A RALLY TO REMEMBER

The stock market’s second-quarter performance was such a hit, Wall Street decided to virtually replicate it in the third quarter.

Lifted by a rising tide of hope for a sustained economic recovery, share prices worldwide continued to rebound powerfully in the three months ended Sept. 30.

The benchmark Standard & Poor’s 500 index posted a total return of 15.6% in the quarter, just slightly less than the 15.9% gain in the second period, as more investors grew confident that stocks’ 12-year lows in early March wouldn’t be revisited any time soon.

And as in the second quarter, the third-quarter rally was broad-based, pulling up nearly every U.S. stock industry sector as well as the vast majority of foreign equity markets.

For stock mutual fund investors, that meant it was nearly impossible to lose money -- other than in bear-market funds that were betting on another plunge in shares.

The average U.S. stock fund gained 15.5% in the third quarter after a 16.8% rise in the previous quarter, according to Morningstar Inc. Year to date through Sept. 30 the average fund was up 23.8%.

Although that’s a big help in rebuilding Americans’ devastated nest eggs, it will take much more of the same just to get back to even after last year’s market meltdown, when the average domestic stock fund plummeted 36%.

In recent months, a growing number of investors seem to have decided that the risk of another stock plunge outweighs the potential for recouping more of what they’ve lost.

Even as the market continues to bet on better times ahead for the economy -- the Dow Jones industrial average reached a new 2009 high Friday, closing at 9,864.94 -- domestic stock mutual funds overall have been suffering net cash outflows every week since mid-August.

Many investors with cash to put to work have been pouring it into bond funds rather than stock funds, opting for the relative safety that fixed-income investments can provide.

Some financial advisors say investors’ caution about the 7-month-old rebound in stocks is well-founded.

Steve Lockshin, a Los Angeles-based advisor at Convergent Wealth Management -- a firm that serves high-net-worth investors -- believes that U.S. equities are overvalued after the 58% surge in the S&P; 500 index since early March.

In the face of still-worrisome economic fundamentals, Lockshin said, “I feel that people are willing the market to go up.” He’s keeping the stock-fund portion of clients’ portfolios lighter than usual, he said, and is holding more assets in cash than he did before the markets’ calamity last year.

It’s understandable that there’s a strong temptation to pare back on stocks at this point. Although the economy has been improving on many fronts the employment situation remains dismal, and many companies and individuals can’t get credit from banks.

What’s more, a crucial question is whether the economy could quickly slide into a black hole if the government tried to pull back from the unprecedented financial life support it has provided.

All of this has made for massive uncertainty about 2010. Will it bring another recession and deflation? Or will inflation begin to surge because of the huge sums of money the Federal Reserve has pumped into the financial system?

What if the dollar crumbles? Then again, what if it soars because the surprise is that the U.S. economy mends faster than expected?

The continuing rebound in stocks has given investors a chance to catch their breath and try to prepare for whatever may be next. The challenge is to maintain a portfolio that reflects your basic expectations for the economy but that also is hedged for the unexpected.

Here are three basic strategy ideas to consider:

* Don’t fight the cycle. Nick Thakore, manager of the Putnam Voyager fund in Boston, worries that too many investors don’t appreciate the economy’s natural ability to rebound from recession.

Although he doesn’t minimize the long-term, or “secular,” challenges the U.S. economy faces, including the need for consumers to reduce debt and boost savings, “Secular concerns have kept people from embracing a cyclical recovery,” Thakore said.

Even after Wall Street’s gains of the last six months, he said, he still considers this to be “one of the greatest stock-picking environments we’ve ever had,” given how depressed many shares still are compared with their 2007 or 2008 highs.

Putnam Voyager, up more than 55% year to date, has benefited from sharp rebounds in stocks such as Apple Inc., Time Warner Cable Inc. and CVS Caremark Corp.

As corporate earnings recover, Thakore believes that there’s much more room to run in shares that are still well below their previous peaks. He cites insurer Aflac Inc., which crashed from nearly $70 in 2008 to as low as $11.50 in March and is back to $45. The company, Thakore said, was unfairly lumped in with other financial firms, even though Aflac didn’t share their troubles.

* If in doubt, stick with high quality. Shares of small and mid-size companies have performed better than big-company shares this year, on average -- which usually is what happens in the first stage of a new bull market.

The average small-cap growth stock fund was up 29.2% in the nine months through Sept. 30, compared with a gain of 26.4% for the average large-cap growth fund, according to Morningstar.

But if the U.S. economy’s recovery will be a tough slog, the advantage could go to bigger firms that have critical mass and can benefit from potentially faster growth overseas.

Joseph Milano, manager of the Baltimore-based T. Rowe Price New America Growth fund (up 41% in the first nine months), said he was expecting only modest growth in the economy next year, at best.

So he’s focusing his stock-picking on firms that have lagged the market this year but whose prospects appear solid even if the economy struggles. “I’m trying to find names that are good growth companies but that haven’t fully participated in the rally,” Milano said.

He counts Wal-Mart Stores Inc. in that group. The stock, up 18% last year, is down 11% this year as many investors have jumped into retailers whose shares were more beaten-up in the market sell-off.

Given the many constraints on consumer spending, “I think you still want to be in the ‘value’ area of retailing,” Milano said.

He also thinks that high-quality stocks selling for relatively low price-to-earnings ratios offer some protection if interest rates rise, which could depress price-to-earnings ratios in general as investors become more risk-averse.

* Have hedges that can buffer your portfolio if things go wrong. Convergent’s Lockshin is in the camp that expects inflation to rise as a result of the Federal Reserve’s trillion-dollar-plus cash injection into the financial system.

To hedge against the inflation risk, Lockshin has about 10% of the typical client’s portfolio in hard assets, with about half of that 10% in gold. He uses the SPDR Gold Trust exchange-traded fund, which invests directly in bullion and tracks the metal’s market price.

Gold is security against panic, Lockshin said. It’s a useful portfolio buffer now, he said, although he doesn’t expect to own it forever.

Another way he’s buffering clients’ portfolios against possible inflation, Lockshin said, is to keep fixed-income investments in relatively short-term securities, meaning bonds maturing in the next few years rather than longer-term issues.

Like many advisors, he’s also maintaining a significant investment in foreign stocks -- a strategy that has become a no-brainer for many Americans in this decade. Owning foreign shares is a way to have a stake in what is likely to be faster growth in many overseas economies than in the U.S. economy. It also offers some protection against a further decline in the dollar, because it provides investors with exposure to rising foreign currencies.

The average foreign stock mutual fund is up 34.3% this year, compared with the 23.8% gain in the average domestic fund. Part of that better performance has stemmed from the sharp rebound in many foreign markets, and part is a function of the dollar’s decline this year.

Of course, if the global economy as a whole were to slide again, foreign stocks almost certainly would plunge with U.S. shares. If you’re fearful about the economy falling off a cliff, there’s only one asset that you can count on holding its value: cash.

Vincent Sellecchia, co-manager of the New York-based Delafield Fund (up 47% this year), says he isn’t finding much value in stocks at current prices, so he has boosted the fund’s cash holdings to about 20% of assets.

If stocks come down, he said, he’ll be prepared to buy.

“We’ve taken a more conservative view given how the market has come so far so fast,” Sellecchia said.

“We’d rather be patient.”

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