Gloomy Bond Investors Clash With Upbeat Stock Managers

It's often said that stock investors, eager for gains, see the glass as half full, while bond investors, careful about losses, see the glass as half empty. Now, however, their views are so different that you might wonder if they're peering at the same glass. Many investors have withdrawn money from the stock market, especially as weak U.S. economic data have bolstered bond managers' case for a gloomier outlook. The U.S. job report on July 2 showed the U.S. economy lost 125,000 jobs in June.

"All these [economic] numbers show this is still a very fragile recovery," says Darrin Smith, portfolio manager of the $3-billion Principal High Yield Fund (CPHYX). "GDP expectations will continue to come down."

The Standard & Poor's 500 index is down 8.3 percent so far in 2010. But speak to the managers of many stock mutual funds, and they sound enthusiastic about the opportunities. "We're in very favorable conditions for equities, especially when you look long-term," says Conrad Herrmann, manager of the Franklin Flex Cap Growth Fund (FKCGX), a stock fund with $1.7 billion in assets.

The Market Vs. Individual Stocks

It's not that stock managers are ignoring the economy or other worries that bother bond managers, such as the European debt crisis or the impact of new regulations from Washington. Rather, they're focused on individual stock prices and see great bargains. "There is a real disconnect between how these companies are doing and how these stocks are doing," says Craig Hodges, co-manager of the Hodges Fund (HDPMX), a $360-million fund that invests in a wide range of U.S. stocks.

In the first quarter, earnings for the S&P 500 rose 54 percent from a year ago. According to Bloomberg, analysts expect earnings to rise 34 percent year-over-year in the second quarter. The S&P 500's price-to-earnings ratio—a common way of measuring how cheap or expensive stocks are—is at 14.8, down from 17.7 on Apr. 23. The average p/e ratio for the past 20 years is 20.4. "The market is now dominated by other forces than fundamentals," Hodges says. "In a couple years you'll look back and say this was the time to be buying."

The problem is it's hard to know when difficult conditions for equity investors will end. "On a short-term basis, there is a lot of doom and gloom," says Dan Genter, president of RNC Genter Capital Management, who manages both stock and bond funds. He expects a long period of quite slow growth in the U.S., making the economy—and stocks—vulnerable to negative growth for quite some time.

Balance Sheets in Need of Repair

Jason Doiron, co-manager of the Sentinel Conservative Allocation Fund (SECMX), predicts "a long, slow grind" for an economy burdened by debt. "It's going to take time to repair the damage that leverage caused [to] corporate, personal, and government balance sheets." In such an environment, bonds could have the advantage. "Bonds will do well with a lower economic growth rate than stocks will," says USAA Investment Management bond manager Matthew Freund. Growth will be enough to ensure companies can repay creditors—i.e. bondholders—but not enough to provide the sales and profit growth that equity investors treasure.

"Bonds are in the sweet spot," Freund says. "The stock market might be a little disappointed."

Those bullish on stocks are trying to keep their focus long-term and ignore the scary headlines and the market's foul mood. "Everybody is on pins and needles," says Peter Andersen, an equity portfolio manager at Congress Asset Management in Boston. "Any slight negativity is magnified." Asked to cite risks that most concern them, managers of all stripes cite the oil spill in the Gulf of Mexico, which is hurting both the overall market mood and the energy sector; the European debt crisis; the possibility of slower growth in China; uncertainty about the impact of federal legislation, such as the financial reform bill; and the state of the U.S. economy.

Herrmann, the Franklin equity manager, says some of these concerns will fade with time. Also, U.S. companies have advantages. "They've been hoarding cash, [which] gives them tremendous flexilibity," he says, while emerging markets continue to grow quickly and the prices of stocks are "extremely attractive."

A key test—which could change market sentiment about equities—could be the second-quarter earnings season, Hodges says. That begins on July 12, when Alcoa (AA) unveils results. Profits—and CEOs' outlook for the rest of 2010—could give investors a better sense of the headwinds facing equities and whether those are troublesome enough to stick with bonds.

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