Two consecutive quarters of job gains and strong fourth-quarter earnings reports will tell fund managers and investors whether or not the U.S. economy is back on track and the market correction and profit-taking that took hold in many sectors on Sept. 20 will cease.

But even if these economic indicators disappoint, the mutual fund industry is likely to continue to see the strong inflows it has experienced since April, simply because investors are anxious to get back into a game that has beaten them for the past three years. Investors in 401(k)s and other retirement plans are especially eager to make up for lost time. And even if there is an "earnings disaster," it would only cause a 5% to 10% dip from the rally, and the stock market would still end the year in the black.

This was the consensus of Lipper analysts as they presented their third quarter and market outlook findings last Wednesday.

Cautious Optimism'

"Since the market bottomed out March 13, we have had almost a straight line of inflows," said Donald Cassidy, senior analyst at Lipper. "However, there has been a very clear pattern of cautious optimism. The kinds of funds getting flows are very clearly the more conservative choices: value, real estate, gold, international, balanced and income. People are not going out and buying the hot stuff."

Although small-cap and science and technology funds were charging ahead to take the top performance slots for the quarter, they lost nearly half of their gains in the final week of September alone. Gold funds, as a result, were the biggest gainers (25%) and could continue to show strength now that they have strong P/E ratios and the capital to continue mining new regions, said Kathryn Barland, senior analyst with Lipper. "Because their financials and cash flow are beginning to be meaningful, gold funds are beginning to be seen as a legitimate part of a portfolio," she said.

Japan and China region funds both returned 21% for the quarter, Japan funds gaining strength from improving local economic data, rather than exports. "Considerable foreign investment in the mainland and a very strong real estate market in Hong Kong" buoyed China, Barland added.

Value has provided considerable strength this year, but in the third quarter, large-cap value funds were the worst performers, primarily because major phone companies have petitioned the FCC to force AT&T and MCI to give them access to their central office switches, Lipper analysts said. In step with this news, utility funds were down 0.88% for the quarter. They, along with bear funds, were the only negative equity performers for the period.

Science and technology funds, which had been on an 18% trajectory, also suffered considerable losses in the final week of last month. "An earnings warning from Sun Microsystems sent shock waves throughout the industry," Barland said.

On the fixed-income front, high-yield funds were the best performers, rising 2.5% for the quarter. Lipper analysts didn't provide any further specific fixed-income figures except to make the general comment that it was one of the most volatile periods for fixed income in a decade.

While Lipper equity analysts are focused on earnings and jobs, Lipper fixed-income analysts are more concerned with consumer debt and the twin trade and budget deficits. "The personal debt/GDP ratio is at a near-record 120%," analyst Martin Vostry noted. This, combined with the specter of rising interest rates and a recent decline in the dollar, leads him to believe high-yield, corporate bonds and short-term Treasuries offer the best opportunities. Should the dollar continue to fall, he added, international income funds are a good hedge for currency markets. On the long end of the yield curve, Treasury inflation-protected securities "provide an interesting alternative, particularly if and when inflation pokes above 2%," he said.

One more bright spot, especially for fund companies looking to develop new fixed-income products, is mortgage-related funds, Vostry said. These funds hold short durations right now, positioning them to "buffer a potential future rise in rates while delivering an interest rate higher than short-term Treasuries," he said.

Finally, while an improvement in unemployment would be welcome news, Vostry warned that it could cause the Fed to raise interest rates. Until then, he predicts that Treasury funds will remain in the 4% to 6% range.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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