Our New Year's issue is always one of our most well read issues, containing our new Model Portfolios. This one will additionally give you two different perspectives on the potential prospects for interest rates and therefore, bonds, as well as stocks.

Click on the title below to jump ahead to it.

Risk Continues To Be a Four-Letter Word; You Should Continue to Avoid It

Will Modestly Rising Interest Rates Spoil the Party for Bond Investors?

Risk Continues To Be a Four-Letter Word; You Should Continue to Avoid It

There are opportunities out there, an optimist would say. The question is, however, how much added risk are you willing to bear to seize them? The following represents my point of view; others may answer the question differently.

In short, my answer is to limit your risk. Since we first discussed the possibility of a bear market a year ago (see "2007 Returns Show Potential Warning Signs of a Bear Market"), things have only gotten worse and worse. Almost everybody failed to foresee the seriousness of the situation. And even now, almost no one is visualizing that yet another, and possibly even bigger shoe, may be waiting to drop.

A pessimist, I am not. But having a face-to-face confrontation with a worldwide situation seemingly losing its bearings more and more each new day, is not a challenge I am willing to fly in the face of.

There are those who may cut and run (or already have). Who knows? Maybe their actions will be proven correct. But while I don't currently plan to take on any new risks, I will not throw away my prior choices - see Our Current Model Portfolios below. A sound plan may encounter many potholes, but the road is still worth taking. I have yet to hear an alternative route without serious potholes of its own.

How deeply do we put ourselves in harm's way? The man who invested his life savings into horse and buggies was likely wiped out when automobiles came along. (And the man with his life savings in General Motors stock had better be on guard too.) But what about those who choose to invest almost solely in stocks? These have not been good times for those so committed. Ten years running with virtually no results for the average US stock, while not a death knoll, suggests a single-minded path may not always be the wisest.

So where can one smooth over the bumps while the world, first, staggers and then likely, stagnates? Under a mattress, in money market accounts or CDs? Only if one wants a repository to store money. Why cash is seen as the place to hide befuddles me even more now that cash rates of return are set to drop to being nearly invisible.

So instead, my answer is my old, but generally unloved friend, bonds - see "No Bull? Bonds Can Trounce Stocks (and Beat Cash Too)" in my Apr. '08 Newsletter. Since that date, investors might be sitting on about a 10% bond fund gain vs. around a 2% gain in cash and a 30% loss in a typical stock.

And with nothing but bad news projected to lie ahead for the world, the gains should continue to be there for well-chosen bond funds, which can be more than just a repository. For example, the 1 year return on the Intermediate Term Govt fund we recommended in Apr. (Vanguard VFITX) is currently about 14.9%; for the Long Term Govt fund (Vanguard VUSTX) also recommended then, it's about 25.2% (data thru 12-29-08).

So, here's my advice. Stick with the stocks you still have (unless you have no choice but to raise cash). And be mentally prepared for the reasonably good possibility, although not certainty, that even worse performance lies ahead; stocks could continue to drop significantly although they will come back to reward investors given enough time. But for the foreseeable future, become a heavy-duty bond investor (at least until inflation as measured by the Consumer Price Index returns to a more normal level of about 2% to 3% - it's currently at 1.1% and likely to drop more in the months ahead).

The horse and buggy may be dead, and maybe even American car companies. But merely staying in one stationary place isn't a viable model for either people or investors. As interest rates and inflation fall around the world, getting a positive rate of return from existing bonds will become more and more desired by investors. As a result, you will most likely get not only a fixed yield, but capital appreciation as more people will want to own the currently best performing asset class around.

Our Current Model Portfolios

Overall Asset Allocations

For Moderate Risk Investors

For Aggressive Investors

For Conservative Investors

Does our low, low allocation to stocks mean we are bailing out, perhaps just at the wrong time? Not at all. Had you bought and held the moderate risk portfolio we recommended one year ago (52.5% in stocks), and suffered the typical loss of about 40% since then, your stock portfolio would have thus shrunk to a current level within the 30% range without taking into account the performance of any additional bonds or cash. So, we haven't cut our stock positions - they have been cut by the markets for us. While we did add a tad to some of our stock positions within the last few months, we are now going to take our time when it comes to adding any more.

Note: Incidentally, this is where you might want to differ. Stock prices are definitely low and you might want to add to your positions to bring them back to your original (or higher) allocation dating back to the pre-bear period. However, I now prefer to wait to signs that the market (and the world's economies) are starting to make significant progress in turning around the crisis. From where I sit, it appears we might still be a little less than half way through the process.

The last time we were more bullish on bonds than stocks was in our Apr. 2, 2003 newsletter. On that date, the S&P 500 Index closed at 881. As of Dec. 29, approaching 6 yrs later, the S&P closed at 869, approximately a 0% return. For comparison, the Vanguard Total Bond Market Idx returned approx. 4.7% annually over those same dates.

Among the myriad of reasons I am so bullish on bonds is this: In Feb. 1999, the Bank of Japan dropped short-term interest rates to near zero, just as the Fed did this Dec., both in an attempt to fight deflation. Ditto for back in June 2003 when the Fed dropped its short term rate to 1%, which to that point, was an historical low. Deflation, inflation's opposite, is public enemy no. 1 (it occurred during the Great Depression). Once started, it is hard to stop (Japan had non-stop deflation between 1999 and 2006.)

What were the effects of these rate cuts on inflation? In Japan, over the following 3 yrs., the already low inflation rate did not stop falling and annualized deflation greater than -1.5% set in. In the US, the inflation rate also continued to drop after the 2003 cut for the better part of a year. But by the latter part of 2006, inflation, as was the case in Japan, was also lower than before the Fed's historic cut, although not in deflation. All this suggests that it will take a considerable amount of time before inflation stops falling and possibly begins to rise again.

Incidentally, what specifically is the Fed (not to mention other central banks) trying to accomplish by pulling out all the stops as it announced it was going to do in December? Of course, dropping interest rates is designed to make it easier for consumers to borrow and spend, which would help foster growth. But, although I can't prove it as I have no access to the Fed's inner deliberations any more than anyone else, it is likely they also have the following goals in mind:

• They want you to get out of money market accounts and CDs. Why? Because in order to get the economy, and esp. the housing market back on its feet, they want investors to continue to buy bonds which, upon comparison, will be seen to still offer somewhat better yields. The more bonds that are newly purchased (or bond funds), the lower intermediate and long-term rates will go (short-term rates can hardly go lower), helping to more quickly reverse the housing market's slide. And if investors decide to buy stocks instead, that too is a plus for the beleaguered stock market and economy as well.

• The government is in the process of borrowing more and more to pay for the various stimulus packages/bailouts. The lower the rates they have to borrow at, the less the cost to be added to the already staggering deficit.

• They would like to see the dollar fall even further which usually is a side-effect of lowering interest rates below those of our trading partners. The lower the dollar, the cheaper and more competitive our exports to those countries become, creating greater demand for our exports. Perhaps even more important, at the same time, a lower dollar helps to create a little more inflation here at home. A little more inflation would be welcome news to the Fed. Since the Fed dropped rates to 1.0% in late Oct., the dollar has fallen significantly.

  Fed chairman Ben Bernanke noted this link this back in 2002, as recently was pointed out in the Wall St. Journal: The devaluation of the dollar in 1933/1934 "ended the U.S. deflation remarkably quickly," he said. (Note: If the dollar continues to decline, this will once again be helpful to US investors who invest both in (unhedged) international stock and international bond funds.)

While bonds will likely not be the best investment for the next 10 years, as they have been the last decade, we expect the good performance to last for at least a year longer. But you should continue to stick to high quality bond funds as described in our Oct 08 newsletter; while there may be considerable opportunity for those who choose to invest in riskier high yield and long-term corporate bonds, we think it more prudent to await real signs of a recovery before committing.

As to whether government bond funds are in a bubble (see Steve's article below), I do not see the kind of "overheated" returns over the last 3, 5, or 10 years that jump out as obvious warning signs that investors have overcommitted to bonds. In fact, long-term "investor returns" (as defined by morningstar.com) in even the highly rated Vanguard Long Term Treasury fund are not really any different than the returns seen during other previous periods of slow growth. Here, then, are our specific recommendations:

Bond Portfolio

Stock Portfolio

Prior Model Portfolio Performance

A complete review of how one would have done by merely buying and holding our moderate risk Model Portfolios from 1, 3, and 5 years ago will be presented on our web site in the days ahead.

Although the data are not yet complete, it does appear so far that our 1 and 3 year stock category recommendations as a whole trailed the S&P 500 Index by a small amount. The Index has proven to be harder to beat since the onset of the bear market. However, our recommendations made 5 years ago look set to beat the Index again as they have done every time going back to our first Model Portfolio at the start of 2000! While many of the specific stock funds we recommended 1 yr ago did not do well, almost all specific funds we selected both 3 and 5 years ago did better than the Index.

But perhaps most significantly, our prior Model Portfolios, when looked at as a whole allocating to not only stocks, but bonds and cash as well, did exactly what we would have hoped for. That is, had you owned the entire portfolio, your returns would have been significantly better than the large losses incurred when looking at stocks alone. In fact, our Portfolio recommendations made 5 years ago, would have eked out small positive returns as compared to the Index alone, whose return was approximately -3% annualized. Our course, our Portfolios for conservative investors, being less weighted to stocks, each did considerably better.

----------------------------------------------------------------

Will Modestly Rising Interest Rates Spoil the Party for Bond Investors?

Editor's Note: 10 yr. treasuries are currently at 2.09% as of Dec. 30th. A rise in that rate would likely cause treasury bond investments to underperform.

On December 18, 2008, the ten year treasury dropped on an inter-day basis to 2.05%, its lowest level in over 50 years. Investors need to consider what the rate will be over the coming year.

The ten year has been in steady decline since it peaked at 15.25% in October 1981 during the current interest rate mega-cycle. For the first ten months of 2008, the rate ranged at the 3.50% to 4.00% level. It was last in that range during 1962. At the beginning of December, the rate plunged to below 3.00%. The rate, which had been 4.00% on October 30, fell to 2.05% on December 18 – an almost 50% drop in the rate level in a 45 day period.

The sudden drop in the ten year rate level is attributable to a variety of factors:

• A flight to safety by investors due to collapsing stock prices and doubt about other bonds such as corporates and municipals;

• A significant increase in the money supply. Since September, the Fed has sharply increased reserves and the monetary base. The Fed funds rate has effectively dropped to zero;

• Proactive policy statements by the Fed. Following its mid-December meeting, the Fed formally announced that it was considering the purchase of long term treasuries to stimulate the economy. Such a step would be a radical departure from established practice;

• Speculation by investors, many trading on margin. This activity has been repeatedly described as the newest investment bubble. For the margin trader in treasuries, a rapid 50% drop in the rate level provided spectacular returns. The run up in treasuries was similar to the run up in oil prices earlier in the year;

• Fear of deflation.

Where is the ten year rate going in the coming year? Barrons asked that question of ten investment strategists from leading firms and reported the results in its December 20, 2008 issue. Their estimates ranged from 1.5% to 4.0%.

Two factors that could drive rates up are increased federal borrowing and a bursting of the current speculative bubble in treasuries. Massive increases in federal borrowing during 2009 are certain to impact the ten year rate. On December 10, Bloomberg reported that federal “borrowing may reach $2 trillion” during the current fiscal year based on a speech by the Assistant Treasury Secretary Karthik Ramanathan. A significant portion of that borrowing would be to refund treasuries that came due and to finance the "TARP" (Troubled Assets Relief Program) program. If the Treasury borrows $2 trillion, it will be equal to 20% of our current national debt. The result would be a far greater percentage increase in federal borrowing than in any year since World War II. Financing that level of increase may be difficult. It is uncertain whether funding sources such as China or the petro-nations will continue to buy treasuries at the same level as they have in the past given that their revenues are falling in the global recession.

The unwinding of the current speculative bubble in treasuries may cause the ten year rate to rise. The very nature of speculative bubbles is that they set the foundations for the bubble to burst. If the economic recovery gains traction, investors will shift assets back into stocks and away from treasuries. This could cause a rapid move out of the treasury market and a retreat of the ten year back to the 4% level.

There is little room to maneuver on the downside for the ten year rate. Even if the economy deteriorates further, it is unlikely that rates will fall more than 50 basis points below the 2.00% level. We are at or near the bottom of the 27 year decline in the ten year rate. A decline below 1.5% will only take place if there is very severe economic distress.

A ten year rate of between 2.00% and 2.50% serves the Fed’s objective of forcing savers to lend their money to higher risk borrowers such as homeowners and corporations in order to stimulate the economy. Investors have already started to migrate to bonds with better returns. I believe that the Fed will not allow the ten year rate to climb above 3.5% in the coming year. In order to achieve its objectives, especially in terms of low mortgage rates, it will need to keep the ten year at or below that level. More likely than not, the Fed will intervene directly and buy long term treasuries as it has threatened to do, if the rate climbs above 3.5%. We may find ourselves in a situation where the Treasury issues ten year bonds and the Fed prints money to buy many of those bonds.

My own best guess is that the ten year rate will vary between 2.5% and 3.5% for most of the coming year. The ceiling will be set by Fed actions. I do not expect the economy to be in bad enough shape for the market to maintain rates below 2.5%. As noted, investors have started to migrate to bonds with better returns. That shift will continue unless the situation and expectations deteriorate substantially.

------------------------

Back to Risk Continues To Be a Four-Letter Word; You Should Continue to Avoid It

Accesses: