Mutual Fund Research Newsletter 1st Qtr. 2005. Copyright 2004 Tom Madell, PhD Dec 29, 2004 Dear Investor: In previous years, our beginning of the year newsletter was usually our most widely read letter for the rest of the year. People, it seems, look at the new year as a time to re-evaluate their investment strategy. Our previous beginning of the year recommendations have enjoyed repeated notable successes at forecasting which fund categories appear most likely to do well in the upcoming year(s). This past year's 2004 beginning of the year selections will likely outperform the major stock and bond indices by large margins. For 2005, arriving at a reasonable allocation decision between stocks, bonds, and cash appears to be fraught with more risks than usual. Although stocks have been doing well since March 2003, we feel it potentially dangerous to assume that the approximate 45% increase in the S&P 500 since then will continue. The same can be especially said for the even more outsized gains in small-cap blend and value, mid-cap value, energy, and REIT funds. Therefore, although we can't be certain that these still on-going trends won't continue a little longer, we feel that it is wise to reduce expectations for all categories of stock funds for 2005 and possibly beyond. Right now, if we had to venture a guess, we would expect only minimally positive returns for stocks in general next year in the range of about 3-6%, with the risk of returns lower than this greater than the risk of higher returns. However, down thru the years, experience has shown that such long-range forecasts of the market by anyone can frequently be way off the mark, so our rather ho-hum view of the market could easily change for better or worse by the end of any given Qtr. based on new data. Why such a tepid forecast? Mainly because we feel most categories of stocks have gotten ahead of themselves. In fact, for the small-cap blend and value funds, returns do not at all reflect the overall bear market results that otherwise prevailed in 3 of the past 5 years. (Average small cap blend up 12.5% per year; average small cap value up 16.5% per year.) Couple this with above average PE ratios, rising short-term interest rates, and the lack of a significant correction in nearly 2 years, and it makes us think that there are few areas within the US market that are undervalued as there were at the beginning of each of the prior 4 years. (The current exception appears to be the growth category.) Given our current analysis, we are therefore recommending a somewhat reduced position in stocks for our Moderate, Aggressive, and Conservative Model Portfolios. (see below). We would reduce our exposure to stocks perhaps even more if we thought that bonds offered a good alternative as they so often had in the last 5+ years. But in 2005, we actually are now expecting cash to outperform most segments of the bond market. While good money market funds (eg Vanguard's) will likely return somewhere in the range of 3-4% for '05, we don't expect to see typical bond funds return any more than about 0-2% given that the loss of principal should nearly offset dividends earned. The one category of bond funds we are still thinking will yield potentially good returns is international bonds, although even here, there is just so far these funds can go given how far they have already come. (Average return of nearly 12% per year for the category over the last 3 years which is nearly on a par with the return over the same period for the average small cap blend stock fund.) Here then are our specific Model Portfolio recommendations for 2005, subject to quarterly revisions as the year progresses: Moderate Risk ============= Stocks 55% Bonds 25% Cash 20% (& alternate investments) Stock Funds +++++++++++ Category Our Favorite Allocation Large Growth Vanguard Growth Index 20% Equity Income T. Rowe Price Equity Income 20 Foreign Vanguard International 25 Growth Small Growth Vanguard Explorer 10 Large Value Vanguard Windsor 15 Mid Cap Blend Hussman Strategic Growth 10 Bond Funds ++++++++++ Category Our Favorite Allocation International American Century 20% Intl Bond High Yield Vanguard High Yield 20 Inflation- Vanguard Inflation 15 Protected Protected Sec Long Term Vanguard Long 30 Corporate Term Inv Grade Short Term PIMCO Total Return 15 More Aggressive Investors ===================== Stocks 75% Bonds 15% Cash 10% (& alternate investments) For more aggressive investors, also consider stock funds focusing on Japan, emerging markets, and mid-cap growth and bond funds in emerging markets and the "multisector" category. More Conservative Investors =========================== Stocks 45% Bonds 30% Cash 25% (& alternate investments) For conservative investors, we still recommend the same stock funds as we did in our end of 2003 Newsletter (see http://funds-newsletter.home.att.net/2004_1.htm ). Best wishes for the New Year! Tom Madell http://funds-newsletter.com