Should you bail out of equity funds?

It’s a rough time for equity fund investors. The stock markets are way down year-to-date and there’s no way of knowing if we’ve seen the bottom yet. Some people have suffered heavy losses and are selling their fund units for fear that there may be more bad news to come.

The fact that this is happening as the economic recovery strengthens makes the whole situation surreal.

Stocks aren’t supposed to act this way. They’re expected to perform well during times of strong economic growth. Instead, the markets have been in freefall, despite positive economic news on a number of fronts, dragging equity funds down with them.

There are two ways to interpret this unusual dichotomy in the directions of the economy and the stock market.

1) The market is right. Historically, stocks have been a leading indicator, forecasting recessions and recoveries months in advance of the actual turn. If the markets are correct now, then the economy is heading for a sharp downturn, probably by the fall. The promising numbers we’re currently seeing will turn out to have been a blip. Instead of a new boom, we’ll experience a W pattern. In that case, we’re on the mdle upward slope of the W, with another down leg left before we finally see real daylight. This theory is given added credence by the reluctance of the U.S. Federal Reserve Board to raise interest rates despite the apparently strong economic numbers.

2) The market is wrong. Investors have lost their perspective, confused by the scandals that have rocked Wall Street and disoriented by the warnings of more terrorist attacks. As a result, they are in the grip of what one broker calls “irrational despondency”, to the point where they cannot discern genuine value.

I don’t dismiss the possibility that the first interpretation may be correct. There have been times in the past when stock markets and the economy disconnected. For example, over the entire decade of the 1960s, the Dow Jones Industrial Average rose only 18% (that’s less than 2% a year!), although the North American economy generally performed well despite rising inflation fears as the decade ended.

The 1970s were even worse, with the Dow gaining only 5% over the entire 10-year period. But that was a turbulent decade that featured runaway inflation, stagnant economic growth, an energy crisis, wage and price controls, and an unprecedented Presidential resignation.

The big question is whether the first decade of the new century will be a repeat performance of the 1970s – stagnant stock markets against a backdrop of on-going political and economic turbulence.

It could happen – the political tensions created by the Middle East mess have the potential to wreak serious havoc, and the spread of nuclear arms to arch-enemies like Pakistan and India must be an on-going cause of concern. The run-up in the price of gold that we saw in the past year is a reflection of that.

But barring another devastating terrorist attack on the U.S., in which case all bets are off, I believe that the second scenario is more accurate. It’s hard to see how this recovery is going to come to a sudden, grinding halt. The technology industry, which led the economic slump, has little downside left. After all, when you’re dead, you’re dead. Meantime, we have seen strength in a number of other sectors, including retailing, real estate, transportation, financial services, and energy.

Therefore, my advice is to continue to build your holdings in carefully-selected mutual funds with a view to positioning yourself to benefit from the market turnaround when it does come.

Keep your risk to a minimum, however. Choose funds that historically display a better-than-average safety profile. This is not a time to be overly aggressive.

Also, continue to maintain a portion of your assets in money market and bond funds. They will provide a protective cushion in the event that Scenario One turns out to be accurate.

Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that provides portfolio-building advice to fund investors.