This Year's Reality Check Produces Cautious Outlook.

IT has been a while since mutual fund investors looked ahead to a new year with such subdued expectations.

They're watching the U.S. stock market zigzag through the final weeks of its worst year since 1990, measuring by such broad indicators as the Standard & Poor's 500 Index (down 7.4 percent) and the Dow Jones Industrial Average (off 6.1 percent).

That's not even to mention the Nasdaq Composite Index, the standard-bearer for many of the 1990s' glamorous growth companies. It's down 31 percent from the start of the year and 44 percent from its high on March 10.

"We're in a bear market," said Greg Smith, chief investment strategist at Prudential Securities Inc. "Now we're in the phase of 'how bad does this get?""

This is not at all the sort of environment that encourages cockeyed optimism, or "irrational exuberance" in the phrase made famous by Chairman Alan Greenspan of the Federal Reserve during the long 1990s boom.

In one eye-catching development, some stock fund managers have abjured their vows to stay "fully invested" at all times and have built up their cash reserves. Their holdings in short-term money market securities jumped to 6 percent of assets in October, according to the Investment Company Institute, from 5.3 percent in September and 5 percent in October 1999.

Yet fund investors, by all the evidence, have stayed unperturbed. Each month in 2000 they have bought more stock-fund shares than they sold. Through the end of October, according to the Investment Company Institute, the net inflows totaled $291 billion, more than stock funds have ever attracted in a full year.

As a group, fund investors never took a big plunge into Internet funds or other specialized sector funds. The way I added up the numbers last spring, when the "tech wreck" was still in its early stages, sector funds accounted for just 5 cents of every dollar in long-term (stock and bond) funds. Since then, by my rough calculations, sector funds' market share has edged up to 6 percent, even with the sharp drop in many tech stocks.

The fund-owning public has by no means avoided punishment entirely. Going into the 2000 sell-off, computer, telecommunications and other "technology" stocks had climbed so high they accounted for about 35 percent of the market value of the S&P 500 index. By early December their share had dropped to 27 percent, and even investors in broad-based index funds felt the pain.

Even so, fund investors -- and some fund managers - are "looking across the valley," to use a bromide heard in brokerage offices during bad markets of yore.

"I am finding an extraordinary number of bargains," Mario Gabelli, chief executive of Gabelli Asset Management Co., which manages $25 billion in funds and other assets, said at a year-end meeting with reporters.

"I'm particularly sanguine about 2002," he joked. "I just want to survive 2001."

The danger in looking across the valley, of course, is that you don't watch where you're stepping and tumble into a ravine. The news on economic growth and corporate earnings is expected to be full of potential pitfalls through at least the first quarter of 2001.

It's reassuring, though, that Greenspan has already signaled that he's sensitive to the hazards investors are worried about. It's also comforting to remind yourself that policymakers and legislators are in good position to lower interest rates and cut taxes to stimulate the economy, if that course of treatment is indicated. Inflation is low and the federal budget is running a big surplus.

After raising interest rates three times in late 1999 and thrice more in 2000, "the Fed's going to have room to ease, and perhaps ease significantly," said Alan Levenson, chief economist at T. Rowe Price Associates of Baltimore, which manages $180 billion including $118 billion in mutual funds.

A tax cut of some sort? "Count on it," says Fred Taylor, chief investment officer at U.S. Trust Co. of New York, which manages $80 billion. The prospect of economic weakness improves the political prospects for tax-cutting, though maybe not of the size and scope advocated by President-elect Bush during the campaign.

Hopeful notes aside, though, the past year has served as a reality check. In the investment markets, no perpetual prosperity machine has been perfected yet.

Chet Currier is a columnist for Bloomberg News.

Long Run of Prosperity Hurt View of Funds

The poet William Matthews once wrote, "The penalty for bigamy is two wives."

To my mind at least, the line laments how success and abundance in life so often under cuts itself - the curse of getting what you want. I bring this up because it strikes me as a jumping-off point for a promising avenue of inquiry: the economics of abundance.

We already study what may happen when demand increases faster than supply (rising prices, maybe inflation and shortages); we tear less from economists about what results when you get a long-term surge of supply throughout the economy, and much demand is instantly satisfied.

As we just saw in the late 1990s, long periods of rising markets bring discontent in many guises: Why isn't my fund doing as well as the top performers? Where do these guys get off charging such high management fees? Now they're sticking me with a tax bill for a capital gains distribution!

Year after year of 20 percent gains, and before you know it ennui sets in.

In many circles "funds aren't fun any more," said Neil Bathon, president of the consulting firm Financial Research Corp. in Boston, at a year-end meeting with reporters. He cited this statement from a financial-planning publication: "It really doesn't matter if their mutual fund earns 10 (percent) or 40 percent. In their (clients') minds, funds are boring."

You could almost hear a sigh of relief from some commentators when 2000 brought a weaker stock market, breaking the Internet bubble. 'Interesting, isn't it, how Wall Street uses the term "correction" to describe market declines? Almost as though prosperity creates a sense of something wrong.

For whatever reason, top regulators on the mutual fund beat feel compelled from time to time to restate what, should be understood far and wide - that these have been terrific times to be an investor, thanks in no small measure to an excellent vehicle called mutual funds.

As Paul Roye, director of the Securities and Exchange Commission's division of investment management, put it in a speech last spring: "The fund industry has done more than perhaps any other participant in the financial services industry to offer solid products that meet the real financial needs of millions of Americans.

This isn't boring, it's delightful. It's not a problem, it's a solution. Don't let the quibblers and the naysayers persuade you otherwise. The penalty for cynicism is disappointment.