more than 10 percent, according to the fund tracker Morningstar.
The year-end figure was slightly better than the 10.4 percent average annual returns equities have produced since 1926.
This represents the first time since 1993 that the average stock fund produced low double-digit or high single-digit gains, which stocks are supposed to generate over the long run. Yet over the past decade or so, investing in stock funds has been anything but normal. Instead, it has been a case study of extremes.
Throughout the mid-to-late 1990s, for example, equity portfolios consistently produced outsize annual gains of more than 20 percent--or in some cases, more than 30 percent. That all changed in 2000, when mutual fund managers ran headfirst into the bear market, which sent stock funds tumbling to three straight years of losses.
In 2003, stock funds came back with a vengeance, as the Standard & Poor's 500 index of blue chip stocks gained nearly 30 percent. In 2004, however, the S&P was up nearly 11 percent, slowing down what had been a dizzying ride on Wall Street.
In 2004, "the actual performance of the indexes was fairly vanilla," says Zachary Karabell, chief economist and portfolio manager for Fred Alger Management. Indeed, the Nasdaq composite index, which soared a hefty 50 percent in 2003, finished 2004 up only about 9 percent. And as for the Dow Jones industrial average, it was up only about 5 percent.
On hold. But Karabell notes that for most of 2004, it did not seem as if the equity markets or stock funds would make it this far. Indeed, despite getting off to a promising start last year, stock funds spent the better part of the year in a holding pattern, as concerns over the war in Iraq, rising oil prices, rising interest rates, and the possible return of inflation kept stocks stuck in a rut.
Take the Dow. The Dow Jones industrials started the year at 10,454, and rose to nearly 10,738 by the middle of February. But by Election Day in November, the benchmark index had sunk as low as 10,035, largely as the result of the uncertainties surrounding the war in Iraq and the presidential race.
But after President Bush's re-election victory, the Dow quickly soared around 800 points, bringing the index close to the 11,000 mark. Nevertheless, this was a modest year for the Dow.
The Dow's muted performance emphasized a major theme in 2004: Despite the predictions of many Wall Street strategists, large blue chip stock funds continued to lag the performance of funds that invest in smaller companies. The average small-company fund that invests in value-oriented stocks, for instance, rose nearly 21 percent in 2004.
By comparison, the typical large-cap blue chip fund that invests in growth stocks was up less than 8 percent, according to Morningstar.
Many analysts say that 2005 is likely to be the year when blue chip stocks finally return to supremacy. One reason: Both long-term and short-term interest rates are expected to rise in 2005. And rising rates lead to higher borrowing costs, which tends to take some of the wind out of the sails of smaller firms that rely on cheap financing to speed along.
Of course, that's only a prediction. And economists were forecasting the same thing at the start of 2004, only to be proved wrong.
Even though the Federal Reserve raised short-term interest rates five times in 2004, it did so only modestly. And surprisingly, yields on the 10-year treasury notes have not shot up, despite the Fed rate hikes. Yields on 10-year treasuries ended the year at 4.22 percent, down from 4.27 percent at the start of 2004. This would explain why the average bond fund rose nearly 5 percent in 2004, despite predictions of losses. Long-term government bond funds returned nearly 8 percent.
But fund managers are convinced that in 2005, stocks will outperform bonds. In fact, a recent survey of global fund managers by Merrill Lynch showed that U.S. bonds are forecast to be the worst-performing asset class this year.
Better bets. Jim Swanson, chief investment strategist for the asset management company MFS, says investors who continue to bet on bonds should probably consider short-term corporate bonds or perhaps Treasury Inflation Protected Securities, or TIPS.
Investment strategists predict the best place to make money this year is in foreign stock funds, particularly those that invest in the emerging markets. Emerging markets stock funds were among the best category of funds in 2004, generating total returns of nearly 24 percent. Latin American funds in particular were the absolute best-performing category of funds, returning more than 38 percent.
Right behind Latin American funds were real-estate portfolios, which rose more than 31 percent on average, according to Morningstar.
Despite forecasts of rising mortgage rates, real-estate investments continued to shine in 2004. Rising global demand for oil and commodities, thanks in large part to China's increased demand, also helped propel natural resources stock funds to gains of 28.5 percent.
The big question in 2005 will be whether the bull market in commodity prices has peaked or whether China's seemingly insatiable demand for raw materials like steel and copper will lead to ever higher prices. Just as Iraq was the big question mark for the markets in 2004, China may be the x factor in 2005.
This story appears in the January 17, 2005 print edition of U.S. News & World Report.