Mutual Fund Research Newsletter 4th Qtr. 2005. Copyright 2005 Tom Madell, PhD Sept 30, 2005 Over the last 12 months, my specific stock and bond fund recommendations, made a year ago, again produced outstanding returns for me and anyone who followed them. Here are the one year results thru 9-30-05: Stock Funds Vanguard Pacific Stock Index +++++++++++++++++++++++++ 29.0% Vanguard International Growth ++++++++++++++++++++++++ 25.6 Fidelity Low-Priced Stock ++++++++++++++++++++++++++++ 21.5 Vanguard Windsor +++++++++++++++++++++++++++++++++++++ 13.5 T. Rowe Price Equity-Income ++++++++++++++++++++++++++ 12.1 Vanguard Growth Index ++++++++++++++++++++++++++++++++ 11.6 Hussman Strategic Growth +++++++++++++++++++++++++++++ 11.2 For comparison, the Vanguard 500 Index returned 12.1% Bond Funds Vanguard Long-Term Investment-Grade +++++++++++++++++++ 7.1% Vanguard Inflation-Protected Secs +++++++++++++++++++++ 5.1 Vanguard High-Yield Corporate +++++++++++++++++++++++++ 4.7 PIMCO Total Return ++++++++++++++++++++++++++++++++++++ 3.8 American Century International Bd +++++++++++++++++++++ 3.7 For comparison, the Vanguard Total Bond Market Index (benchmark) returned 2.8% We were also on target in recommending a majority (60%) of your funds remain in stock funds, while only a much smaller portion (35%) in bond funds, for moderate risk investors. (We recommended an 80%/20% position for stocks/bonds for aggressive investors.) While our current specific recommendations, which are presented after this commentary, have changed somewhat since then, there continue to be several on-going themes from 2004 which have carried over: 1.Maintain a significantly greater allocation to stocks than bonds, but don't go much beyond 50% stocks if your are a moderate risk investor. (In other words, I suggest you reallocate if necessary to trim down.) 2. Also, trim down your bond fund holdings if they go much beyond 25% of your overall portfolio holdings. (Naturally, if you are retired and count on bond fund distributions for income, you can ignore this call; my recommendations are geared toward achieving above average total returns, capital gains and dividends, while remaining diversified enough to prevent large losses in the event of severe bear markets for either stocks or bonds.) 3. I continue to advise an overweight position in foreign stocks. To be even more successful, I highly recommend owning one or more funds that invest a significant proportion of their assets in Japan and the Pacific region. 4. Continue to be leery of funds investing in real estate investment trusts. If you occasionally invest in sector funds, you might continue to ride with the energy group but I would recommend limiting that position to no more than a few percent of your stock portfolio. Here briefly are the rationales I have in arriving at these overall recommendations: 1. Although I agree it's nearly impossible to correctly call bear or bull markets in advance, current conditions appear to me to suggest some caution. These include rising interest rates, some recent signs of economic deceleration, and about 2.5 years without a significant stock market correction. 2. The current combination of low but rising interest rates represent the worst time to own bond funds. Better to wait until interest show signs of having peaked. There is no indication we are going to be at that point in the immediate future. Therefore, rather than my usual expectation that bond funds will most likely outperform cash, for the time being, I think that being in cash will be nearly as good as most bonds with no chance of loss of principal if rates rise more than expected. So far this year, cash has actually outperformed most bond funds, justifying my Jan. 2005 allocation of my highest allocation to cash (20%) in perhaps the last 10-15 years. 3.Japan, the worse investment of the last decade or more, has been showing strong signs of becoming one of the best investment opportunities currently available. Most traditional, non-emerging foreign markets seem more undervalued than U.S. markets. Additionally, Asian currencies, in particular, seem likely to strengthen which will add to returns for U.S. investors. 4.Real estate investments are interest sensitive and will suffer if interest rates keep rising. Energy funds, while likely risky given their spectacular rise over the last number of years, might continue to be worth holding because it's hard to see the slowing down of the world's reliance on traditional energy producers soon. But, too, realize that most large cap funds are already invested in that sector for you. If you hold either of these two sectors, keep a close eye on the economy, but REITs are already just about the worst performing category over the last 3 mos. while energy remains the best. 4th Quarter '05 Model Portfolio The following tables show our stock and bond fund category recommendations as well as the specific fund we recommend within that category. Allocations =========== Stocks ++++++ 52.5% Bonds +++++++ 27.5 Cash ++++++++ 20.0 The above percentages are for moderate risk investors including myself. If you consider yourself an aggressive investor, I would still limit myself about 60% to stocks, with the rest in bonds (10%) and cash (25%). If you consider yourself a conservative investor, I'll stick with 40% stocks, 35% bonds, 25% cash. Stock Fund Category Allocations & Specific Fund Recommendations =============================================================== Category ++ (Our Current Recommendation) ++ Allocation Large Blend + (Vanguard Growth & Inc) +++++++++ 25% Large Growth ++ (Fidelity Contra) +++++++++++++ 10 Large Value/Equity Income ++ (ICAP Equity) ++++ 15 Mid Cap Blend ++ (Hussman Strategic Growth) +++ 15 Small Growth ++(Vanguard Explorer) ++++++++++++ 5 Foreign ++ (Vanguard International Growth) ++++ 22.5 Foreign Asia/Japan ++ (Vanguard Pacific Idx) +++ 7.5 Note: Hussman Strategic Growth is not like the typical Mid Cap Blend fund so I recommend you do further research to learn more about it. Although it is classified as mid cap blend by Morningstar, it is well distributed across categories. It also has shown low volatility with the potential to do well if the overall market falters as a result of the hedging strategy it uses. I highly recommend this fund, which has tremendously outperformed the S&P 500 over the last 5 years and am in the process of switching some of my own funds over to it. Bond Fund Category Allocations & Specific Fund Recommendations ============================================================== Category ++ (Our Current Recommendation) ++++++++++++++++++++++ Allocation Long Term ++ (Vanguard Long Term Inv Grade) +++++++++++++++++++++++ 30% Short Term ++(PIMCO Total Return) +++++++++++++++++++++++++++++++++ 25 Inflation-Protected ++ (Vanguard Inflation Protected Securities) ++ 20 High Yield ++(Vanguard High Yield) ++++++++++++++++++++++++++++++++ 12.5 International ++ (American Century International Bond) +++++++++++++12.5 In case you haven't seen our main web page lately, our quarterly stock model portfolio category recommendations have outperformed the S&P 500 index over the next 1 and 3 yr. periods nearly every single time we over the last 5 years. Still, very few people, it seems, regularly check out our advice. It's too bad that marketing, more than any other factor, determines what advice people are able to locate, and subsequently trust enough to read. If you find our advice worthwhile, think about recommending it to a friend. We are not planning on doing any further marketing activity to publicize results that most other mutual fund advisors simply have been unable to match. It appears then that only by word of mouth, or sheer serendipity, will very many people ever learn of our excellent record, nor see our future recommendations that could prove very valuable to them. Regards, Tom Madell, Ph.D.