Greetings to our new and long-term subscribers alike!

This issue covers:

-Our Philosophy of Investing
-Our Current Assessment of Today's Investment Environment
-My Suggested Allocations
-How Our Prior Recommendations Have Been Doing

As you should know by now, the purpose of this quarterly newsletter is to help you do well in your investments, but without taking undue risks. (Editor's note: Beginning Jan. 2008, we started posting new Newsletters every month.) Naturally, many sources of investment advice, or even specific "hot" stocks or funds, may appear to be the way to generate outsized returns. That is apparently why many aggressive investors seem to merely shrug when they see my site and my past recommendations.

But what goes up like a rocket can (and usually) does come down like a rocket. And so, while my recommendations may not appeal to some aggressive investors, we feel we have a better chance of coming out ahead in the long run by helping people steer past the kind of investments that have the potential for serious corrections which can easily wipe out years worth of prior gains. (Isn't this what happened in the dot.com era of not that long ago?)

We do at times recommend particularly aggressive funds. Take, for example, our recommendations on 3 overseas funds of a little more than 1 year ago (see results of our prior recommendations below). But for every investor who beats the market averages, there must be another who loses by an equal amount. Thus, always betting on more aggressive choices will likely work only half of the time; the other half time, it will likely be a losing bet.

We like to think that our very consistently market-outperforming results reported on our website show that ours is a better way of investing than followed by most. But we recognize that it is human nature to think that if there appears to be way of doing better than average, most people conclude that they are one of those who can do it. But the sheer complexity of investing, its "counterintuitive" nature, and the law of averages dictate that the best the typical investor can expect to do is equal the market averages, less the expenses of their funds.

So, many experts say it is nearly impossible to do consistently better than average. They therefore eschew any approach to investing other than just buying mainly index funds, and by consequence, also advise disregarding newsletters such as mine.

We disagree to the application of both of the above orientations. We believe that one can do a little better than the markets. Not by expecting to always win by choosing the most aggressive investments, nor by assuming that no investment advice has any value. Rather, my quarterly newsletter is based on the assumption that good research can and usually does pay off. It has year after year for me. Otherwise, I would have stopped producing it years ago and closed down my web site, as have so many other smaller financial sites. (We recently completed our 8th year of doing our free Newsletter - and most of our advice over these years has proven to be pretty good. Some people might even say it has been remarkably good!)

What to Make of Current Market Conditions?

Right now, the ongoing bull market of the last 4+ years in stocks appears to remain intact. On the contrary, most bond categories continue to show, at best, mediocre results. The big question, though, is whether some of the negatives facing the US economy wil cause these 2 asset classes to switch fortunes. For example, if the housing market continues to fall further, will this affect enough people seriously enough to cause a general decline in consumer spending? That would result in lower corporate profits likely damaging stock prices, and at the same time, cause the kind of weakness that favors many categories of bonds.

Unfortunately, no one can claim to have a sure answer to this question. The financial media are full of people making predictions on both sides of this issue. But it is our position that right now, at least, the answer is just not knowable. Therefore, rather than come down on either side of the question, we prefer to suggest a neither very bullish stock position, nor a bearish position which might favor bonds. In fact, for those of you who may not be aware of it, this newsletter arrives at part of its strategy by examining the overall trends that the markets have shown over the last 1, 3, and 5 years in arriving at our Model Portfolios. (The other element in our strategy involves an analysis of economic data. For example, current inflation data, as seemingly confirmed by recent Fed meetings, suggests that inflation may still have the potential for running a bit too high. This adds to our relative bearish towards bonds.) We favor fund categories that have been doing well for at least a year (and usually 3 years), but remain somewhat "undervalued" when looked at over the last 5 years.

Right now, most categories of stock funds have definitely been in a bull market when looked at over each of these above periods. The one exception would be Large Growth which has only started to do really well over the last year (Foreign stocks, especially emerging markets, with the exception of Japan, have been in what we would consider a "super" bull market with average yearly returns roughly in the 20 to 40% range for each of these periods.)

On the other hand, generally speaking, US Bond funds, after languishing somewhat for much of the last five years, have started to improve, but only slightly, during the last 12 mos.

Therefore, the best snapshot that we have suggests that UNLESS something dramatically changes, such as the potential spillover of the housing/subprime situation into the rest of the economy, we currently think the bull market in stocks is likely to continue as the prevailing trend. And, continuing mediocre bond returns can also be expected. (In fact, bond returns may get even poorer if the economy and underlying inflation prove to be stronger than the Fed deems desirable, resulting in rising, rather than falling rates. An actual trend of falling rates would be a magic elixer for the bond market.)

Given these considerations, we carefully suggest that stocks may be given a slightly higher allocation than our previous 52.5% recommendation. Although we feel it is late in this bull market cycle, and that such cycles must inevitably end, we do not feel it is too much of a stretch for moderate risk investors to be invested at a 55% level. (This is still below what we would consider a "normal" allocation of 60% to stocks.)

Also, perhaps somewhat against the average investor's reluctance, we are starting to see, for the reasons mentioned above, possibly real outperformance opportunities in the Large Growth category.

Regarding bonds, we remain more bearish than usual, and even urge a reduced allocation from 25 to 22.5%. We are especially pessimistic that long term bonds are the place to be until the Fed starts cutting interest rates, something we don't see as likely for the foreseeable future.

Let me reiterate something that long-term readers will likely have heard me say before: One of the best ways to deal with your investments is not to think that you can ride your most successful investments forever. (EXCEPTION: If you truly are that rare investor who buys and has the fortitude to hold investments with absolutely no thought of ever taking a profit, or protecting against losses when they inevitably go through some extremely underperforming periods. If so, you may indeed be like a real estate investor who buys a house and holds it his entire lifetime, seeing the value go up perhaps 10 or even 20 times over. Then, a newsletter such as this is not likely going to add much value for a person like you. But how many investors really do this? And, conversely, how many would have been better off had they trimmed down their winners in the late 1990s and avoided much of the harm done in the early 2000s?)

Therefore, in spite of my somewhat positive outlook on the stock market overall over a time span encompassing at least a year or two, I have been urging anyone who asks me to continue taking some profits out of funds that have been going up at an annualized 20 or 25% rate over the last 4 to 5 years. These include, for example, emerging markets and European stocks.

My New Suggested Allocations

Stocks 55%

Bonds 22.5%

Cash 22.5%

Our large allocation to cash is mainly a result of our belief that bonds will barely, if at all, outperform cash. So why take on the interest rate risk inherent in bonds if rates do rise? And having a large cash position can prove useful in the event of a significant stock market correction. Thus, if and when any of your chosen funds suffers from a 10 to 20% correction, consider adding a little more into that fund. (Far too many people take such a downdraft as a time to pull money out of a fund, but usually we would say the reverse is the way to go.)

For more aggressive investors, we recommend 65%/15/20 (Stocks/Bonds/Cash)

For conservative investors, we recommend 40%/25/35.

These allocations are designed with the idea of outperforming the market averages over the next few years. I might add that being 55% in stocks is unlikely to outperform being 100% in stocks. However, for the average investor, I think the risks are too great not to have at least some of your overall portfolio in cash and/or bonds.

Category Recommendations

Stocks

Category --- My Personal Pick ---------- % of Your Stock Allocation

Large Blend -- Vanguard Growth & Inc -----27.5% (vs. last quarter: 32.5%)

Large Growth -- Vanguard Morgan Gr ------ 12.5 (5)

Large Value -- T. Rowe Price Equity Inc - 12.5 (15)

Mid-Blend --- Vanguard Mid-Cap Idx ------ 15 (15)

International --- Vanguard Internat Gr -- 25 (25)

Asia/Pacific -- Vanguard Pacific --------- 7.5 (7.5)

Note: My personal picks are generally funds that have relatively moderate risk; if you are seeking even higher returns (with higher risk), pick funds within my recommended categories that are managed with the hope of advancing more than most "ordinary" funds within that category.

Bonds

Category --- My Personal Pick ---------- % of Your Bond Allocation

Long-Term -- Vanguard L-T Inv Gr or a -------------(pick the muni bond fund
------------Vanguard L-T muni bd fund ---25% (35) if in a moderately high tax bracket)

Interm ------ Vanguard GNMA ------------- 25 (25)

Short Term --- Vanguard S-T Inv Gr ------ 30 (15)

Internat ----- Amer. Cent. Intl Bond ---- 10 (15)

Hi Yield ------ Vanguard Hi Yield --------10 (10)

Note: See our July 27 Alert on our website regarding High Yield bonds.

A Look at How Our Past Recommendations Have Been Doing

From 1 Year Ago

A year ago, in our 3rd Qtr '06 newsletter, our two largest stock category recommendations were International Stocks and Large Blend. Each carried a suggested 25% allocation of your stock portfolio. As of June 27, 2007, the average Foreign Large Cap Blend fund showed a 1 yr return of nearly 32%; US Large Blend funds were returning nearly 23%. The International results exceeded every other US diversified fund category and the US Large Blend results were ahead of all the Small Cap categories. Both results were in keeping with what we expected and discussed within the newsletter.

Our next highest allocation (17.5%) was to Large Cap Value. This too was a winning choice, returning over 24% over the last year. (For comparison, the S&P 500 returned approximately 0.5% less.)

Our next highest choice was Mid Cap Blend at 15% of your stock portfolio. This category also beat the 500 Index, returning about 24.5%.

Our final 2 categories were much less successful, with Japan recommended at 10% and Long-Short at 7.5%. Actual results were only in the 8 to 9% range. But all told, had you followed our recommendations, the remaining 82.5% of your portfolio that exceeded the Index would have more than made up for the 17.5% that trailed it. And our choices of a specific fund within each of these categories exceeded or equaled the category averages in 4 out of 6 cases.

Although we usually focus on selecting moderate risk funds, we occasionally suggest funds that may produce even better returns. In our 2nd Qtr 2006 Newsletter, we urged considering investing in the Asia/Pacific region, not including Japan. A specific choice we recommended was T. Rowe Price New Asia. We also recommended Janus Overseas, an aggressive foreign fund that has a moderately high exposure to emerging markets. We also recommended considering, although not as enthusiastically, investing in a fund that invests in India, namely the Matthews India Fund. As of June 27, 2007, had you followed our advice, your 1 yr. return would have been:

T. Rowe Price New Asia ++++ 72.2%
Janus Overseas ++++++++++++ 52.6%
Matthews India ++++++++++++ 66.1%

These latter results exceeded even our own moderately bullish expectations. While we still like the long-term prospects for the above 3 funds, we would be very cautious about recommending new purchases at their current lofty levels.

From 3 Years Ago

In July 2004, we were somewhat more bullish than today with a 60% recommended allocation to stocks. (We recommended an 80% allocation for more aggressive investors.) Here were our specific recommendations for your stock portfolio, suggested allocation, and approximately how well they have done on an annualized basis over the last 3 yrs:

Foreign (25%) +++++++++++++++++++ 21%

Large Growth (20) ++++++++++++++++ 9.5

Large Value/Equity Income (30) ++ 14

Small Blend (10) ++++++++++++++++ 14.5

Mid Cap Blend (10) ++++++++++++++ 15

Japan (5) +++++++++++++++++++++++ 10

Compare these results with the 12% ann. return for the S&P 500, and the 3.9% ann. return of our bond benchmark for the 35% suggested allocation to bonds. And our results from stock recommendations made 5 years ago (see http://home.att.net/~funds-newsletter/letter65.htm ) appear to have easily beaten the S&P 500 as well.

Look for further more complete performance updates on our main web page in the near future. Continued wishes for many happy returns!

Tom Madell, PhD
http://funds-newsletter.com
e-mail: funds-newsletter@att.net

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