The roller coaster ride that was the first half of 2006 may be over, but fund investors best not unbuckle their seatbelts just yet. The second half could very well provide even more thrills and spills. Stocks dipped in January and then climbed steadily until early May, when inflation fears and a tough-talking Fed suddenly caused a sharp drop in equity prices. The situation quickly leveled off before the quarter's end, however, enabling the major indices to finish fairly close to where they started. The Dow gained 4% from January through June, the S&P 500 rose 1.8% and the Nasdaq fell 1.5%. But while the indices' final results may not reflect the bumpy ride of the first half, investors will not soon forget the whiplash they suffered. Shareholders of emerging markets and small-cap growth funds are certainly finding their necks especially sore, and many have lost their stomachs for excessive risk. For a quick first-half recap as well as a look ahead to the rest of the year, TheStreet.com checked in with Ned Notzon, chairman of the asset allocation committee at fund giant T. Rowe Price ( TROW). TheStreet.com: What is your assessment of the first six months of 2006? Ned Notzon: We think that the economy has been growing moderately. Generally there has been a concern about inflation continuing to increase. The week before the June FOMC meeting, at least three governors raised their concerns about inflation. But when the Fed actually met, they did not sound nearly as extreme, and investors were thinking more about a moderately slowing economy. Our role is to look at stocks vs. bonds, and I don't think we are going from stocks straight to cash just yet. So what is your split between stocks and bonds now? For a balanced fund that's usually 60% stocks and 40% bonds, we would be 65% stocks and 35% bonds, or a 5% overweighting in equities. That's because we are more concerned about bonds than we are in love with stocks.
How does your asset allocation stack up in terms of sectors going forward? In domestic equities, we are overweighting large-cap growth and funding this move by taking money from large-cap value and small-cap stocks. Actually, we've been doing this gradually since 2004. That said, our shift to underweighting small-cap stocks has not really come to fruition, but we suspect it will fairly soon. What about international stocks? We are neutral when it comes to international stocks. They certainly have done well recently, and we are glad about that. We think long term they should do quite well because there are more opportunities for productivity increases in other countries. Europe still looks forward to doing a lot of the things we already did in terms of consolidation and automation. I say Europe because they are 70% of the EAFE, so it has a large impact on the market. But in terms of implementing these changes,
Europe has run into a lot of obstacles. Changing work practices has been difficult for them. In the long term, these changes will have to come about because if the workers don't come to the capital, then eventually the capital will come to the workers. So it is going to happen at some point over there. But we are still being cautious, so we remain at a neutral weighting. What are the biggest risks to your outlook? A recession. The Fed could overtighten, and that's happened in the past. Or there could be a trigger event that changes investors' perception of risk. Actually, comparing the last half of 2005 to the first half of 2006, people were much less concerned with risk back then. And there was not much of a premium for taking risk. But this year they became much more concerned about risk in the equity sectors. So if you had a trigger event which causes people to think about risk again, it could change our thinking.
You don't think the selloff in May -- especially in high-beta groups like emerging markets -- was enough of a trigger event? That was an overdue correction and in the end did, not seem to scare too many people away. Those markets came back fairly quickly. What should people do with their high-yield bond fund allocations? We are slightly below neutral right now. That said, we like high yield, and more to the point, we really like our own high-yield funds because they tend to buy companies with good business models that won't default in a recession. The reason we are slightly underweight high yield, however, is because the spreads are so incredibly tight. At some point there has to be a widening. Last month they widened a bit, and when they widen a bit more, then we will go to a neutral and then probably to an overweight. In general, people tend to overestimate the risk in many high-yield companies.