Our Current Perspective on the Markets

To be honest, I don't like what I see on the part of investors these days. In a nutshell, there appears to be too much confidence, most likely bred by 4 straight years of almost continually rising stock prices. What we have now looks more like a traders' market rather than a place where long-term investors should be buying. Yet, the latest reported data shows that apparently ordinary investors are pouring money into both stock and bond funds, especially international stocks.

Are these investors wrong? No one knows, of course, but I doubt that their timing is good. The best time to invest is when prices are low, not high.

Look, for example, at the performance of one of my recommended international stock funds, Vanguard International Growth. Today's price is in excess of 24. (Over 1 1/2 years later, the price is below 17, a loss of approx. 30%.) But exactly 4 yrs ago, the price was less than 12. The 4 yr gain then between Jan '03 and Jan '07 has been approximately 100%.

So, is after a 100% gain over 4 yrs a good entry point? We don't particularly think so. In fact, on June 30, 2003, when the price (NAV) was less than 14 we recommended a 15% position. Likewise on that same date, we also recommended a 10% position in the emerging markets category. Vanguard's Emerging Market Index on that date was priced at about 9; today it is also above 24. (Fast forward to 2008 to see its price is down to 19.70 or down about 20% since we wrote this and about 40% over the last year!) The gain here between the ends of '02 and '06 has been well in excess of 150%.

We have continued to highly recommend the international stock category raising our stake over the last few years. But we think a little caution is now in order. That's why we're reducing our recommended allocation here a little from last quarter. We have not specifically included emerging market funds in our model portfolios since the 4th qtr. of '04 although we have occasionally referred to them as a good place for a rather small percentage of your portfolio. (They represent about 13% of Vanguard International Growth.)

The same concerns can also be applied to the US stock market in general. Vanguard's 500 Index's NAV has gone from around 75 about 4 yrs ago to above 132, although not yet at a level we would consider being outrageously expensive. (Now it's around 101.) And small cap stocks? Vanguard's Small Cap Index's return is also up over 100% during the same 4 yr. period and therefore likely excessively expensive, with a NAV today nearly 34 compared to less than 15 four yrs ago. (Now it's less than 26.) (Back then, we recommended a 20% allocation to the small blend category; right now, we don't recommend making any new purchases here, but we would continue to hold previous purchases at maybe 10% of your stock funds.)

So what's a non-trading oriented investor to do? Since our portfolios are geared toward long-term investing, we are still comfortable holding the majority of our investments in stocks. Over the next 3-5 yrs, they should continue to outperform both bonds and cash. But we think it makes sense not to be overly involved in some of the stretched categories.

As suggested above, and perhaps by default, large cap funds seem to be where it's at. And if small caps are, in our view, too over-priced, the only other US category left that seems worthy of consideration is mid-caps.

I can understand why investors have been coming back into bonds lately, although again, we can't share much of their enthusiasm. While there appears to be a decent chance of somewhat lower interest rates in the next 6-9 mos., my reading of the Fed's comments suggests that one could also argue there appears to be nearly as much chance of unchanged (or even higher rates) over this period. Lower rates would be the best outcome for most bond funds since bonds especially prosper in a period where significant slow growth appears to lie ahead. But even if rates go lower, we don't think they will go low enough to create outstanding bond returns. And if interest rates do go down a little (rather than a lot), this will also presumably be good for stocks too, so why should one favor bonds over stocks?

So, overall, since neither stocks nor bonds are very compelling to us, we must maintain and actually slightly increase our cash position. But given our focus on the long term, we would be remiss to argue that cash is going to outperform either stocks or bonds for very long. Any such outperformance, while it may occur, especially over bonds, probably wont last long enough that we want to overload our model portfolio with it. If and when the Fed actually starts to lower rates, we will likely become much bigger bond enthusiasts since they will likely only do so, with inflation now still a threat, if they start to sense that the economy could be trouble. That would be an environment that is bad for stocks but very good for most bonds.

(The following paragraph was key - if more people had bee aware of this possibility back in March of 2007, which has come true in spades, they would have been better prepared for the bear market that has now swallowed up nearly all regions of the world. Note: Italics above & below added) And what form might that trouble take? For approximately the last 2 years, a colleague of mine has been telling me that the housing market will indeed cause significant trouble to the overall economy - far beyond what most people realize. Two years ago, it seems, not many people were even aware of a potential ticking time bomb. While a few now are, most are still not ready to acknowledge a serious, looming blow not only to the US economy, but possibly, to most of the international markets, due to the tendency for all markets to follow the presumptive leader in determining global economic health, that is, the US.

Here then are our specific overall portfolio and category recommendations:

Stocks 52.5% (unchanged from the 1st Qtr)
Bonds 25 (-2.5% from the 1st Qtr)
Cash 22.5 (+2.5 from the 1st Qtr)

These allocations are for moderate risk investors; for more aggressive or more conservative investors, either add or subtract 12.5% from Stocks and do the reverse for Cash.

Stocks

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

Large Blend -- Vanguard Growth & Inc -----32.5%
Large Value -- T. Rowe Price Equity Inc - 15
Mid-Blend --- Vanguard Mid-Cap Idx ----- 15
International --- Vanguard Internat Gr -- 25
Asia/Pacific -- Vanguard Pacific ------- 7.5
Large Growth -- Vanguard Gr Idx -------- 5

Bonds

Category --- Our 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 ---35 ---- if in a moderately high tax bracket)
Interm Govt -- Vanguard GNMA -------------25
Short Term --- Vanguard S-T Inv Gr ------ 15
Internat ----- Amer. Cent. Intl Bond ---- 15
Hi Yield ------ Vanguard Hi Yield --------10

New Long-Term Performance Data Continue to Show that Our Recommendations Do Better than the S&P 500

Year after year, our model portfolio results have proven better than you would have done by investing in the S&P 500 Index, or in the typical fund.

Consider our 1st Qtr 2004 portfolio recommendations made a little over 3 years ago. Look at http://home.att.net/~funds-newsletter/2004_1.htm to see the actual recommendations; or go to our Archive page at http://home.att.net/~funds-newsletter/full_arch.htm to see all back issues. It is only by drawing attention to our Newsletter's ability to help most investors do considerably better than without it that we can demonstrate that our research does work.

Over the 3 years that followed through Mar 14 of this year, that is, a period of 38.5 months, the S&P 500 returned approximately 29.4% (not annualized). Although this is a good return, it would have been hard to achieve even in an index fund - index fund results must be less than the actual index due to fund costs. If you deduct about 0.2% per year in fund costs, your total return would be reduced to about 28.8%, assuming you invested in a very low cost index fund, such as the Vanguard 500 Index.

For Jan 2004, our recommendation was to divide your stock portfolio into 6 very different categories of funds. This provides better diversification than most investors have, or just investing in the large cap US stocks that make up the S&P 500.

While it makes things a little more difficult for many investors to spread their picks over as many as 6 funds, we believe that the long-term results are worth the effort. From our point of view, the best reason for investing in each of the categories we recommend is that our research indicates that each of these categories has the right characteristics for outperforming the index over subsequent years. However, we do believe that some categories have more potential than others. So, even if you don't invest in all of our recommended categories, we have urged investors to emphasize those which we show as having the highest percentages in our Model Portfolios.

How did our recommendations from 2004 do? Here are the results you would have achieved over the following 38.5 mo. period by investing in each our recommended categories, vs the 29.4% return for the S&P 500 over the same period.

Foreign 55.6%
Small Blend 39.2
Mid cap Blend 38.4
Equity Income 35.5
Large Value 34.1
Large Growth 18.0

As you can see, 5 of the 6 categories beat the S&P 500 with foreign stock funds returning over 26% more than the S&P 500. And foreign funds, at a suggested 25% of your portfolio, were our most highly recommended category.

If you had merely invested equally in our recommended categories without breaking your investments down into our recommended portfolio percentages, you would have earned 7.4% more (that is 36.8% vs 29.4%) than the S&P 500 over the entire period (not annualized). And if you did go to the extra trouble of investing in a portfolio allocated into the exact percentages we recommended, you would have earned 8.26% more (37.66 vs 29.4) than the Index.

Are such improved results as compared to the S&P 500 worth the effort to pursue? I suppose it depends on how much money you plan to have invested in upcoming years. So, if your stock portfolio will likelybe relatively small in upcoming years, say about 10K, and if our 3 year outperformance results are similar, you could expect have $826 more ($13,766 vs $12,940) accumulated at the end of this period. If your stock portfolio will be relatively large at 100K, you could expect to have $8,260 more (137,660 vs 129,400) at the end of this 3 yr period.

Perhaps the effort to achieve $826 more than the S&P 500 may not seem worth it to an investor with only 10K on the line, investments that should not be switched from these stock investments during the 3 yrs. But the more you have invested, the more you will want to consider our suggestions. So, an extra return of $8,260 means, for example, an additional accumulation over $200 over each and every month.

Obviously, these Index-beating results can only happen if our Newsletter continues to be able to correctly spot in advance fund categories that do indeed outperform the S&P 500. While most investors and experts alike believe that any such predictions are unlikely to be able to do so, our quarterly predictions going back to Jan 2001 have indeed beaten the Index every single time 3 years later! That is 17 straight quarters with an average annualized outperformance of about 5%, or about 15% not annualized.

Knowledgeable investors realize that only about 30% of mutual funds beat the S&P 500 in any given single year. So most investors will not even achieve the Index's return. How have we been able to consistently beat it? Mainly by taking a long-term approach and devising a consistently applied strategy which we have published on our own and other sites. And remember, we don't attempt to beat the index by taking large risks. For example, even though we thought international stock funds were your best bet in 2004, we never urged that you put nearly all of your investments into that single category.

How did our bond fund recommendations do over the same 3 year period? At the start of 2004, we recommended 60% of your total portfolio go into stock funds and only 35% into bonds (with the rest in cash). And in fact, we also recommended that 80% vs 20% (stocks vs bonds) go into stocks if you were a more highly aggressive investor.

With that in mind, had you invested in one of the best and lowest cost diversified bond funds available, the Vanguard Total Bond Market Index, your return over the same 38.5 mos (thru Mar 15, 2007) would have been approximately 12.5% (not annualized). Here is how you would have done if you had invested instead in each of the 5 bond fund categories we recommended and earned the average of how funds in those categories performed over the same period.

Hi Yield 24.5%
Intl Bond 18.3
Inflat Prot 13.4
LT non-govt 12.8
ST non-govt 8.7

So, 4 of of 5 categories beat the bond index. And high yield funds, at a suggested 30% of your portfolio, were our most highly recommended category, returning nearly double that of the index.

Had you merely invested equally in our recommended categories without breaking your investments down into our recommended percentages, you would have earned 3.0% more (15.5 vs 12.5) than the index over the entire period, not annualized. As with stock funds, if you did go to the extra trouble of investing in a portfolio allocated into the exact percentages we recommended, you would have earned 4.6% more (17.1 vs 12.5) than the bond Index.

And how would you have done with that part of your portfolio that stayed in cash? Even in one of the best performing money market funds, your return for the same 3 year period would have been a mere 10%, not annualized.

So, our 60, 35, 5 overall allocations to stocks, bonds, and cash proved to be correctly weighted to take advantage of each category's subsequent forward-looking potential.

In Conclusion

The above results are similar to the kind of consistent model portfolio outperformances we have been showing for the last 7 years! We hope you have been with us for long enough to have potentially profited by using some or all of our suggestions. And we hope even more people will eventually discover or be shown the merits of subscribing to our free newsletter. But regardless of how many people we are able to reach, it has been a great ride for those of us that have had faith in what we offer. And it has been a great enjoyment to be able to tackle a challange that most people think is nearly impossible - to provide sound, consistently market-beating long-term fund advice!

P.S. We also try to answer your questions on fund investing and gladly accept any feedback, positive or negative, or just your own suggestions about our Newsletter.

Best wishes,
Tom Madell
http://funds-newsletter.com

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