Hard Knocks and High Hopes

By CONRAD DE AENLLE

THE first quarter of 2011 was a tempestuous time for the world and for the financial markets. But for the markets, at least, there has seemed to be relatively little lingering damage.

While the full effect of a devastating earthquake in Japan is unclear and political turmoil across North Africa and the Middle East is still unfolding, holders of most types of mutual funds recorded moderate to strong gains for the period, as investors apparently took inspiration from a generally improving tone in economic and corporate data.

The average domestic equity fund in Morningstar’s database rose 6.2 percent during a volatile first quarter in which the Standard & Poor’s 500-stock index rose nearly 7 percent at one point, then lost all of that and a bit more, before recovering in the last two weeks of March to finish 5.4 percent higher.

Commodity funds showed particular strength during the quarter, with gains of 7.6 percent, on average, for diversified funds and 13.8 percent for portfolios focusing on energy. Funds that specialize in smaller companies and such sectors as health care, communications, cyclical industries and technology gained more than 6 percent, on average.

International funds were so-so performers among stock funds, gaining 2.6 percent. They were dragged down by weakness in Asian stock markets, especially Japan’s.

Bond funds, meanwhile, eked out modest gains; the average one was up 1.6 percent, as Treasury bond yields were little changed in the quarter but spreads on lower-quality debt contracted, sending prices higher.

Professional investors attributed the up-down-and-up-again performance of stocks to a tug of war between mounting evidence that the economic recovery is gaining momentum — net job creation has been positive for the last six months, something that hasn’t happened since June 2007 — and the troubling events abroad. They marveled at the stock market’s ability to hold up so well amid trying and virtually impossible-to-foresee circumstances.

“There are two crosscurrents that kind of cancel each other out,” said Thomas H. Forester, manager of the Forester Value fund. “Despite what’s going on in the Middle East and Japan, the market is extremely resilient. In other cases it would be down 10 to 15 percent.”

Mr. Forester expressed exasperation at the United States’ economic gains because the Federal Reserve has had to devote so many resources to QE2 — the second round of quantitative easing, or Treasury bond purchases — in order to achieve them.

Speaking of the part of the stock rally that began last summer, around the time QE2 was announced, he said: “I look at the market and would say that it’s largely the Fed pumping in liquidity. The problem is if the Fed has to take liquidity out of the market, we could end up with a 2000 kind of event” — when stocks, led by the technology sector, fell sharply. “If and when it gets taken back, what happens? Do we get QE3, QE4 and QE5?”

If investors start to think that the Fed has backed itself into a corner, the stock market may fare badly, Mr. Forester warned.

THE same applies to the bond market, said Thomas H. Atteberry, co-manager of the FPA New Income fund and a partner at First Pacific Advisors. He sees signs that this is happening already — notably in a rise in Treasury yields since QE2 began.

“The Federal Reserve Bank is likely to be the biggest holder of Treasury bonds” after QE2 is done, Mr. Atteberry said. “Who are they going to sell to?”

Another potential headwind for the stock market results from the robust growth in corporate profits. Standard & Poor’s estimates that operating earnings for the S.& P. 500 companies reached $22.17 in the first quarter, the most since the second quarter of 2007.

Brett Hammond, chief investment strategist at TIAA-CREF, warned that such strength could be a tough act to follow.

“What we should watch for is companies being squeezed on earnings in terms of percentage growth,” he said. “We could solve Japan and the Middle East and still have a squeeze on earnings growth by the end of the year.”

Jonathan Golub, a strategist at UBS, views the gains made by the economy and businesses with more unalloyed optimism. “We’re seeing substantial improvement in incoming economic data, in particular the employment picture,” he said. He minimized the potential impact of higher energy prices, saying, “If you take an unemployed guy and give him a job, he’s happy to pay more for gas.”

Mr. Golub highlighted stronger readings in surveys of manufacturing activity, and said he expects earnings to keep improving, even from high current levels. He sees the stock market rising a further 10 percent or so this year and recommends owning sectors exposed to continued robust economic expansion, including technology, financial services and cyclical industries, as well as shares of smaller companies.

Less optimistic investment advisers encourage putting an emphasis on stability and value.

“Stocks are not necessarily something you want to run screaming from, but you want to rotate out of cyclical stuff like energy and into countercyclical stuff like health care,” Mr. Hammond said. He generally prefers larger companies that can take advantage of opportunities to do business in countries with strong currencies, and he likes real estate investment trusts, too.

For Mark R. Freeman, manager of the WHG Income Opportunity fund, “we come back to where we were finding value before this turbulence” overseas, he said. “Higher-quality, upper-market-capitalization companies offer the most opportunities at the moment.” He noted that large companies were recently trading at about three-quarters of the valuation of smaller companies.

Mr. Freeman especially likes health care and, in a contrarian play, insurance companies with exposure to Japan. As for bonds, he said that “the fixed-income opportunity set is limited.”

MR. ATTEBERRY has the same opinion on bonds. “I have told people that bonds are not a place where I would be putting risk capital these days because I don’t think you’re getting paid for the risk you’re taking,” he said.

With the possibility that such an observation may apply to many stocks, too, Mr. Hammond recommends that investors avoid counting too much on any one type of asset.

“The events of the last few weeks show the importance of not putting all your eggs in one basket,” he said. “How would you have anticipated the Middle East and Japan? Those kinds of shocks to the system are very difficult to anticipate. We’re seeing volatility increase, and that’s going to continue. A diversified portfolio is important.”