China Led World Again In October; GDP Lives Large

Mutual funds kicked off the final quarter of the year with a bout of volatility, with stock funds notching their first down month since February.

The market took its biggest dive since July after hitting a one-year high in mid-October. During the month, news hit that the U.S. unofficially marked the end of the worst recession since World War II, with GDP in the third quarter growing at an annual rate of 3.5%.

The average U.S. mutual fund lost 3.18% in October but has gained 19.58% year to date. In the past 12 months, equity funds were up 12.14%. In February, they sank 8.98%.

World equity funds outperformed by losing less, 2.07%. Small-cap growth funds, down 6.07%, sold off the most, suggesting that investors have lost their appetite for risk and speculation. Large-cap growth funds, down 1.88%, were spared the most from heavy selling.

The S&P 500 and Nasdaq indexes (down 1.98% and 3.64%) closed in the red for the first time in eight months. They ended the month just 5%-6% below their 52-week high. The Dow ended October nearly flat. Year to date, the major indexes have rallied 14.72%, 29.68% and 10.67%, respectively.

The market is in a topping phase, said Barry James, a portfolio manager at James Advantage Funds.

"The news that has come out in terms of earnings and GDP are as good as it gets," said James, whose firm oversees $2 billion in assets.

Low-Quality Rally

"Companies with the highest probability of going bankrupt, with the worst earnings and that have fallen the most have done the best in the rally. And higher-quality companies lagged," James said. "We're starting to see a change."

His funds are loaded with companies that not only have a history of strong earnings but are also buying back their shares, which are few and far between. They include IBM (NYSE:IBM - News), McDonald's (NYSE:MCD - News), Bob Evans Farms (NasdaqGS:BOBE - News), Darden Restaurants (NYSE:DRI - News), Del Monte Foods (NYSE:DLM - News) and ConAgra Foods (NYSE:CAG - News).

For his James Balanced Golden Rainbow Fund (NASDAQ:GLRBX - News), he bought gold and silver miners, along with ETFs tracking the precious metals and industrials, "especially those with overseas sales to take advantage of a weak dollar and good dividend yield."

The fund also owns country ETFs tracking Taiwan, Korea, Japan, Germany, Denmark, Australia, New Zealand and international treasuries.

The rally in low-priced, low-quality stocks has frustrated John Montgomery, the founder and fund manager of Bridgeway Capital Management, which uses quantitative models to pick stocks based on fundamentals.

"It's a very unusual period," Montgomery said. "If you think this phenomenon will unravel with reversion to the mean, companies with strong earnings and cash flows that haven't seen a big run-up will come back."

Two companies in his funds, HealthSpring (NYSE:HS - News) and Corinthian Colleges (NasdaqGS:COCO - News), have not only accelerated sales growth over the past three quarters but also beat third-quarter earnings forecasts. Yet the market doesn't appear to acknowledge their value. Share prices of the HMO and private-school operator have fallen 26% and 5% year to date.

"I honestly don't get it," Montgomery said. "But things like this don't last forever."

Thyra Zerhusen, portfolio manager of Aston Optimum Mid Cap (NASDAQ:CHTTX - News), with more than $1 billion in assets, has trimmed back her positions owing to concerns that prices have gone up too far too fast. She's overweighted her fund in tech stocks such as Akamai Technologies (NasdaqGS:AKAM - News), Molex (NasdaqGS:MOLX - News) and Unisys (NYSE:UIS - News), which she believes is a good takeover target.

"It's trading at 0.26 times revenue, which is dirt-cheap," Zerhusen said. "They can double and still be undervalued."

She's also overweighted health care, industrials and energy. Her picks were Varian Medical Systems (NYSE:VAR - News), Jabil Circuit (NYSE:JBL - News), FMC Technologies (NYSE:FTI - News) and Chicago Bridge & Iron (NYSE:CBI - News). She's avoiding banks and underweighted financials and utilities. Nearly half of the companies in her concentrated portfolio of 40 stocks get 50% or more of their sales from overseas.

Among sectors, commodity funds topped performance with a 2.37% gain. Resisting the downward tug were safe-haven consumer goods, down 0.46%, and natural resources, down 0.93%. Crude oil rallied 13% to nearly $80 a barrel after trading in a narrow range between 69 and 70 for the trailing four months.

Hardest-hit sector funds were telecom, down 6.18%, and health-biotech, down 5.00%.

Foreign Funds

China region funds rose 1.88% to lead world equity funds. Emerging market funds fell 1.31%, holding up better than U.S. stock funds. Developing economies grew 8.9% in the third quarter, the fastest in the world. Growth for the first three quarters of the year came in at 7.7%.

Latin American funds rose 0.97% and were the only other regional group to end October in the black. Japanese funds fell 4.13%, lagging all foreign markets. Europe funds shed 2.03%.

"Portfolios should include an international allocation, as lower correlations can improve the overall risk-return profile, and in light of a longer-term downward trend in the dollar," Liz Ann Sonders, chief investment strategist at Charles Schwab, wrote in her monthly commentary. "However, these markets are likely to pull back after strong performance in 2009 with any rise in the dollar.

"The dollar's long-term outlook is hampered by fiscal and trade deficits," she continued. "But investments that play on dollar weakness are 'crowded trades,' and countertrend rallies in the dollar are likely."

For the month, the dollar rose 1.2% against a basket of major world currencies. It strengthened against the euro but not the yen or the pound.