Magellan Head Betting Rates Headed Lower Troubled Seas May Lie Ahead For Largest Mutual Fund

Investors in America’s largest mutual fund might not know it, but they are betting that the Federal Reserve is about to ease interest rates - and sharply.

In a speech last week in New York, Jeffrey Vinik, manager of the $44 billion Fidelity Magellan fund, spoke at length about what is, for a mutual fund manager, a risky proposition - the direction of interest rates.

The Federal Reserve, Vinik predicted, will lower short-term rates “very soon and very rapidly over the next several months.”

Specifically, Vinik forecast that the Fed could ease rates as many as “four times by the end of the year” in response to signs of a slowing economy.

The prediction holds significant implications for Magellan shareholders. All of Wall Street knows about the fund’s huge bet on technology stocks, which account for more than 40 percent of Magellan’s assets.

The strategy has paid off so far this year, as Vinik has guided Magellan to a gain of more than 18 percent.

After technology, the fund’s second-largest group of investments, at 25 percent of assets, is in cyclical stocks, including big-ticket industrial manufacturers like Caterpillar, Deere and Parker-Hannifin.

Because the earnings of such companies typically fall as the economy slows, a move by the Federal Reserve to extend the economy’s growth by lowering interest rates could greatly improve their prospects.

But there is also great risk in relying on lower rates to keep the prices of cyclical stocks moving up. While the Magellan fund’s Gargantuan size gives Vinik an ability to make self-fulfilling prophecies that most mutual fund managers don’t enjoy, his influence on Alan Greenspan and company is less of a certainty.

There is no better example of Vinik’s ability to move markets than his bet on technology stocks, which have been on a several-year rally. In September 1992, three months after Vinik took over Magellan, only 7.8 percent of its $22 billion in assets were in technology stocks.

As he has increased Magellan’s stake, other mutual funds and institutional investors have followed his lead.

Those stocks have cooled off in the last two weeks, a downturn that Vinik says is simply the sector’s traditional summer doldrums. “I think the best technology stocks could go up for 5 to 10 years,” he said. “We’re only two years into that bull market.”

But the two big sector bets together leave the Magellan fund open to the possibility of a double whammy if, for example, the weakness in the dollar dissuades the Fed from lowering rates, undermining his cyclical-stock argument, while at the same time technology stocks cool further.

Vinik offered no apologies for his outlook, which he admits flies in the face of reason if the economy is indeed taking a breather. “How can you own cyclical stocks when the economy is slowing down?” he asked rhetorically during a speech to subscribers to Worth magazine, a financial monthly published by a unit of FMR Corp., parent of the Fidelity mutual funds.

He answered with his interest rate prediction. “As bullish as I am on technology stocks right now, I think the best opportunity in the U.S. stock market is in cyclicals,” Vinik said.

While companies like Caterpillar have reported huge earnings gains, “most people think this is the top of the cycle,” he continued, adding, “I think we’re going to have a pause and then they’re going to take off again.”

Vinik distinguishes between what he calls early-stage cyclicals - industrial-equipment makers, automobile and auto parts companies, and home builders - and late-stage cyclical companies, including retailers and makers of consumer staples, industries he says suffer from an excess of inventory.

As the latter companies begin to burn off that inventory, built up over the last year as the economy has grown, “prices for those commodities go down, and the stocks follow,” he said. “The early cyclicals go against interest rates. When rates go down, the companies I own go up.”

If he’s wrong, of course, the Magellan fund could be in for a rough stretch.