Contents:

--The Only Certainty: Holding Cash Will Not Be Productive
--Model Portfolios
--How Our Recommendations From 1, 3, and 5 Years Ago Did
--Fixing the Banks: A 50/50 Chance of Success

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The Only Certainty: Holding Cash Will Not Be Productive

In last month's Newsletter, I talked about investors' desire to find information that will enable them to correctly decide what to do now, if anything, about their stock fund investments. Should one increase or decrease them, or just stay on hold?

When looking out over the next 6 months or less, is there anything that can reliably tell us if the stock market is near (or already past) a bottom, or should one wait if they have money they would like to invest? In other words, can anyone using all of the data we have available ascertain whether the market is headed up or down over the next 6 months?

In that Newsletter, I concluded that no matter how hard we try to forecast, including studying the words of knowledgeable market, economic, and government experts, it is just about impossible to determine the market's near term direction any better than flipping a coin. As hard a pill as this is to swallow, we must if we are to be able to basically ignore the short term and continue to make sound long-term investment decisions. The same likely applies to making decisions about where the overall bond market is headed over the next 6 months or so.

While nothing then can reliably help us to answer the above questions, there is one thing that is totally certain, or 99% so. At least in terms of absolute returns, I can see almost no positive outcome as a result of holding significant amounts of cash within our current investment environment.

Normally, it can make sense to hold cash if no other investment appears to offer the prospect of better returns, or as a possible form of diversification. Of course, you may hold some cash for other reasons, such as to have a guaranteed source in the event of job loss or another extreme event which can be tapped without the need to cash out of stock or bond funds if prices happen to be low. Or, you can hold cash, not because you think it is a good investment, but because you plan to use it to fund future purchases of stocks or bonds when the time seems more appropriate.

As you may have already noticed, the returns available on cash have been falling rapidly. They have now reached levels that, to my way of thinking, make them entirely unacceptable as an investment option. For example, one of the highest paying money market funds available, Vanguard Prime, currently pays only 0.73% (per year)! If you think that's bad, just wait and see what will happen soon. Since the Fed Funds rate is now at 0 to 0.25%, you can likely expect that money market rates will drop closer to that range over the next few months! And if you hold your liquid funds in a state-specific MM fund, such as for example, the Vanguard California MM, the current rate is a mere 0.47%.

If you reason that at least you are getting a positive return, as opposed to the negative returns possible in the stock market, you need to take into account any taxes due on the MM fund, and, more importantly, the current rate of inflation. Assuming even a low 1% inflation rate over the next year, your MM fund will actually be losing purchasing power. And CD rates are hardly any different - for example, Fidelity Investments CDs are currently offered at 1.20% for a 12 mo. CD. That yield is just about zero after taking into account likely inflation and taxes.

You may not realize it but one of the reasons short-term interest rates are currently so low is part of a deliberate strategy by the Fed to persuade all of us to take on riskier investments. To help resolve the housing and banking crises, mortgage rates need to be as low as possible to induce enough potential home buyers back into the market. This will put a floor under falling home prices. As ordinary citizens get dissatified with the return on MM funds and CDs, the Fed hopes they will turn to higher yielding investments such as bonds (not to mention stocks). When this happens, the hope is that the resulting drop in bond yields (as higher demand causes a drop in yields) will also pull down mortgage rates, which key off of other bonds. And banks are able to be more profitable (or, more aptly, stay solvent in today's environment) when they can borrow money at extremely low rates and lend it out and higher rates.

So, just as when George W. Bush urged people to shop after 9/11 to keep the economy going, the Fed is somewhat more subtlely trying to influence our behavior. To invest in somewhat riskier assets will presumably help the economy to recover. But aside from doing something "patriotic", you will, in my opinion, be helping yourself if you currently have excess money in cash by considering putting it to better use in other types of investments. While no non-cash investment is without at least some risk, if you are able to take a long-term perspective, it seems highly implausible that you will not do better than by merely holding a bundle of cash.

How Best to Beat Cash

• Intermediate term government bond funds would appear to offer the surest ways to beat the paltry returns on cash. With little likelihood of interest rates rising (or dropping) over the next 6-12 months, you will likely earn an amount similar to the bond fund's current yield. Typical yields for low cost bond funds such as offered by Vanguard range from about 4.2% for the GNMA and Total Bond Market Funds to about 2.4% for the Intermediate Treasury Fund. (We particularly like GNMA funds right now because their high quality bonds are backed by the U.S. government, unlike ordinary mortgage-backed securities which were tainted by the subprime crisis, and tend to do best in a stable interest rate environment.)

• Other good fixed income options now are inflation protected bonds (TIPS) and municipal bonds. Vanguard's TIPS fund is paying about 1.8% to which is added an additional amount depending on how high inflation goes. In the muni arena, Vanguard's Limited-Term Tax Exempt yields about 2.25%, free of Federal taxes; higher rates of return are available if you select a fund with somewhat longer-term municipals such as Vanguard's Intermediate-Term Tax-Exempt currently at about 3.6% (State-specific muni funds are also available which are usually free of both Fed and state taxes.)

• If you are willing to assume a higher degree of risk which could lead to better returns (but also run the risk of underperforming cash at least until the economy starts to get on better footing), you could choose short to intermediate term corporate bond funds such Vanguard's Short-Term Investment Grade paying about 4.95%. Or, you could check out the availability of a variant of the Pimco Total Return Fund (see below), likely paying about the same.

  Note: We still do not recommend so-called high-yield corporate ("junk") bonds. Long time readers will likely be aware that in July 2007 we advised on our Alerts page avoiding the category all together. Over the last 21 mos., high yield returns have been down a significant amount, approaching the losses on many stock funds. While the yields offered look attractive, such funds remain a high risk in the current economic environment.

• A final possibility is international bond funds although these often carry the risk of currency losses. (However, if the dollar starts to lose value in the international currency markets, something seen by some as a likely result of our increasing budget deficits, these funds will see an added boost to U.S. investors.) Such a typical fund currently yields about 3 to 4%.

• While stock funds will always subject you to higher risk, consider this:

  By merely buying and holding a fund emulating the S&P 500 Index, you will considerably outperform the average money market fund, even if the Index goes nowhere over the next year. When you consider that the Vanguard 500 Index is paying over 3.15%, this should be approximately the return you will receive if the fund is able to stabilize and hold its own. Right now, despite all the volatility, this fund is about at the same price as it was in Oct. 2008, that is, over 5 months ago.

  Naturally, one doesn't normally invest in stocks just to get the dividends, but right now, one is being paid to "ride out the bear market" at dividend rates that are only taxed at a maximum of 15% (so called "qualified dividends") vs up to 35% for dividends from MM funds ("ordinary income"). So, if you are a long-term investor who expects the market to, at a minimum, level out, and at best, go higher as the years pass, you will earn considerably more returns by being in one of these safer than most stock funds. This will be true even if you are "too early" in making the switch out of cash.

New Overall Allocations

Referring back to last month's Newsletter again, and what I have reiterated at the start of this Newsletter, you will see that it makes little sense to adjust the overall percentage of your portfolio allocated to stocks vs. bonds if you are doing so with the expectation of improving your portfolio's performance for periods of as little as 6 mos., or even perhaps up to a full year later. Since no one can reliably ascertain where the markets are headed in the short term, such adjustments will only make sense if they are done with the long term in mind.

However, extremely poor performing 5 year periods for stocks are reliably associated with good subsequent 5 year performance (and even more so for poor 10 year periods as we are in now). Further, it has been repeatedly shown that when the investing public as well as investing professionals become extremely negative about stocks, a condition we certainly have today, such occasions are usually a good time to increase your exposure (and, of course, vice versa for times when most people feel extremely positive about stocks).

Also discussed in last month's Newsletter, each investor must decide upon their own level of portfolio allocation to the stock market based on their own circumstances. However, I continue to provide my overall Model Portfolio allocations as a guideline.

For Moderate Risk Investors

Asset	Current (Last Qtr.)
Stocks	45% (37.5%)
Bonds	47.5 (50)
Cash	7.5 (12.5)

Who are moderate risk investors? This may include include the majority of investors, although it appears that, on average, people's risk tolerance may have become less lately. They should be able to tolerate a moderately strong degree of market ups and downs, with the possibility of several years of losses in stocks at any given time, but having the expectation of being able to to achieve better than average portfolio returns over the longer term. ('Average portfolio returns' might be defined as returns that are in the vicinity of 3-5% a year ahead of inflation, or possibly even more.)

For Aggressive Risk Investors

Asset	Current (Last Qtr.)
Stocks	65% (50%)
Bonds	30 (50)
Cash	5 (0)

Aggressive risk investors are investors who can tolerate a very high degree of volatility, including significant losses over at least several years, in an attempt to achieve significantly better than the returns possible for moderate risk investors. Historically, a basket of stocks such as found in a diversified mutual fund portfolio has been able to achieve, on average, about a 7% better return a year above inflation. Aggressive investors who include some bonds and/or cash in their overall portfolio should realistically expect to earn in the vicinity of 5.5 to 6% a year ahead of inflation, or possibly even more. (Of course, aggressive risk investors might also do an above average amount of trading in an attempt to outperform.)

Note: Even aggressive risk investors may not want to invest all their assets in stocks. Why not? Because it may not be worth the risk to make only a few more percent above inflation after weighing in the possibility of doing more poorly than moderate risk investors.

For Conservative Investors

Asset	Current (Last Qtr.)
Stocks	20% (15%)
Bonds	70 (70)
Cash	10 (15)

Conservative investors are those who can tolerate only a low degree of volatility and short-term losses in an attempt to achieve better returns than available by investing in solely in bonds and/or cash. Expected yearly returns might be in the vicinity of 1.5 - 2.5% per year ahead of inflation, or slightly more depending on how much is in bonds vs cash. (Investing in cash will most often only yield returns that at best barely keep up with inflation, and at worst, will lag inflation.)

Specific Category Allocations

Stock Fund Categories with the Current Best Prospects

As we have recommended for a while, we continue to favor Growth funds, especially Large Cap Growth. In addition, we are even more strongly recommending that our readers establish at least a small to moderate position in the Long-Short category. As mentioned previously, while this category may be unfamiliar to many, the best and safest such fund, one that I have been recommending on and off for over 5 years, is the Hussman Strategic Growth Fund (HSGFX). Over that period, this fund's return has been a positive 2.3% annualized, thru 3-30. (It is UP 7.5% over the last 3 mos.). Compare it to the S&P 500 which is down 5.0% annualized for the last 5 years and is down 10.9% over 3 mos.)

Note: Returns from Japan have exceeded most other categories of international stock funds over the last year, although the 3 and 5 yr. returns have been among the worse of all categories. Given the risks of this category, we now suggest you may want to obtain exposure to Japan by selecting an International stock fund that invests some of its portfolio in Japan.

Bond Fund Categories with the Current Best Prospects

In our Jan. Model Portfolio, our specific recommended bond funds included a heavy dose of intermediate and long treasury funds. This time around we are substituting a GNMA recommendation for our Intermediate Govt. position. The reason is that treasury funds, especially intermediate and short term funds, may no longer be the best way to play the bond market in light of low yields and the leveling out of treasury prices due to concerns that too much supply is in the pipeline (eg from government efforts to support the economy).

Note: Govt bond funds can include muni bonds as opposed to taxable bonds for those in an intermediate to high tax bracket. In fact, muni bonds may offer one of the best opportunities of all within the bond market, given their relatively high tax-free yields.

How Our Recommendations From 1, 3, and 5 Years Ago Did

The performance of our Moderate Risk Stock Fund Model Portfolio is shown under the "see track record" link on our home page. The following are some observations:

The good news is that anyone who followed our overall allocations for moderate risk investors to stocks vs bond vs cash from 1 year ago did significantly better than had they followed a more typical portfolio allocation at the time of at least 65% stocks/25% bonds/10% cash. Starting a year ago, we recommended only a 47.5% allocation to stocks with 35% to bonds and 17.5 to cash (and have reduced our stock allocation since then). Since stocks performed very poorly over this period, our underweight in stocks would have resulted in a lot less losses than suffered by the typical investor. So, had one invested following our suggested overall allocations and earned the returns of our basic benchmarks, the Vanguard 500 Idx, the Vang. Tot Bond Market Fund, & the Vanguard Prime MM, your portfolio would have lost approx. 16.5% vs close to 24%. Thus, for a $50,000 portfolio, you would have lost approx. $3750 less over the last year.

Our specific category allocations to stock funds underperformed the S&P 500 for both 1 and 3 year periods. This was almost totally a result of our high allocation to foreign funds which have underperformed over the last 3 years, especially over the last one year. However, our stock fund category choices from 5 years ago appear to have once again beaten the S&P 500, but if so, by a pretty small amount. And also on a positive note, the majority of our recommended specific fund choices within a given stock category from our stock portfolios from 3 and 5 years ago did better than their category averages. It should be noted that over the last few years, only a small proportion of active fund managers (as opposed to passive index funds) have been able to beat the S&P 500.

With regard to our specific bond category suggestions, it has also been hard to beat a good index fund, namely the Vanguard Total Bond Market Fund. Generally speaking, in fact, unless you owned some of the specific bond funds I have repeatedly recommended in my Model Portfolios, such most of the Vanguard funds and PIMCO Total Return, your bond fund returns would have probably not even done better than the typical money market fund.

For example, a year ago, my largest bond fund allocation was to the Intermediate Term Non-Government category at 25% with a specific fund recommendation of PIMCO Total Return. However, over the last year, the category return has been about -5%. However, the PIMCO fund has returned about +3% over the same period, resulting in an 8% net difference! The difference has been even more stark for Intermediate Term Government category. Here, the average category return has been about -0.9%; my specifically recommended fund within that category was the Vanguard Intermediate Treasury Fund which returned +7.7%. (For comparison, the Vanguard Total Bond Market Fund returned about +3.2% over the same period.)

The conclusion to be drawn from this preliminary data is that even if you are very carefully monitoring your investments, regularly weeding out losers and finding new winning categories, it is always going to be very hard to beat stock index funds. And regarding bonds, it may nearly always be best to stick with low cost funds such as those at Vanguard or funds run by legendary fund managers, such as Bill Gross at PIMCO.

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Fixing the Banks: A 50/50 Chance of Success

In a bit of verbal legerdemain, the administration has renamed the commonly labeled “toxic assets” held by banks as “legacy assets.” Treasury Secretary Geithner says he has a plan to increase the market price for these assets, justifying the new label. For investors, renaming the assets will not do the trick. They want to know, "Will the plan work?"

Secretary Geithner stated the plan’s principal purpose in an article appearing in the Wall Street Journal:

Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets ... will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury. (emphasis added)

Whether we call them toxic or legacy assets, the core of the plan is designed to increase the market price of securitized loans, which are plagued by underlying defaults. Under current accounting rules, the banks have been required to mark these assets down to market – a dysfunctional market, according to the Treasury. To a substantial degree, the administration’s plan has morphed from an effort to divest banks of toxic assets to a program aimed at increasing the price of legacy assets and thereby enhancing bank balance sheet solvency. The antidote to the toxin is now to jack up the price.

A Wall Street Journal article appearing the day after the plan’s release keyed in on the core objective: “Much will depend on how much Treasury can raise asset prices with this new liquidity play.” Simon Johnson, former Chief Economist of the International Monetary Fund (IMF) wrote, “The government has no way to bring down the banks' minimum sale prices, especially without the threat of receivership. So the only option is to induce buyers to pay more than they think the assets are worth in today's generally risky climate, and the only way to do this is through subsidies.”

University of Texas economist James Galbraith sees things differently, “The Geithner plan’s real design is thus not to help the market but to steer it. It is not to discover a price but to create a new one, based on rules the Treasury is just now making up.” This conclusion is in contrast to Geithner’s claim that the price of these assets is artificially depressed because the markets are not properly functioning.

The strategy to drive up prices of legacy securities is fairly simple. The keys are increased liquidity, low risk, leverage and low rates. The plan is to increase the pool of capital willing to purchase these securities by providing FDIC guarantees for $500 billion up to $1 trillion of loans for their purchase. The guarantee will also assure that investors who borrow these funds in order to buy the legacy securities will get far lower rates than would otherwise be available on the open market. The private party purchasers of these securities will put up 7.5 percent of the purchase price. The Treasury will put up 7.5 percent and the remaining 85 percent will be borrowed with FDIC guarantees. This leverage will provide substantial return to investors if the securities rise in value after their purchase. The investors’ downside risk is limited to the 7.5 percent initially invested, while the upside potential is unlimited.

Given the multiple incentives, it seems likely that legacy security prices will be significantly increased but there are reasons for concern. There are numerous potential pitfalls in the plan: (1) Banks might not be willing to sell the assets for the price investors are willing to pay. (2) Investors may only be willing to buy up the troubled assets that stand a fighting chance of recovering some value above the purchase price, saddling the banks with truly toxic assets no one wants at any price. (3) Banks may play possum, holding back on selling their assets in the hope that the market will drive up prices. (4) The banks may try to dump their most toxic assets. Buyers, fearing exactly this behavior, will reduce all their bids accordingly. This behavior will make it harder for buyers and sellers to agree on prices. (5) Banks probably will not sell if the price requires them to suffer further write downs of the assets on their books. While these assets have been marked down, they may still be booked above the subsidized market price created by the plan. The almost certain relief from mark to market accounting requirements about to be announced by the Federal Accounting Standards Board will further reduce pressure to sell these assets. As the Economist opined, “Tim Geithner’s toxic asset scheme will not work unless banks are forced to sell their problem loans.” Required sales are not a component of the plan.

Simon Johnson indicates that “the subsidy may not be sweet enough to close the deal.” By contrast Nobel laureate Paul Krugman concludes, “The way the funds are structured provides a strong incentive for investors to overpay for the assets.” Such a belief may drive away prudent investors.

If the legacy assets are to be successfully sold, potential buyers will need reliable data on which to place their bids. The lack of clarity has been a major impediment to the sale of these assets in a declining market. The securities at issue vary from packages of home and commercial mortgages to derivatives of derivatives. The government will need to collect and analyze detailed data in order to assure due diligence and a successful market. Both the structure and performance of these assets requires careful vetting. This will take time. It may take three months or more to get the program up and running. Some analysts have expressed concern that proper vetting will be difficult to achieve. Other critics suggest the time lag necessary to achieve transparency could undermine the program’s effectiveness.

These issues articulated above add up to a host of unknowns which make the success of the plan hard to predict. Even the objective is fuzzy. Does the administration aim to increase these asset prices by 5, 10 or 25 percent or more? They have not said. Most likely, they have not even set an internal goal for fear it would leak to the press. Vince Reinhart, former director of monetary affairs at the Fed wrote, “So the government has once again opted for the circuitous route to the goal of sorting out financial firms. This will take longer than necessary and sacrifice clarity. But obfuscation was probably a design principle.” The danger here is that the goal is not only hidden from the public but not clearly thought out by the plan’s authors.

Listening carefully to the comments of savvy investment bankers, the plan appears to have a 50/50 chance (a coin toss) of successfully driving up legacy securities to a level where they will provide banks with meaningful relief. There is a high level of uncertainty about this undertaking. The initial stock market reaction seemed to suggest that the program was likely to be 80 to 90 percent successful. If this turns out to be wishful thinking, the market will claw back some of those gains.

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