Risk check: Gold, small caps and other hot markets rated
It's tempting to invest in what's working...but that's often when the risk is highest.
NEW YORK (MONEY Magazine) - Though the leading stock-market indexes are on firmer footing than they were, the real action has been in emerging markets funds, portfolios hitched to soaring commodity prices, and the stocks of small, risky companies.
Here's what you can expect from the market's hottest spots, and how they might fit into your portfolio.
Risk level: Medium for small value shares and near-sky-high for small growth.
In recent years, small-company shares had three big things in their favor: low interest rates, strong economic growth and relatively low prices. But the recovery is long in the tooth, and small-caps are no longer cheap.
Lehman Brothers analyst James Furey notes that the companies in the small-cap Russell 2000 index were selling for 1.2 times sales at the end of March, their highest quarter-end price since 1998. Why are they so popular?
John Hussman of the Hussman Funds senses an element of desperation here: Blue chips haven't fallen enough to look like incredible bargains, but investors remain hungry for big returns, which small companies can provide if they keep posting huge earnings growth.
"The investor is taking an interest in things that are working right now," he says.
Eventually that kind of thinking ends - usually when the economy sputters. "You don't want to be around small-caps in a recession," says Furey.
Prudential Equity Group small-cap analyst Steven DeSanctis notes that when small-caps stop beating the bigs, they lose an average of almost 22% in nine months. Even some of the fund managers who specialize in small-caps expect them to cool.
"It's been a special moment for small-caps," says manager Chuck Royce of the Royce Funds, which recently closed two portfolios to new investors to keep assets manageable. "This is the end of that run, not the beginning."
Risk level: Near sky-high
Emerging markets funds have been rallying since 2003, and they are starting to show signs of faddishness, with money managers opening funds to take advantage of the hottest markets or investment themes.
Templeton, for instance, is opening a BRIC fund. (That stands for Brazil, Russia, India and China, natch.)
Of course, the trends driving these markets - most important, the emergence of China and India as major players in the global economic system - aren't going away soon. But it's still easy to imagine events that could knock shares down fast.
For starters: another round of nuclear brinkmanship between India and Pakistan, or a U.S. face-off with Venezuela.
"I tell my clients, emerging markets are going to be the highest-returning area in your portfolio," says financial planner Chris Cordaro of Regent Atlantic Capital in Chatham, N.J. "But I know that within six years one of those countries is going to do something stupid and drag everyone down, and we'll be down 20%. That's when we buy more."
If you don't have the stomach or the time horizon for that kind of thing, don't go there. Or consider getting in less directly.
"Start with a diversified foreign fund with some emerging markets exposure, and that's probably enough," says Morningstar director of fund research Russel Kinnel. MONEY 65 pick T. Rowe Price International Discovery (PRIDX (Research) recently had about 9% of its assets in Indian stocks.
Risk level: Near sky-high
In 1981 oil prices hit $39 a barrel, from around $15 in 1979. Armand Hammer, then chairman of Occidental Petroleum, was warning that oil could hit $100. In fact, prices tumbled to just $10 by 1986.
This is a useful bit of history to keep in mind as oil dances around $75 a barrel.
Big-money investors love commodities right now, and it's hard to say how much of this is driven by a long-term interest in better diversification and how much is due to pure speculation. Worsening tensions with Iran or the political troubles inside Nigeria could push prices still higher, but by the same token an improvement in the political situation, or a faster-than-expected global slowdown, could knock them back down hard.
Most natural resources funds aren't directly exposed to the ups and downs of oil prices. Instead, they buy stocks in energy-related businesses and may diversify into other sectors, including natural gas and metals.
That means they can perform differently from oil. Nevertheless, they can still lose 30% or more in a year. The best rationale for buying these funds is that they're decent diversifiers: The same rising energy prices that can pump up their returns may be pummeling the share prices of companies that you hold elsewhere in your portfolio.
Risk level: Sky-high
Just like oil, gold has been on a frantic tear lately. It recently topped $700 an ounce, up from $250 in 1999. And, again like oil, investors can expect huge swings of fortune.
If you bought an ounce of gold in the early '80s, you're down about $200 before inflation.
As an investment, gold is an oddity. It's not terribly useful: Most of it goes into making jewelry, about half of which itself may be purchased as an investment. Gold tends to do best when people lose faith in other assets, including paper money.
There's a lot of that angst going around.
Joe Sterling, comanager of American Century Global Gold fund, says scary world politics, big U.S. deficits and rising inflation fears are in the metal's favor. But even if you think you can handle gold's volatility, think twice about buying a gold fund if you also own other natural-resources stocks.
Rising energy prices have not only stoked inflation fears. They've also pumped a lot of cash into oil-producing countries, and it's possible that some of that money is being parked in gold for now, says Mark Johnson of the USAA Precious Metals & Minerals fund.
Gold also seems to be a favorite of the same investors who have fallen in love with other commodities. When this bull market in real assets dies - whether it's in a few months or a few years - you may well be glad you hung on to those boring old Microsoft shares.