Mutual Fund Research Newsletter
http://funds-newsletter.com
Copyright 2009 Tom Madell, PhD, Publisher
August 2009
Published July 31, 2009
Contents:
-Stocks vs. Bonds Going Forward
-A Time-Tested Investment Approach
-Correction
-The Home Construction Depression and Its Aftermath
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If we had to venture a guess at this particular juncture as to where the stock market is headed, we would break down our guess into the near term (next several mos.) vs. the longer term (next year or two). In the near term, we wouldn't be surprised to see continuing advances. But looking out a little further, we particularly wouldn't be surprised to see another major substantial downdraft. Whether or not the latter materializes, we currently might project upcoming overall yearly average gains for stocks which might be somewhere in the range of 5 to 8%.
As for bonds, while we agree that they may be less risky than stocks in the next year or two and that positive returns will still prevail, the gains are likely to be significantly less than the excellent returns already achieved by some categories of bonds over the last year or so. (e.g. our strongest bond fund recommendation from a year ago, PIMCO Total Return, has returned approaching 12% over the last year, thru July 31st.)
Surprisingly, in spite of the tremendous stock rally since early March, data show that mutual fund investors over the period have apparently finally embraced a great deal of our long standing fondness for bonds. In fact, fund investors have been net buyers of bond funds to the tune of approximately 4 times the amount that they have been investing in stock funds.
Could it be that many of these newly adoring bond investors have been convinced by this Newsletter's positive slant on bonds? (No, just kidding). But if these investors are merely "chasing performance," why aren't they sucking up rocketing stocks a whole lot faster than bonds?
Perhaps one might truly say that there is a "new moderation" among fund investors and that the American public is genuinely in a more conservative (or perhaps, even austere) position than they have been in many a year. While we think that greater diversification into bonds is a welcome development, and may even in itself help to keep interest rates at a pretty low level, we doubt that bonds prospects will prove to be worth a four times bigger bet than stocks going forward.
Finding meaningful success from investing in stock mutual funds these days seems a little like recent reminiscing about astronauts landing on the moon: it's something that hasn't happened for a long time.
The aim of my Newsletters has always been to help investors achieve good relative returns without taking on excessive risk. Coming out ahead as compared to most investors and even market indices by, for the most part, starting with and tracking a relatively constant set of fund recommendations over at least several years is our modus operandi. In trying to help investors achieve such good relative returns, we cannot expect to always achieve positive returns over the shorter run. And as an outgrowth of our approach, only when things change significantly and reliably enough to likely affect one's returns over the next several subsequent years, do we suggest a major change of strategy.
Of course, some people would rather attempt to select good investments just one time, and hardly ever make any adjustments. We agree that this can be a particularly good strategy for stock fund investing, assuming sound investments can be held through thick and thin with a long-term holding period of a minimum of 10 years, or better still, 15. For such buy-and-hold investors, use of an investment newsletter, or an investment advisor, seems likely to be restricted mainly to starting up an appropriate portfolio rather than making changes along the way.
On the flip side of the coin, some people choose to dart quickly in and out of their investments. While in some cases, you might think of these people as traders, this group also includes those who, once in an investment, want reassurance fairly quickly that it is doing well, or at least, that it is not losing ground. For these investors, holding an investment over at least a several year period that inevitably will include both ups and downs tends to be extremely difficult.
As we have emphasized many times, while we wish we might be able to be more helpful to those inclining toward more rapid changes, especially in the event of losses, we have found little evidence that this is usually an effective strategy for fund investors. While some investors are able to minimize losses using such a strategy, minimizing losses in itself is probably less than half the battle. Unless one's overall strategy can also achieve sufficient gains, "less losses" are still losses.
If neither buy-and-hold, nor recommending frequent, substantial changes fits, how then would you describe our Newsletter's approach? Although we may have not written much about this before, we have continually tried to emphasize the importance of patience. We believe that patience is perhaps the most important quality to have in order to be a successful investor. (Incidentally, can you think of any area of extended endeavor where patience is NOT important? I can't.) But patience in investing, we believe, does not simply translate to mere waiting. Yes, patience implies waiting. But while you are waiting, you should also be watching.
Perhaps hardest of all is the patience and conviction required while waiting for a would-be bloomer of an investment to grow productively. But a second type patience may also be called for: waiting for possible new, and particularly significant, buying opportunities to arise. Such will tend to occur, in our view, not every week or even every several months, but more likely, only about once every several years. Thus, there is much to be said for the strategy of "keeping your powder dry." This entails patiently waiting for a meaningful "shift in the winds" in an asset category (usually, a particularly big downdraft followed by a significant period of stabilization) as a new found opportunity to buy. We think we may be close to quite a few such opportunities in the months ahead, IF stock prices which plunged head-over-heels roughly between Oct. '07 and Oct. '08, achieve a new level of stabilization which brings them back to at least where they were a year earlier.
And there is yet a third type of patience. Investors should also be waiting for those occasions during which investments might need to be trimmed down; once winnings are achieved, you should be willing to take at least some of them off the table. Our approach suggests that you sell on performance strength, not on weakness. Selling on strength preserves gains; selling on weakness actualizes losses.
Unfortunately, failure to act to preserve your gains when winnings are strong (such as during ongoing bull markets, which realistically can't, and won't, go on indefinitely) seems to be almost hard-wired into the human psyche. This truth was reported recently on CBS's Sixty Minutes: Very few people who are ahead at the Las Vegas casinos ever simply pocket their profits. Most continue betting until their winnings are completely gone. Unlike gambling winnings which may seem to be "playing with the house's money," if your goal is indeed to come out ahead, it is imperative for investors not to be lulled into a state of inattentive complacency, or even a degree of overconfidence, both brought on by prolonged positive market action.
Learning when to slowly withdraw from the action, "settle" for reasonable winnings, and not be willing to shoot for even higher but increasingly less likely gains, is where many of us stumble. (Reminder: Whether you accept the situation now as a bona-fide bull market which is likely to go on for many years, or just a sharp, but real, rally within an ongoing bear market, we are again currently seeing bull market returns. This is once again a time to re-evaluate what action, if any, you should take.)
Of course, it should go without saying that our goal of trying to help you outperform a target over several years time, such as the S&P 500 Index and a similar index on the bond market side, is extremely difficult to achieve. What specifically, then, are our overall guideposts, which have, so far at least, very consistently succeeded?
First, rather than looking at the performance of the stock and bond markets each as single entities, we look for pockets of opportunity within each market, including trouble on the horizon, as well as signs of unsustainable performance.
While no single one of these guideposts is unique to our investment approach, the combination of all of them together, we believe, will give you a significant advantage.
Due to late changes in final category performance during the 2nd Qtr. of this year, our Model Stock Portfolio wound up outperforming the S&P 500 over both 3 yrs. and 5 yrs. We had originally reported that only the 5 yr. Portfolio outperformed. (See our track record website page for the updated data.) While small, this correction may be significant to those who follow our Portfolio's outperformance record.
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A key question going forward for the economy and GDP: When will we recover from the home construction depression and at what rate?
First, a bit of history to put the issue in perspective. Housing starts are a standard measure of home construction. The Census Bureau each month reports the total number of starts for single homes and units in multi-family dwellings. There has been a steady and very steep decline from the peak of housing starts during 2005, at 2.05 million units, down to 0.90 million units for 2008 and then further down to an annualized rate of 0.53 million units for the first six months of this year. This is the greatest percentage drop in housing starts since the Great Depression. A 74% drop in housing starts from its peak is drastic and can only fairly be described as a “home construction depression,” although the media and public officials are reluctant to use that term. Looking beyond the housing bubble years of 2003 through 2006, the approximate annual rate for the past 20 years was 1.5 million units per year. Even using that figure for perspective, at present, the 2009 rate amounts to a decline of 67% from the norm.
The government has taken numerous steps to bolster the overall economy and the home construction industry in particular. The Federal Reserve has aggressively acted to lower overall interest rates and home mortgage rates. In August 2007, the Federal Funds rate stood at 5.25%; by December, 2008, the Federal Reserve had effectively lowered that rate to zero, where it stands today. In March, 2009, the Federal Reserve announced that it intended to purchase 1.25 trillion dollars of mortgage backed securities in the remaining nine months of the year. By mid-July, it had already purchased half that sum. For perspective, the 1.25 trillion figure exceeds the entire amount the Obama administration indicates it needs to fund its health reform proposal. The Fed’s efforts have contributed to the reduction in the 30 year fixed mortgage rate from 6.7% in July, 2007 to a low of 4.8% in April, 2009 – a mortgage rate last seen in 1953.
The Congress has passed an $8,000 tax credit for first time buyers of new and resale homes. California enacted an additional $10,000 credit for first time buyers – the funds for that program are now exhausted
Thus far, all of these efforts have led to limited improvements in the prospects for future home construction. Housing permits are the measure of future housing production. Overall, they are near flat year to date, although permits for single family homes have climbed from an annualized rate of 0.34 million in January to 0.43 million in June – a gain of 26%. Sales of single family homes are up from 0.32 million in January to 0.38 million in July.
Looking forward, a critical question for housing construction and the overall economy is: What are the prospects for a return of housing starts to the normal range of 1.5 million units per year? How long will it take to reach that level?
Three factors are likely to determine when and if housing construction will return to normal levels: (a) The current excess of housing inventory built over prior years and the time needed to burn off that excess; (b) The level of household formation; and (c) Consumer confidence and the condition of the overall economy. .
New home inventory has been steadily declining for the past three years. On an unadjusted basis, the inventory of new single family homes stands at its lowest level since 1998 and is half its peak level in 2006. At the same time, there is currently 8.8 months of inventory given the current sales pace. This is in excess of the 5 to 6 month level that most economists deem acceptable as a basis for sustained growth, but represents a significant improvement from the 12.4 month level at which inventory stood in January.
In addition to new home inventory, resale homes resulting from foreclosures and the desire of investors/speculators to sell prior purchases will compete with new home sales and thereby hold down new home construction. Many foreclosures are of homes built over the past five years, which directly compete with nearby new construction.
One demographic unknown is the residential plans for retiring baby boomers. Over 10% of United States housing stock is second homes owned primarily by baby boomers which sit vacant for most of the year. An open question is how many of these second homes will become primary residences, leading their owners to sell their current primary residence and thereby add to inventory.
Household formation provides a constant source of new demand for both newly constructed and resale homes. During the last decade, net new household formation averaged approximately 1.4 million per year. Last year, however, the Census reported that the United States added only 544,000 new households – during severe contractions, the young stay at home, singles “double up,” and household formation normally slows. Even with declining demographics, however, many analysts foresee new household growth resuming to a level of at least 1 million by 2010 and beyond.
Of course, the health of the overall economy contributes to the rate of home purchases at the same time the health of home construction contributes to the overall economy. Rapid improvement in housing starts and construction have been a major source of economic recovery and job growth following all of the post war recessions. But establishment economists have repeatedly stated that the pace of recovery out of this recession will be exceptionally slow. The Federal Reserve made that point in its last minutes. Fed Chairman Ben Bernanke and White House economist Larry Summers have both reiterated that position.
A slow recovery that does not follow the pattern of recession recoveries over the past 50 years will slow down household formation as well as job and wage growth needed to support new home purchases. Also, during the past quarter century, falling interest rates on home mortgages have repeatedly enhanced housing affordability. Falling rates have contributed to the demand for new construction. Going forward, further decreases in home mortgage rates are unlikely
Putting this all together, there are a host of unknowns. It seems no more than 50% likely that housing starts will regain a normal 1.5 million unit level in the next three years.
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