As we've noted before, early this year fund investors were plowing tens of billions into funds – right before the market caved in. Now that market is rebounding, and inflows have improved again. This sort of buy high/sell low/buy back high is exactly why fund investors typically underperform the market, and why we try to do the opposite of what most investors do.

(Published 09/01/06) The last time we upgraded technology-oriented mutual funds was in August 2002, when we raised the category from a (Weak) to a (Neutral). At the time, the Nasdaq was in the 1,300 to 1,400 range – close to the crash low and near the index levels of 1996.

Why didn’t we upgrade to a (Interesting) or even a (Most attractive) given the opportunity in tech at the lows of 2002? The main reason was, at the time, there were better opportunities in other fund categories and our rating system is relative to the market.

Recent subscribers may think of us as negative on most fund categories, but at the time of our 2002 tech upgrade we had top ratings on several fund categories: small-cap growth, telecom, natural resources, utilities, convertibles, balanced, international diversified, global, global balanced, Japan, Asia, Europe, and Latin America. Most funds in these categories have beaten tech stocks over the three years following August 2002. Today, with valuations and investor optimism where it is, we’d be more excited about tech only if the Nasdaq was at 1,300.

In 2002 our rationale for the tech upgrade was–-

“…largely because the valuations of many tech stocks today are not that far out of whack with the rest of the market, adjusting for potential future growth. We don’t see tech stocks as a class dramatically underperforming the market as we have the last couple of years. We’d be perfectly happy if it takes five years for the NASDAQ to reach 2000 because from these levels that would be a 10% return per year. “

As it turned out, the turnaround in tech came on pretty strong after it finally bottomed in late 2002. The Nasdaq broke 2,000 – almost a double from the crash low – at the beginning of 2004 but has been holding at that level ever since. We downgraded the category back to a (Weak) in June 2004 (at Nasdaq 2,000).

Such is the nature of the stock market – often it takes an advance on the future prosperity of corporate America, and then has to sit and wait for fundamentals to catch up.

The Nasdaq took a quick dip to below 1,800 in 2004 after our summer downgrade and we upgraded back to a (Neutral) in September 2004. Along the way we’ve picked up some tech funds (usually ETFs like iShares Semiconductor – IGW) in our higher-risk portfolios during moments of weakness. Some we’ve sold after the Nasdaq ran up a few hundred points to the outer reaches of reasonable valuations.

We don’t see technology stocks as a particularly great value now, just reasonable compared to everything else, hence the upgrade to a positive rating – our first for tech. We expect a 6 to 8% return annually in the coming years, with some swings that may make it possible to see 10% or more with the right entry point.

Fundamentally, technology stocks are risky and sensitive to an economic slowdown (computer budgets get slashed during hard times – at home and at work). More important to us, investors are not that interested in technology anymore – they see better upside abroad or in commodities. Mega-cap tech, the old 1990s growth favorites, like Dell (DELL), Intel (INTC), and Microsoft (MSFT), are particularly out of favor compared with just about any time in the last decade or so (the market crash bottom of 2002 being the only possible exception). Some of this is warranted as growth going forward is going to be slow and margins compressed. Without a major recession it’s unlikely these sorts of companies will fall on much harder times – or at least do no worse than most other companies. We’d have to see actual panic selling in tech and even better valuations – maybe Nasdaq 1700 or so – to upgrade to our highest rating, but funds investing in tech stocks should perform better than most going forward.

Tech ETFs are among the least favorite of the more mainstream ETFs around. Total assets in all no-load tech funds and ETFs are just under $20 billion today. For comparison, near the bubble peak just two tech funds collectively had over $20 billion in assets (T.Rowe Price Science and Technology - PRSCX and Janus Global Technology - JAGTX).

More stunning is the fact that fund investors have lost more money in tech funds in the 2000-2002 crash than currently is in tech funds. They even lost more money collectively than was made in all those hot, triple-digit return years of the late 1990s. Buy high, sell low.

It’s almost impossible to find a tech fund that isn’t sitting on tens of millions – sometimes billions – in loss carryforwards from the crash. Paper gains quickly became very real losses for millions of investors. Don’t expect any taxable dividend distributions anytime soon in this category.

It’s a good idea to invest in fund categories that other fund investors have lost gobs of money in. It’s proof you are doing the opposite of other fund investors – and doing what the other investor isn\'t is the cornerstone of the Powerfund strategy.

Category Rating: (Interesting - should outperform the market and 60% of stock fund categories over the next 1 to 3 years)

Previous Rating: (Neutral - should match the market\'s return and perform in the middle of other stock fund categories).

Expected 12-month return: 8% (raised from 6% in our last favorite fund report)

In July, safer investments performed better than more speculative ones. The Dow was up 0.45%, the S&P500 gained 0.62%, and the S&P100 – the largest stocks from the S&P500 - rose a solid 1.7%. The Russell 2000 small cap index was down 3.25%, while the Nasdaq fell 3.71%. Larger cap foreign stocks more or less stabilized and moved up with the U.S. market, but smaller cap foreign stocks had some trouble. Bonds gained as interest rates headed downward – so much for the big interest rate increase. The Vanguard Total Bond Index was up 1.35% for the month.

Inflation is increasing and economic growth is slowing. The Federal Reserve knows they created inflation with their recent stint of economic stimulus, but is worried attempts to cool the economy could cause a major recession. If they take a wait and see stance, inflation could spiral out of control even with a slow economy – the dreaded stagflation of the 1970s and early 80s