What is down must go up sometimes, but when?

Mutual fund managers are waiting to find out themselves, but according to one survey, they are cautiously optimistic about 2009 after experiencing devastating losses in 2008.

The fourth quarter 2008 survey of 206 portfolio managers by Russell Investments in Tacoma, Wash., revealed that half believed the markets were going to rise at least 10%. The vast majority were buying, not holding or selling.

Another 27% thought the stock market would rise up to 10%. Seventy-two percent believed the market was undervalued. That's considerably more than the 45% who thought it was too low in the previous quarter and more than double the 34% who thought so one year earlier. The managers in the survey were most bullish in corporate bonds, U.S. small-cap and midcap stocks and high-yield bonds. Managers also showed a preference for growth investing rather than value, but the gap in the attractiveness of the two had shrunk considerably since the last survey.

"Managers believe that the market has overshot the damage done by the ongoing recession and is now oversold and undervalued," says Erik Ristuben, Russell's chief investment officer, North America.

Although the outlook for equities remained guardedly optimistic, the greater appeal of bonds in the survey represents a major development. Manager bullishness for corporate bonds reached a historic high of 60%, up from 37% the prior quarter, and from a survey low of 8% in the first quarter of 2006. The level of bullishness for high-yield bonds also soared to a new high, reaching 53% from just 39% the prior quarter and 28% one year earlier.

Last year was a miserable year for both stock and bond funds. Domestic stock funds, on average, declined 35%, according to Morningstar Inc. Meanwhile, high-yield bond funds dropped 25%, long-term corporate bonds lost 6% and multisector bond funds dropped 17%. Long-term municipal bond funds lost 10%.

The best-performing funds were long-term government bond funds, up 22%, and bear market funds that gained 24%. Inflation hedge investors saw precious metals funds and real estate funds both drop, by nearly 33% and 41%, respectively (see table).

The good news is that the bear market has matched the average loss during the 14 worst bear markets since 1900, according to Mark Salzinger, publisher of The No-Load Fund Investor in Brentwood, Tenn. "Many stocks are now cheap not only on a relative basis but on an absolute one," he says.

Meanwhile, investment strategists such as Milton Ezrati of the Lord Abbett Funds see a glimmer of hope that the housing market is improving. They cite a fed funds rate that has been almost zero and home mortgage rates that have hovered below 5%.

There are a lot of fingers being pointed as people try to decide who was at fault in the global financial meltdown of 2008. The complex problems hit a crescendo in September 2008, when banks found themselves unable to make loans. Many blame lax financial regulation and consumers, who, along with the U.S. government, borrowed like there was no tomorrow. Then there were the lenders who carelessly made loans to subprime borrowers with poor credit.

Like many other value investors, Chris Davis, co-manager of Selected American Shares, says his performance was hurt by plunging financial stocks such as AIG, Wachovia and Merrill Lynch. "We mistakenly assessed the deterioration in their cultures," he says. "At any leveraged financial firm, culture is critical and it starts at the top. The chief executive officer must serve as the ultimate chief risk officer."

Going forward, however, Davis is on the lookout for "opportunities amid the chaos." He's focused on companies' financial strength and "franchise value." The business model of financial companies is not obsolete, he says. And he expects large banks and financial institutions to register returns on equity in line with historical averages because their business models are still in demand.

Davis is also investing in companies he considers global leaders because they have strong balance sheets and reasonable pricing power. He likes oil, natural gas, coal, turbine power, power plants and timber companies.

Muni Bonds in Turmoil
Meanwhile, municipal bonds have been out-yielding comparable Treasury bonds by a wide margin. But there is a greater danger of defaults. Investors are squeamish because states and cities are running large budget shortfalls. There is also a risk that some issuers may call their bonds.

Alex Grant, manager of the RS Tax-Exempt Fund, says now is the time to buy good credit because "historical spreads are at the widest ever." He stresses that national municipal bond funds are lower-risk than state-specific funds but don't sacrifice yield. And investors have minimal exposure to credit default/mortgage issues. But investors need to do their homework because insurance ratings are flawed.

Another bond manager, David MacEwen, co-manager of the American Century Diversified Bond Fund, was on the defense in 2008, when his portfolio avoided asset-backed subprime mortgage loans. He also shortened the duration of the fund. The portfolio was overweighted in Treasury securities and he used default swaps to cushion losses during the financial meltdown.

Now, though, he's maintaining a neutral duration of 5.75 because the yield curve has steepened. The fund has nearly 14% in 'AAA' rated corporate bonds and 37% in high-quality mortgage pass- through securities and collateralized mortgage obligations. He also invested in 'AAA' rated municipal bonds because of their historically high yields. MacEwen, however, is underweight in Treasurys.

"We added value with sector rotation," he says. "We used credit default swaps for protection with financial bonds and it worked. Today, you have to be very careful about credit selection, and bond covenants have been more important in security selection."

MacEwen's biggest concern is future inflation that could result from the U.S. fiscal stimulus package and the devaluation of the U.S. currency. As a result, he is prepared to use inflation hedge strategies in the portfolio.

Mike Balkin, manager of the William Blair Small-Cap Growth Fund, is an optimist, even though his fund was down about 50% in value in 2008. Eventually, when the economy improves, small stocks are expected to lead the way, and could mean double-digit or even triple-digit gains as market sentiment and business conditions improve.

"It is a very difficult time for investors," he says, adding that today could "be one of the great opportunities to buy small-cap stocks in my lifetime. You could make a tremendous amount of money in the next three to five years."

He sees the biggest gains in micro-cap stocks. The largest holdings in the fund include DG FastChannel Inc., United Online Inc., Smart Balance Inc. and Silicon Laboratories Inc.

International fund managers are not very optimistic about 2009, yet the valuations and growth rates of overseas stocks are more attractive than those in the U.S., says Thomas Melendez, a portfolio manager with the MFS International Equity Fund.

"There was no place to hide in 2008," he says. "But there should be less correlated equity returns going forward as economies in the emerging markets return to faster growth rates than those of the developing world."

Todd McCallister, co-manager of the Eagle Mid-Cap Stock Fund, invests in midcap and small-cap companies with strong balance sheets, good free cash flow and stable-to-improving profit margins. He believes 2009 could be another bad year because of a slow economic recovery, but that 2010 could be a great year for midsize companies and small companies.

"I'm buying high-quality stocks that are going down as much as lower quality," he says. "The stocks held by the fund are selling at or below book value but have strong cash flow and balance sheets."

McCallister particularly likes small insurance companies and reinsurance companies. These firms don't have the credit problems of other financial companies. Reinsurance company premiums are rising because other firms are looking to insurance as an alterative source of capital. The fund's largest holdings include AON, Reinsurance Group of America and Arch Capital Group Ltd.