WSJ – Small Investors Pile into Emerging Markets, Junk Bonds, and Commodities

Contrast the lemmings running into "what’s hot" with what you’ve been reading here – about a month ago I was saying commodities is crowded and I would not want to be exposed highly there. People who heeded that thought process avoided the sand blasting that has gone on for 3 weeks running in this sector. While I do like these emerging markets for the long term, I think they are vulnerable here as well; some are beginning to roll over – Russia has already been in a "technical" bear market (down over 20% from peak). And I am saying the same thing I said in commodities a month ago, now for the latest darling – technology. It is crowded – everyone is hiding there. Beware.

I don’t really talk much bonds but while junk bonds (highest risk) has provided the most juice the past 3-4 months, its basically been a parallel to the stock market. The ‘worst of breed’ has run up the most as green shoots flower across the world. Just as with the green shoots themselves, I find the junk bond love way premature. This economy is stalled and I expect many more companies to suffer – so buying bonds of the worst seems not such a great intermediate term strategy. I’d be more interested around next spring when a lot more carnage is exposed. This thesis has left me lagging the lemming pack for much of May and part of June but lately things have been going back my way.

But all that said, let’s see what "Mad Money" watching money is doing now. Boo Yah!

• It’s amazing the difference a rally can make in investors’ appetite for risk. A few months ago, mutual-fund investors were yanking money out of stocks and high-quality corporate-bond funds and parking it in safer places, like money-market funds and U.S. Treasurys. Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.
• They’re back to buying relatively safe investments like high-quality corporate bonds. But they’re also pouring money into the riskiest investments. They’re lukewarm toward U.S. stocks but plunging into high-octane vehicles like emerging-market companies, commodities and junk bonds—making these among the 10 best-selling mutual-fund categories this year.
• Some market watchers think these investors are trying to quickly recoup their massive losses from last year. Or they believe these investors are simply chasing performance.
• In the first five months of this year, investors poured a net $4.9 billion into diversified emerging-market mutual funds, more than reversing the net $2.6 billion they pulled out in all of 2008, according to Morningstar Inc. 
• In comparison, mutual funds that invest in large U.S. stocks have had outflows of $11.2 billion, following a $52 billion outflow last year. (hmm, that last point is interesting – perhaps Joe 6pack is looking around on Main Street and unlike the Wall Street crowd realizing just how bad it is out there in America – he/she seems to have a lot better feel for what reality is… so I suppose they must be thinking "can’t be worse in Thailand!")
• Meanwhile, natural-resources and precious-metals funds combined have had inflows of $7.8 billion so far this year, versus an outflow of $2.1 billion last year. (that’s just a staggering switch in terms of amounts of money) 
• As for junk-bond funds, investors have put in $12.6 billion, after adding $1.2 billion in 2008. (another staggering switch)

So let’s look at some thinking from an individual anecdote

• Murray Schofield, a retired orthodontist in Arizona who sold most of his foreign investments in the second half of 2008, has been buying emerging-market funds, and funds dedicated to China and India, since March. He now has 23% of his portfolio in funds that invest in these stocks. “I have to recapture part of my losses,” says the 84-year-old. “Otherwise I’d be more conservative.” His portfolio is up 20.4% for this year, following a 44% loss in 2008, he says.

I kind of worry for Murray if this market begins to tank again – I hope he is quick to pull the trigger is things go awry. To make up a 44% loss he needs to make +79% – just to get to even. Sounds like – despite enjoying one of the biggest stock market rallies in our lifetime – he is only 1/4th of the way there. Shows you again, the first rule of making money is… not to lose money.

A deeper look into all 3 of the "favored" groups

Emerging Markets – aka decoupling all over again

• Stock markets of developing countries like India and Brazil have gone through the roof since early March, reversing some of their declines from last year. The MSCI Emerging Markets Index is up about 34% for the first six months of the year, after losing 54.5% in 2008. Some niche markets have had wilder swings. Russia’s benchmark RTS index is up 56% for the year’s first half, after losing 72.4% in 2008. [May 24, 2009: NYT – As Economy Struggles, Russia’s Market Has Surged] 
• What’s changed? Not only do investors have a greater appetite for risk these days, they’re also more optimistic about the economic outlook for some of these countries. In China, the world’s third-largest economy, the government’s massive stimulus is starting to take effect. While exports are still down, internal growth is gaining strength. Meanwhile, commodity prices have been on the rise, improving confidence in Brazil and Russia.
• Despite hot performance for emerging-market funds so far this year—an average 33% return—some money managers say caution is in order. While they’re optimistic that emerging-market economies will grow at a much faster rate than the U.S. over the next several years, some worry about the recent explosive rally in these markets. “It’s been the lower-quality, the riskier companies that have done better this year,” says Simon Hallett, co-portfolio manager of the Harding Loevner Emerging Markets fund. “Emerging markets have probably overshot in the short term.”

Commodities – aka reflation trade

• The price of oil has been on a roller coaster since 2007, hitting an all-time high last summer and then losing more than half its value over the next several months. Since February, however, it has reversed course, more than doubling. Stocks of companies that operate in the commodities space, like drillers and gold miners, have fallen and risen even more steeply than the underlying commodities.
• Recently, investors have been piling into commodities, partly because they fear impending inflation, as the U.S. government prints money to deal with the financial crisis.
• What’s more, a number of people who were sitting on cash waiting for markets and the economy to improve have rushed in lately. The upshot: The average naturalresources fund, which invests in stocks of energy-related companies, is up 15% so far this year, after losing 49% in 2008.
• What do the pros think? Fred Fromm, co-manager of the Franklin Natural Resources fund, is bullish on commodities over the long term but says challenges remain in the near term. r. Fromm says until there’s confirmation that demand is picking up or supply has slowed down significantly, the rally in prices might not be sustained in the near term. Pimco’s Mr. Worah says a dip in the market wouldn’t surprise him, given the recent gains in commodity prices.

Junk Bonds – aka "the coast is clear" and the Federal Reserve will protect even the worst companies in America under "no company left behind"; stretch for yield – the feds has your back.

• Bonds of companies that have low credit ratings have been on a tear lately, after a crushing 2008. Mutual funds that invest in these bonds have gained on average 23%, making them the second-best-performing bond-fund category, after bank-loan funds, which are up 26%.
• Last year, junk-bond funds lost 26%, making them among the worst performers in bonds. Investors feared that the financial system was on the verge of collapse, and companies wouldn’t be able to repay debt. Lately, investors have turned to these bonds in search of high returns and yields of 11% or more.
• But long-term fund investors should weigh the risks before buying. Given the weak economy, analysts expect that an increasing number of companies will be filing for bankruptcy protection and defaulting on their debt.
• Given all that, as well as the recent run-up in bond prices, money managers are approaching junk bonds with caution. Dan Shackelford, manager of T. Rowe Price New Income fund, had been buying such bonds late last year when they appeared to be cheap across the board. But he’s more selective now. “At some point, we do a gut check here and say, ‘Have things fundamentally improved that much?’ ” he says. His view: “A lot of the value has been squeezed out.”