Sense of unease gripping Wall Street

by Tom Petruno Los Angeles Times July 17, 2010 12:00 AM

Investors in stock mutual funds couldn't have asked for a smoother ride higher in the 12 months through March. But that just made the second-quarter market sell-off all the more jarring.

Most equity funds lost 9 to 14 percent in the three months that ended June 30, halting a winning streak that had lifted the average U.S. stock fund nearly 50 percent over the previous four quarters.

It wasn't that investors were unprepared for a pullback. Everyone knew the stock market would "correct" at some point. But many thought the catalyst would be rising interest rates triggered by a V-shaped economic recovery.

Instead, the mood turned grim as a rapid pileup of bad news - the government-debt crisis in Europe, a shocking lack of job growth in the U.S., the Gulf of Mexico oil-spill catastrophe and more - fueled fresh doubts about the global economy's ability to sustain its recovery.

A report released Friday showed that consumer confidence fell in July to its lowest point in nearly a year. American consumers appear to be having second thoughts about the recovery, clamping down on their spending in May and June.

Equity investors now have to contend with a chorus of well-known economists asserting that deflation and depression are becoming real risks again.

Princeton University economist Paul Krugman became one of the loudest voices, warning in June about a depression. He contends that Europe, Japan and the U.S. should roll out more stimulus money to fill the void left by still-weak private-sector and local-government spending.

Instead, Europe and Japan are pledging to cut government outlays to pare their budget deficits, and pressure is rising on Congress to do the same. Policy makers, Krugman says, are repeating the mistakes of the 1930s.

In the Treasury bond market, a stampede of buying during the quarter showed that some people were taking the deflation/depression talk to heart, much as they did in late 2008.

Painting a dire picture of investors' fears, the benchmark 10-year T-note yield dived to 2.93 percent by the end of June, from nearly 4 percent in early April, as investors rushed for the perceived safety of U.S. bonds.

Given all that, the surprise may be that stocks didn't fare worse. Losses in most of the world's stock markets have stayed within the limits of a classic short-term correction, meaning a 10 to 20 percent drop from the highs reached in early spring.

By Wall Street's traditional yardstick, it takes a decline of more than 20 percent to mark a new bear market.

The Standard & Poor's 500 index of big-name stocks dropped 16 percent from its second-quarter peak of 1,217.28 on April 23 to its recent low of 1,022.58 on July 2.

In July, the selling has abated and indexes have risen. The S&P 500 is still up more than 60 percent from the 12-year low reached in March 2009.

Foreign-stock funds, which on average fell more sharply than domestic funds in the second quarter because of Europe's government-debt woes and the dollar's strength, have been outperforming domestic funds over the past few weeks, partly because of a reversal in the dollar.

With the stock market's losses modest so far - certainly compared with the crash of 2008-09 - investors who fear the economy will crumble have time to rethink their tolerance for risk.

The good news is that basic portfolio diversification worked well in the first half. Bond mutual funds, which saw record inflows of cash in 2009 as many Americans sought to play it safer with their nest eggs, mostly scored total returns of 2.5 to 5 percent in the first six months, according to Morningstar Inc.


Sense of unease gripping Wall Street