Mutual Fund Research Newsletter http://funds-newsletter.com 3rd Qtr. 2006 Copyright 2006. Tom Madell, PhD Welcome to our new subscribers! Our quarterly newsletters are primarily for long-term investors who can be patient even in the face of short-term market volatility, as we've had lately. We would like to point out the following: It is often not likely that you will see improved results from any recent changes to your investing program within periods of less than 1 year. Instead, we expect to be able to see improved performance in our own portfolio, and in those of our readers, over the course of at least an entire year. So, we continually encourage you to scrutinize the value of our recommendations over periods of starting 1 year after we first made them, and better yet, several. Why? We take the position that while almost anything can happen in the short term, true changes can sometimes will take several years to materialize. We measure our success in terms of our entire portfolio's performance, not the performance of a single fund or two. Thus, our overall stock fund investment choices, while not necessarily always showing outperformance in the short term, have a near perfect record (so far at least) of outperforming over periods of 1, 3 and 5 yrs from when we made them. The latest results going back now as far as Jan 1, 2000, again show that our recommended quarterly model portfolios continue to have an eye-opening record. We now have beaten the S&P 500 Index 22 out of 23 times after 1 year has elapsed from issuing our fund category recommendations. Additionally, EACH AND EVERY quarterly moderate risk stock portfolio has outperformed the S&P 500 after 3 and 5 years has elapsed! (More about our latest 1, 3, and 5 yr performance results going back to periods ending June 2001 thru and June 2006 will be published on our web site within the next week. We will inform you when they are posted there.) Note: This newsletter can't be of much help to you if you are exclusively a buy-and-hold investor (as many of my own friends and acquaintances are). Our Current Analysis Long-term readers may be aware that we have been cautious toward both stock and bond funds since the start of 2005, recommending a lower than usual allocation to both groups, while recommending a high cash position. (see our Jan 2005 newsletter available upon request). Three years ago, as the stock market had just suffered thru several years of a crushing bear market, our stock/bond/cash allocations were much closer to normal. Let's take a quick overview of how each asset class has done since then: Various Category Returns Since start 1/1/05 Over the last 3 yrs (approximate; annualized) (thru 6/30/06) (7/1/03 - 6/30/06) ================== =========== ========= Most Widely owned domestic stock funds 5% 11-12% Best Bond Funds 1 2 Best Cash Funds 3.5 2 Clearly, during the last yr. and a half, US domestic stocks have been disappointing. When considered over the last 3 years, however, stock fund returns have been moderately good. But unlike the S&P 500 Index and the great majority of domestic funds owned by most, some lesser owned categories of stock funds, categories our portfolios tended to emphasize, have done far better. For example, it would have greatly helped to have had a decent percent of your investments in international funds. And smaller stocks have done nearly twice as well as the most widely owned large cap stocks over both periods. Various Category Returns since start 1/1/05 over the last 3 yrs (approximate; annualized) (thru 6/30/06) (7/1/03 - 6/30/06) ================== ============ ============= Typical Internat Fund 16-17 21-23 Typical Sm Cap Fund 9 19 Does recent stock weakness, both during the last 2 mos. and the last year and a half, mean you should continue to be cautious about US stocks (in spite of the big June 29th rally attributed to favorable interpretations on the future direction of interest rates)? My sense is yes. And should you continue to load up on cash? Yes, but not to an extreme as by selling out of many of your positions. And should you try to avoid bond funds as much as possible? Well, maybe not. Cash will continue to do relatively well. Perhaps equally important, a high cash position enables you to buy funds at times when the market has fallen and fund prices start to become low enough to beome enticing. Bonds likely will have a bit further to fall. But when we finally see a leveling out of interest rates,you will start to do better holding bonds than cash. Have international stocks now lost their appeal given their recent drops? No. These funds have fallen somewhat faster than US stocks since early May, but they were more ripe for a correction as their near 75% total return over the past 3 yrs shows. The fundamentals remain good for foreign stocks although emerging markets may have seen their peaks for a while. And what about smaller stocks? We expect that the fundamentals will indeed turn against this group as their longstanding outperformance has shrunk recently. But many investors appear to be caught up in a speculative, performance-chasing mood concerning small stocks. They are reluctant to recognize that these big winners of the last 5 years are at a much greater a risk than all other categories of stock funds (except perhaps emerging market funds) in the event of a larger than expected economic slowdown in the US. So, when considering your overall portfolio, where should you be invested right now? Suggested Stock vs Bond vs Cash Allocations For Moderate Risk Investors Stocks 50% Bonds 27.5% Cash 22.5% For More Aggressive Investors Stocks 60% Bonds 15% Cash 25% For Less Aggressive Investors Stocks 40% Bonds 32.5% Cash 27.5% Note: We do not think we can predict where the stock market averages will go in the future. Rather, we are trying to maximize return over the next few years without taking excessive risks. Obviously, if you think you can make better returns by just being 100% in stocks, you may be right. But you should at least be aware of the risks you are taking, esp. if you are investing to achieve a specific goal such as an assured minimum level of retirement funds. If your allocations to stocks are currently higher than in the above tables, I suggest you use any further market strength, such as on/after days like June 29th to reduce your position. In our view, many investors are being far too speculative and optimistic about the favorable prospects for stocks in the year or two ahead. We feel there are too many seeds planted for a slowing economy ahead along with somewhat above average inflation to justify making big bets that you can make a whole lot of money in stocks within this environment. Our models suggest that the economy will, as the Fed predicts, slow down, but there will continue to be an upward bias in interest rates. This will not be particularly helpful to either stocks or bonds, but will allow for increasingly higher returns on cash. We don't have a particular longer-term prediction regarding inflation although we don't expect any near term "Fed engineered" improvement to be successful in cheering stock or bond investors. Stock Fund Recommendations It is not wise, in our view, to invest just in stocks funds, to the exclusion of bonds and cash. Exception: If you have generously divided your investments into at least 4 categories of stock funds drawn from large, mid, and small-cap sectors, as well as a diversified international fund, and will not cash out for at least 10 years from your starting date, you may be OK. If you had invested in some of the "best" (or even "safest") funds that most of the experts were recommending 5 to 10 yrs. ago, between the end of 1998 and mid-2001, your annualized returns up to the present could be still as little as 2%! To do well going forward, you need to be in funds that aren't way overpriced (as we believe some categories of funds are today) and have a good chance of doing better than average in the years ahead. Here are our general recommendations for the next several years: -Focus on Large Cap funds with only small allocations to small cap funds -Do not tilt heavily to either growth or value funds but stick close to the middle ("blend funds"). An S&P 500 Index fund is, unlike 5 years ago, actually a good choice -Continue to seek well diversified foreign stock funds, but for now, avoid new commitments to emerging markets -If you want to make a play for higher returns, continue to favor foreign funds with decent allocation to Japan -Invest in a "long-short" fund (such as Hussman's below) if the market indeed turns bearish (or you believe it will) Here are the specific categories of funds we are now recommending along with our recommendations for the percent of your total stock portfolio they should occupy. Category Our recommended fund Recommended percent of Stock Portfolio Large Blend Janus Fundamental Equity 25% (same as Janus Core Eq.) Foreign Vanguard Internat Gr 25 Large Value ICAP Equity 17.5 Mid-Cap Blend Vanguard Mid-Cap Idx 15 Japan Vanguard Pacific 10 Long-Short Hussman Strategic Gr 7.5 Bond Fund Recommendations We feel it is currently much trickier to pick the correct bond funds to be invested in than it has been in the last few years. While most people wonder why I might recommend bond funds at all now that it is obvious that we are in a bond bear market with negative returns in even the most popular bond funds over the last year, we believe that better times may be now be closer at hand. And for many people, the more they allocate to bonds, they may thus allocate less to stocks, helping to mollify portfolio risk. (Most bond funds have still performed better over the last 5 years than most stock funds!). Here are some suggestions for the current adverse interest rate climate: -Long-term bonds still look a little risky; emphasize intermediate and short term bonds. -High yield (junk) bonds are becoming dicier. Don't assume that the prior outperformance over the last 5 yrs is going to continue. -Muni bonds, for moderate/high tax bracket investors, are showing lower volatility than other categories - a plus. -International bonds (but not in emerging markets) may be OK as a diversifier. More specifically: Category Our recommended fund Recommended percent of Bond Portfolio Interm Govt Vanguard GNMA 20% Short Term Vanguard S-T Inv Gr 20 Long-Term Muni Vanguard L-T Tax Exempt 20 Interm-Term Vanguard Tot Bnd Idx 15 High Yield Vanguard Hi Yield 12.5 International Amer. Cent. Intl Bond 12.5 Remember, our selections have consistently outperformed the market by at least several percentage points on average over the long term, as you can check at our website within the next week or so. Of course, there is no guarantee that they will always do so, but our outstanding track record is something that you may be able to profit from if you have the patience to research our recommendations, come to similar conclusions, and perform the necessary portfolio moves to enable you to generate your own similar investment results. Best wishes! Tom Madell Publisher