This month's Newsletter should give you insights into whether there is the likelihood for a recovery in stock prices any time soon.

Stock Investment Strategies In the Deep Freeze

Are there any strategies you can employ to protect your portfolio in the event the bear market continues considerably longer? Sell, Buy, or Hold revisited. How much faith should you place in stock market forecasts?

Bailing Out Banks – A Further Threat to Economic Recovery and Your Portfolio

How much do you really understand about the current bank crisis? Far from just an academic discourse, Steve Shefler's explanation of the harsh realities of the unpleasant choices that must be made ahead will likely damper hope for a quick turn around in the stock market, while presenting food for thought to bond investors as well.

Stock Investment Strategies In the Deep Freeze

No matter whether you are a small or big-time investor, nor what your stock fund strategy, nothing seems to be working. And this has been true for at least the last year. Here's further proof of that:

Regardless of what type of mainstream stock fund you invested in starting in Jan. of '08, as the bear market got off the ground, it almost didn't make any difference. The average stock fund was down nearly 39% over the year. If you invested all of you money in the average Small-Cap Value fund, you were down 33.5%; if instead, you were in a Mid-Cap Growth fund, you were down by 44.5%. All the other major fund categories were in this tight 11 point range. (Some specialized international funds did even poorer though.) In other words, investors did not see value in any traditional stock category as measured by the fact that they indiscriminantly sold all types of funds to about the same degree.

A stock fund picking strategy is based on the idea that some funds should perform better than others. And usually that is the case. If we go back to Jan. '07, which type of fund you were invested in that year truly made a big difference. The average US stock fund returned +6.6%. But if you were in the average Small-Cap Value fund, your return over the next year was -5.5%. If you were in Mid-Cap Growth, your return would have averaged +16.5%. That's a 22% range, exactly double the 2008 range.

It is normally the case that a good stock fund picking investment strategy can make a big difference, even the difference between achieving good results vs. mediocre (or worse) ones. But when a bear market hits, it seems investors are no longer paying attention to picking the wheat from the chaff; they are throwing out everything. And when they do, it becomes almost impossible for any stock fund picking strategy to work.

In this case, overall asset allocation strategy, that is, which broad types of assets you have your investments in, would appear to be far more important. If no mainstream categories of stock funds are doing well, then the only way to do significantly better than what stocks are delivering is by trying to be in bonds or cash, assuming, of course, that these categories will do better than stocks.

Obviously, though, changing your overall allocation strategy is not an easy decision to arrive at. Many of us have come to believe that stocks are the best investment for the long term, regardless of relatively short-term fluctuations. Perhaps changes in allocations should only occur as a function of your age, or if you anticipate the need to withdraw a proportion of your assets in order to cover a large upcoming expense within the next several years.

Aside from hesitation to change one's previously well-thought out strategy and thereby undo prior decisions, one obstacle, especially now, is that you might have to accept a loss when moving out of your current fund into another asset. This involves not only the actual loss of money but the psychological loss that comes with acknowledging that you "erred" by choosing a given asset, or at least, stayed too long before things got considerably bad. Or, if held in a taxable account, you might have to pay taxes on any fund that might still have a gain. All this pain might be avoided one could be reasonably sure that the fund in question will eventually come back and still provide ample rewards. So when faced with these choices, it is not surprising that the majority of people will wind up deciding to keep on holding even in the face of adversity. And many will continue to do so as long their patience, nerves, and necessary financial resources hold out.

Of course, if you are investing new money, changing you asset allocation strategy can occur without the potential drawbacks of selling anything. You just gradually direct your new investments, such as ongoing 401(k) contributions, into types of funds that now seem more prudent. Or, if allowed as an investment option, re-direct your fund distributions from being re-invested within the original fund, to a different one.

For readers who might remain skeptical as to the advantages that can accrue from changing one's asset allocation strategy in the face of harsh economic realities, let's, as an example, see what the difference is between remaining invested in a typical allocation, 60% stocks, 25% bonds%, and 15% cash vs. following the allocation I recommended in my 3rd Qtr '08 Newsletter for moderate risk investors which was 45% stocks, 35% bonds, 20% cash.

For ease of comparison, assume the funds were invested in the Vanguard S&P 500 Index fund (VFINX), the Vanguard Total Bond Market fund (VBMFX), and the Vanguard Prime Money Market fund (VMMXX).

The return for "typical" portfolio in the latter half of '08 would have been -15.9%, not annualized.

The return for "bear market adjusted" portfolio over the same period would have been -11.2%, not annualized.

Nor has the first month of 2009 started well for stock portion of either portfolio. As of 1-30, the above 3 funds would have shown total returns of -.084% (VFINX), -.007% (VBMFX), and +0.0016%(VMMXX) (all not annualized). So, combining the results over just the last 7 months, the typical portfolio would have lost 19.6% while the bear market adjusted portfolio would have lost relatively less at 14.1%. These losses are also not annualized; if they continued at this pace over a full year they would start to approach double these amounts.

Let's see what these loses translate into in terms of actual dollars. Suppose your entire investment portfolio in mutual funds was worth $100,000 on July 1, 2008. Had your portfolio been similar to that of the typical investor you would now have $80,337 left; an investor following the bear market adjusted portfolio would have $85,893 left. The difference is $5,556 less now remaining for the former investor than the latter. If you had even more than $100,000 invested, the difference is proportionally greater. And, if your original allocation was even higher in stocks than 60% (some people might still have 100% of their total investments in stocks), your "paper" portfolio losses in during this admittedly short period would be far greater.

(You should note that for the 4th Qtr of '08 and the 1st Qtr of '09, my Newsletters recommended a further lowering of your stock allocation below the 45% used in the above calculations to 42.5% and 37.5% respectively. I also recommended a raising of your bond allocations from 35% to 40% and then 50%. Had one made these modifications, their portfolio losses thus far would be have been considerably less than those shown above.)

While negative returns are obviously never pleasant when a bear market hits, losing less, even if it is just "on paper", can make a big difference. Less loses may help you better withstand the ravages of the bear and enable you to have greater resistance to the urge to sell.

ALERT >>> HOLDs Now Predominate Our BUY, SELL, or HOLD Category Recommendations Along with a New BUY Signal!

Six months ago in our Aug. '08 Newsletter, we described our research which examined mutual fund category returns over the preceding 13 years. From that data, which spanned both bull and bear markets going back to 1995, we were able to develop a method of classifying stock fund categories in terms of whether they should be considered BUY, SELL, or HOLDs at any given time.

At that time, we stated that all the major fund categories were, according to our rating system, "SELLs". This call has proven to be 100% correct since all categories have shown major drops since. In fact, going back to Oct. '07, near the start of the bear market (before the research had been done), if we had been able to classify categories at that time, our system would have shown nearly all of the morningstar.com categories of funds as SELLs. (The main exceptions were Large Cap Growth and Large Cap Blend which were "HOLDs".)

Here is an important update on what our classifications show as of Jan 30, 2009. All major categories are now classified as HOLDs, except for Small Cap Growth, which as of that date, crossed over into the BUY category.

Based on past data, a category classifed as BUY may actually be considered a "super buy" (see the Aug Newsletter). In fact, an index fund such as Vanguard's Small Cap Growth has done well recently, moving from a NAV of 9.30 on 11/20/08 to 11.61 on 1/28/09.

Given that our overall view is that rocky times likely remain ahead for the stock market, one might want to wait up to a few months longer for confirmation that SC Growth may indeed be the next category that will outpace the market. But for those investors who are tempted by the possibility of making good gains over the next few years, you may want to create or increase exposure to this category.

How Much Faith Should You Place in Stock Market Forecasts?

How successful were some of the most well known investment experts in helping their readers avoid the bear market? Let's take a quick look by referring to the website www.cxoadvisory.com. This site shows comments from a slew of market experts and provides an estimate of how accurate their stock market judgments have been over a number of years. The list of forecasters rated can be found at

       www.cxoadvisory.com/gurus/

I will select a few recognizable names from their list of "gurus" and present what these experts said near the beginning of the bear market. Remember that while the bear market actually started in Oct. 2007, it was really only recognized by mid-2008 when the S&P 500 first showed a 20% loss.

Bob Brinker - has one of the most popular newsletters and website and is well known from his weekly syndicated radio shows.

1-23-08 "...the risk of a cyclical bear market decline in excess of 20% is not likely to the materialize any time soon ...We expect the S&P 500 Index to achieve new record highs this year and to reach the 1600's range. (His model portfolios are fully invested.)"

Ken Fisher - commentator for Forbes magazine and investment advisor.

1-28-08 "I'm still bullish ...We aren't likely to get much gloomier. Eventually we'll come around. So 2008 is more likely to be a robust market than a bust one. Stocks are cheap ..."

Louis Navellier - writer of several newsletters and investment advisor.

2-1-08 "...there could be a great buying opportunity for conservative investors ... soon, ... we are now in the midst of an incredible buying opportunity. Aggressive investors can jump in any time ..."

Of course, to be fair, there were some forecasters who pretty much got things right. For example:

John Mauldin - advisor, newsletter writer, and author of "Bulls-Eye Investing":

2-8-08 "You need to use these bear market rallies to lighten up your ... exposure... I would not want to be anywhere close to an index fund. And it is not too late to get out. There is still more downside in this bear." (Note, though, that index funds did a tad better than the average US stock fund last year. And on 1-4-08, Mauldin said that he expects "to become more bullish on the market some time this summer, if not before.")

My purpose in presenting these quotes is not to belittle my fellow newsletter writers and/or advisors. Rather, it is to point out that bear markets frequently hit when we least expect them. And, as stated above, once a bear market hits, nearly all stock funds go down in unison so that there is little advantage to be had anywhere; in other words, there appears to be no place to hide.

What did we say in our Jan. 1, 08 Newsletter? (approximately a month before the above quotes)

"...we hope that investors can refocus on just how bad it can get if we indeed do enter into a new bear market (or already stealthfully have, since we may continue to pull back from 2007's highs.) ... even if the losses of a potential bear market turn out only HALF of what they were during 2000-2002, it makes sense for all of us to consider taking some precautions...We are presenting data here that a bear market ahead seems to be a real possibility."

The funds-newsletter.com website does not explicitly make stock market forecasts. Rather, we focus on making suggestions for asset allocations both across asset categories (ie stocks vs. bonds) and within each category (ie which specific stock/bond funds are the most attractive) for portfolio enhancement, rebalancing, or trading purposes. However, one can readily judge our attitude toward the stock market not only from our commentary, but from the percentage of our portfolio which we allocate to stocks each quarter.

We think it might be informative if our readers could see where we rank in the ratings against other forecasters. If any reader is interested in seeing whether the www.cxoadvisory.com website would consider objectively rating our forecasting record (which we think has been pretty good), you can contact them to suggest this at the following e-mail address:

       steve.lecompte@cxoadvisory.com

Note: At least one of our readers did contact the above site and we thank them for doing that. Unfortunately, Mr. LeCompte, while he did expend considerable effort to go thru our site, rated it in terms of a short-term market timing model only. That is, he compared our overall asset allocations to stocks, bonds, and cash, to how stocks and bonds performed over the following quarter.

We, however, from our very beginning have always focused on achieving long-term results. That is, our Model Portfolios were never designed, nor do they, as Mr. LeCompte found, have any value if you are expecting to get improved results every quarter. Rather, our Models are predicated on the attempt to improve results over at least the following year or two, and continuing up to five years later. That is why on our "see track record page", you will find that we compare each of our quarterly Stock Model Portfolios performance with the performance of the S&P 500 Index over the following 1, 3, and 5 years.

Our main focus has also always been on asset allocation to the major mutual fund categories as opposed to trying to predict the short-term ups and downs of the stock market, which we consider extremely difficult if not next to impossible to do. Mr. LeCompte's analysis only includes looking at overall asset allocations. It did not address our primary purpose which is to help an investor in making fund selections and portfolio rebalancing by recommending those categories within the stock market as well as within the bond market that appear to have the best prospects for relatively better performance.

Of course, it would be interesting to see if Mr. Compte's analysis of our overall quarterly stock, bond, and cash positions could show whether they might predict where the stock and bond indices might be a year or more after making them. (We hope to perform such an analysis and publish it in our next Newsletter.) But even if such an analysis does not show particularly promising results, it cannot negate the history of positive findings we have already shown in terms of improved performance over the S&P 500 Index when one measures how one's stock portfolio would have outperformed vs. the Index.

We, above all else, value using research evidence and we commend Mr. LeCompte for also taking that approach. No investor should take at face validity what any supposed "expert" says. If data isn't available to support someone's statements, then "let the reader beware". But the data provided must be appropriate for what the model suggests; only by using a long-term analysis will anyone be able to correctly ascertain whether Mutual Fund Research Newsletter is useful for investors who also have that goal.

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Bailing Out Banks – A Further Threat to Economic Recovery and Your Portfolio

New York Times economic columnist Joe Nocera knows how to talk straight. Consider his recent comments about the current banking crisis:

       As for taxpayers, the harsh truth is this: there are hundreds of billions of dollars of prospective losses still on the balance sheets of banks that will have to        be written down. Everybody knows that. Someone has to eat those losses. Even wiping out shareholders will only get you so far. The rest is going to        have to be absorbed by the government. There is no other option. This fact needs to be faced squarely. (1/23/09)

       A quick reminder for readers who wonder why the banks shouldn’t be allowed to go bankrupt, like any other company that made the kinds of mistakes        banks made. The answer is that the banking system is the engine of the economy; if banks stop functioning, economic activity will grind to a
       halt. (1/17/09)

President Bush and Secretary Paulson failed to speak clearly and plainly about the realities summarized by Nocera. As for President Obama, the New York Times reported:

       Privately, most members of the Obama economic team concede that the rapid deterioration of the country’s biggest banks, notably Bank of America and
       Citicorp is bound to require far larger investments of taxpayer money, atop the more than $300 billion of taxpayer money already poured into those two
       financial institutions and hundreds of others…. Adam S. Posen, the deputy director of the Peterson Institute for International Economics [says]: “I would
       guess that sometime in the next few weeks, President Obama and Treasury Secretary Tim Geithner will have to come out and say, ‘It’s much worse than
       we thought, and just bite the bullet.’ So far the Obama administration has signaled that it is trying to avoid that day.”

Whether President Obama and his administration will take the brave step of biting the bullet and speaking clearly to the public about these realities is yet to be seen.

Will the "Bad Bank" Solution Work?

The consensus among economists is that in order to re-establish sustainable growth in our economy, the banking system must be restored to solvency. Given the intense public focus on the solvency and stability of the nation’s banking system, if the Obama administration fails to take corrective action, and do so relatively soon, an adverse reaction in the equity markets is almost certain. Based on statements of Secretary Geithner, the markets expect that the administration is developing a plan to restore solvency to the banking system. In the short run, President Obama can divert attention to the needed fiscal stimulus, but that window of opportunity is limited.

There are key practical and political impediments to the "bad bank" solution currently bandied about in the news media and by public officials as the solution du jour. The proposal would reportedly buy “toxic assets” from banks and transfer them to a government run rescue entity similar to the Resolution Trust Company, which was used to liquidate saving and loans during the 1980’s debacle.

The first problem is that there is no good way to value these toxic assets. This was the principal reason that the Bush administration abandoned the original TARP proposal to buy these assets. As Geroge Soros has stated, “Toxic assets are, by definition, hard to value. The introduction of a significant buyer will result not in price discovery, but in price distortion.” Many of the instruments at issue are so arcane and complex that there is no adequate pricing mechanism

Even if some pricing mechanism for the toxic assets could be formulated, the result would be two unattractive alternatives: (1) the government will pay market prices for the toxic assets. In that case, the banks would not sell them to the government or, if they did, the collapse of the banking system would be accelerated; (2) the government will pay substantially more than fair market value, in which case the banks will receive a huge gift and taxpayers will suffer a big loss.

Paul Krugman, this year’s winner of the Nobel Prize in economics, believes that the Obama administration will make the huge gift to banks. In a recent New York Times column (1/19/2009) he stated:

       Maybe private buyers aren’t willing to pay what toxic waste is really worth... But should the government be in the business of declaring that
       it knows better than the market what assets are worth? What I suspect is that policy makers — possibly without realizing it — are gearing
       up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts
       to bank shareholders at taxpayer expense, disguised as a “fair value” purchases of toxic assets.

He says that if the Obama administration adopts such a course it would be engaged in a new form of “voodoo economics.” In short – a smoke and mirrors approach that hides the underlying reality. Both liberal commentators such as Krugman and the Republican congressional leadership would be harshly critical of such an approach.

One thing is certain – President Obama does not want or intend to be seen as making a “huge gift” to bank shareholders. At the same time, the banking system needs a major capital infusion, which it seemingly has limited ability to pay back. This dilemma is a major challenge to the new administration.

Commentators disagree on the additional amount that the U.S. banks have yet to write down in order to achieve solvency and stability. Most analysts, including the International Monetary Fund, indicate that it will be well over a trillion dollars. Simon Johnson, the former chief economist at the IMF, estimates the additional cost to the government will be between $1 and $2 trillion. By contrast, President Obama’s fiscal stimulus plan is estimated to cost $825 billion. A trillion dollars of additional cost would amount to almost 10% of the current federal debt. Obviously, any estimate of the total cost of a “bad bank” is better characterized as a guestimate. There are a host of hidden aspects and unknowns. Key variables such as when and how vigorously the economy will recover are highly speculative.

There are several other political challenges to the adoption of the bad bank plan: (1) The Obama administration will be extremely reluctant to fashion bank relief that on its face is more generous than the relief provided by the Bush administration; and (2) President Obama both politically and philosophically will want shareholders to pay for bank losses before taxpayers pay for them.

While many individuals have called the first expenditures of TARP funds for the banks a “gift,” in fact, it was far from that. Rather than simply “giving” the banks money, the Treasury purchased preferred shares in the banks, which requires the banks to pay 5% annual interest for the first five years and 9% thereafter. Treasury also obtained an option to purchase common stock equal to 15% of its investment in preferred stock. The second stage of preferred stock investments of $25 billion each to Citicorp and the Bank of America required an interest payment of 8% and further required the two banks to reduce their common stock dividend to one cent for the next three years. Thus, while the common stock was not directly watered down, it was effectively so. After the agreement, the stocks of both banks dropped sharply.

If the Obama plan appears to give banks more than the fair market value of the purchased toxic assets without a substantial quid pro quo, it will suffer by comparison to the Bush plan. Following the example of Citicorp and the Bank of America, banks who sell their assets to the “bad bank” might be required to reduce their dividends to one cent for three years or more in order to rebuild capital. It is hard to imagine that the administration would not require such a concession from banks that benefit from the toxic asset buyout, given the BofA-Citi precedent. In the alternative or in addition, banks might be required to provide the government warrants on common stock to help pay for any shortfall that the “bad bank” suffers during its administration of the toxic assets or at their eventual resale to private investors. If either of these steps is required, it will significantly offset the boost to bank stocks that investors are hoping for from a toxic asset buyout. In any event, as Joe Nocera warned, taxpayers are likely to be stuck with a big bill for which there will be no compensation.

A further major obstacle for the bad bank is the up to $2 trillion cost to taxpayers when added to the $825 billion stimulus. News reports indicate that administration officials are concerned that borrowing that amount may drive up interest rates to a level which would impair the economic recovery or imperil the dollar.

Anyone who believes the “bad bank” is a sure thing needs to think again. There are a lot of hurdles to be cleared. The alternative of totally wiping out shareholders and effectively nationalizing the banks involves political risks that Obama is unlikely to take. As some commentators have indicated, such an option would be politically poisonous. Whatever the Obama administration does to rescue the banking system is almost certain to provoke a higher level of criticism than the fiscal stimulus package.

The bottom line is that the entire bank bailout problem is a huge quagmire. Working though that quagmire will be no easy task. The devil is in the details. While announcements that a “bad bank” relief plan is on the way may propel the markets upward in the short run, the problems of working out an acceptable political compromise and requiring concessions from financial institutions are likely to wipe away some, if not most, of those gains in the long run.

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