March 2, 2006

Waiting for Mr. Bernanke

Domestic Equity Funds -- February 2006 Review

After galloping out of the gate in the first month of the new year, domestic stocks and equity funds cooled down in February. In addition to high energy prices and geopolitical tensions in oil-rich Iran and Nigeria, investors appear concerned over the direction the Fed will take on interest rates in March, when Bernanke chairs his first meeting later in the month.

All mutual fund style categories were essentially flat in February, with domestic stock fund slipping 0.46% on average. Large-cap value funds held up best, edging up 0.15% for the month, while mid-cap growth vehicles showed the worst returns, falling 0.95%. But returns from the start of the year are impressive: The average domestic equity fund has risen 4.27% year to date, while small-cap growth funds have climbed 7.78%, topping all style categories. The large-cap S&P 500-stock index rose just 0.27% in February, but is up 2.93% through the first two months of 2006.

Standard & Poor's believes that investors should not be disheartened by February's flat performance. Sam Stovall, Standard & Poor's chief investment strategist, notes that U.S. stocks have historically performed poorly in February, reflecting a seasonal pattern. Since 1945, the S&P 500 index has incurred an average decline of 0.2% during the month of February, making it the second worst month after September, which has recorded 1.1% drop on average, he said.

John Augustine, chief investment strategist at Fifth Third Asset Management, said that among the headwinds facing the U.S. stock markets this year are sustained high energy prices and Fed policy. "There are fears that any supply disruptions could disturb oil markets and such concerns are holding back both economic growth and stock prices," he said. "In the absence of any such disruptions, we expect that crude will stay in the $50-$70 range this year and will likely always be on investors' minds."

The volatility of oil markets came into clear focus last week when reports of a foiled terrorist attack on a Saudi Arabian processing plant pushed the price of crude more than $2 to nearly $63 in just one day. Future terrorist activities, diplomatic crises, or extreme weather patterns, could roil the energy markets for the foreseeable future. Augustine noted that while U.S. and global economies seem prepared to live with oil priced at $60, the $65 level triggers fears among both consumers and financial markets. Standard & Poor's forecasts that the price of WTI crude will finish the year at $61.75.

On the final day of January, the Fed raised short-term interest rates for the fourteenth consecutive time to 4.50%, but seemed to indicate that its tightening campaign may be nearing an end, citing generally good economic growth and modest core inflation. Given the somewhat firmer U.S. inflation reports of late, Standard & Poor's believe rate hikes seem likely at both the March 28 and May 10 FOMC meetings, leaving the fed funds rate at 5.0%.

After six years of outperformance, small-cap stocks may finally have run out of steam. Kevin Cronin, head of investments at Putnam Investments, believes that from a macro perspective, "large-cap growth stocks are poised to outperform as small-cap valuations are stretched relative to large-cap, and value has had an extended period of out-performance versus growth." Cronin said he sees signs that buyout activity -- which has been one of the key drivers behind the recent strong performance of small- and mid-cap names -- is now "moving up to the larger-cap space, propelled by increasingly larger private equity deals."

Augustine agrees that large-caps will likely outperform small-caps in 2006. "Technically, we already saw this in 2005 since the S&P 500 [up 4.91%] slightly beat the Russell 2000 [up 4.55%]," he said. "But now in 2006, we are seeing a migration to large-caps and mega-caps. Some of this rotation is due to an expected slowdown in overall corporate profits. During such an environment, investors are more comfortable with large-cap companies which are stable and more consistent in performance."

Standard & Poor's expects the S&P 500 to deliver a 9% gain for the full year.

Fund Investment Style

February 2006 Average Returns* (%)

Year-to-Date Average Returns* (%)

Large-Cap Growth

-0.89

+2.26

Large-Cap Value

+0.15

+3.17

Large-Cap Blend

-0.12

+3.05

Mid-Cap Growth

-0.95

+5.14

Mid-Cap Value

-0.20

+4.55

Mid-Cap Blend

-0.77

+4.62

Small-Cap Growth

-0.45

+7.78

Small-Cap Value

-0.54

+6.66

Small-Cap Blend

-0.38

+6.88

All-Cap Growth

-0.88

+3.91

All-Cap Value

-0.36

+3.89

Domestic Equity Funds (excluding sector and balanced funds)

-0.46

+4.27

S&P 500-Stock Index

+0.27

+2.93

*Source: Standard & Poor's. Total returns include reinvested dividends. Preliminary data as of 2/28/06.

InvestmentAdvisor.com has more mutual fund news from Standard & Poor's available here.

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