CHICAGO -- While the majority of the mutual fund industry's attention has been squarely focused on the scandal and operational aspects of the business, the investment climate has taken a sharp turn for the worse.
Morningstar officials rightfully called for a renewed focus to be placed back on the stock-picking aspects of the fund industry at its recent investment conference, as many have gotten away from talking about investing and performance once the scandal broke. However, a number of well-respected managers' predictions for 2005 and beyond were less than uplifting. Several executives joked about leaping out of windows or slitting their wrists due to the bleak outlook, and panelists told attendees of the expected hardships to come in the next year when searching for quality investment opportunities.
"Next year is what I refer to optimistically as a black hole," said Jeremy Grantham, co-founder of GMO and panelist at the conference. "Regardless of your view, you have to play it safe. Last year was the biggest return to risk we have ever seen. This was a risk taker's year, [and] this is not how bear markets end." Grantham said there is nothing wrong with building up cash levels and "biding your time" until better opportunities arise. "There's no harm in sitting out in cash and conservative hedge funds for the time being," he said.
Bob Rodriguez, CEO and director of First Pacific Advisors, called the investment landscape a "vast wasteland," noting that his cash levels are extremely elevated right now and that he believes earnings growth will decelerate in 2005. Rodriguez is also the portfolio manager of the FPA Capital Fund, which closes its doors to new investors in early July, and the FPA New Income Fund, a bond fund. "We can't find much of anything to buy," he told a packed audience at the Hyatt Regency hotel in Chicago. "This is a flat market," he said of equities. "This is the worst I've seen since 1983."
Rodriguez is also warning investors in his funds not to get overly optimistic about the run-up the market has undergone starting in 2003. He said he has advised clients to expect returns of 5% or less over the next five years. "We are very much cautious. We are anxious about 05 and 06," he said, noting that the preservation of capital is paramount.
"There's this feeling out there that you have to do something. You don't have to do anything. Some of your best decisions are what you don't do," said Rodriguez, adding that it is important to wait until the investment odds are favorable.
That may take some time. Grantham noted how markets are often stimulated during the third year of a president's term in order to favorably build up the economy leading up to the elections. Not since 1932 has there been a painful third year, Grantham contended. He also indicated that the markets tend to coast during the fourth year, which we are currently in, but that some pain is needed in years one and two of a president's term so that a third-year stimulus is possible. "We have never needed more elbow room than we need now," he said, noting the unprecedented debt levels.
Not all were preaching total doom and gloom for equities, however. Joseph Deane, managing director of Citigroup Asset Management, manager of the Smith Barney Managed Municipals Fund and a panelist alongside Grantham and Rodriguez, said that we are in the middle of a "good, solid market recovery" and that he would recommend putting risk money in equities.
However, he is much more bearish on bonds. "The bond market, as it was priced last summer, was as overpriced as the Nasdaq was in 2000," he said, adding that all the "knuckleheads" from 2000 flocked into the bond market following the dot-com bubble burst.
Deane said that historically bond investors who could withstand short-term pain would always do well in the long run, but not anymore. "Today, if you stick your head in the sand you will get killed twice. The wind that has been at your back for the last generation will now be in your face."
Many at the conference had major concerns about the upcoming economic picture. Scott Brayman, senior vice president and portfolio manager of the Sentinel Small Company Fund, said he has a guarded overall outlook. Brayman, who was part of a panel on small-cap stocks entitled "Small Stocks, Big Opportunities," said he expects profit deceleration, which will exacerbate the flight to quality and a shift to larger-cap stocks. However, Brayman said many managers do not have the flexibility to sit on the sidelines. "Most in this industry don't the have flexibility to keep high cash on hand," he said.
Christopher Davis, keynote speaker and manager of the Davis New York Venture Fund and Selected American Shares, said most of the managers he admires have huge amounts of cash on hand, but he generally doesn't raise cash. "I will not be successful at raising cash at the right time," said Davis, who is also the chairman and chief executive of Davis Advisors.
But despite all the talk of a tough environment, it still comes down to research and making quality selections, and every manager has his or her favorites. Rodriguez likes energy, anticipating the sector will be the beneficiary of a growing demand for oil and natural gas with supplies waning. Grantham said that emerging equity is a reasonable area to watch, but, specifically, he likes the unusual asset class of timber. Although not your typical tree-hugger, Grantham is bullish on the asset class he thinks is mispriced.
"In the three great bear markets, only one asset class has gone up, and that's timber," he said. "If the rain rains, the sun shines, then the suckers grow. If you don't want to sell, then they get bigger and more expensive."
Once investments again become center stage for the fund industry, complexes will have a whole new set of worries to deal with. "In our opinion, the current stock market rally is just an interlude to a period that will be dominated by high levels of price volatility," Rodriguez said. "Unlike the past 20 years, we do not anticipate a new bull market for the foreseeable future. We believe equity investment returns will likely be in the low single-digit range, as corporate earnings growth is mostly offset by P/E contraction."
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