Contents:

-Investment Lessons From The Recent Past
-Model Portfolios
-How Our Recommendations From 1, 3, and 5 Years Ago Have Been Doing
   (updated to show changes in Model Portfolio performance)
-Is the Index of Leading Economic Indicators Signaling a Recovery?

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Investment Lessons From The Recent Past

Summary: Most investors have learned to make certain assumptions. In this article, I will present a chronology of events over the last few years which seem to demonstrate that it often pays to question such assumptions by looking at things from a different perspective. A few of the things to be learned from the events of the last several years are:

• the consensus, as expressed by the current overall direction of the stock and bond markets and within the media, is quite often wrong.
• one should not generalize very much at all from monthly economic data releases that can, at best, only reflect short-term trends; while such data may be important to traders, being swayed by it is likely to be counter-productive for long-term investors. Conversely, by gathering enough data to form a long-term picture, you have a considerably better chance of doing well.
• do not assume that by just investing in "plain vanilla" or "conventional" stock funds, or with a portfolio consisting of 100% stocks, you will necessarily come out OK. Conversely, investing some of your portfolio in bonds, cash, as well as some specialized stock positions, is a far safer way for most investors to help achieve a reasonable degree of success.
• in order to help ensure doing well in your investing, you should have at least enough time to occasionally monitor your investments, and the willingness to change course when sufficient data justify making such moves; otherwise, given the risks of investing, you may want to keep your money only in risk-free investments such as CDs.
• finally, do not assume that there is little anyone can do to improve their results, nor that it will always turn out OK to put your investments "on hold" indefinitely; if you do not think you yourself can navigate the above channels, look for a source of help that has a good long-term track record, regardless of how "non-mainstream" that source might appear.

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Year after year, going all the way back to 1999 when I started this newsletter, I have attempted to give readers convincing arguments as to why they should "think outside the box." However, trying to change the way people think about investing has never been an easy task.

One of the best ways to illustrate thinking differently is to review a small sample of what has transpired over the last few years as presented in prior Newsletters. This enables us to see directly how looking at things differently from consensus opinions would have assisted readers through what proved to be a series of "unforeseen" events. Some of these happenings were not nearly so unforeseen to those who, rather than accepting what most people believed, viewed events using "a different set of eyes".

Looking Back Chronologically

As recently as July 8, 2008, we were still officially in a long-running bull market. It was only until the S&P 500 Index finally reached a 20% drop the following day that we knew for sure of its end. Unfortunately, for many people whose thinking might have closely paralleled the consensus, the transformation from bull to bear, and subsequently, from good times to deep recession, seemed to catch them seriously off guard. As a result, their investments suffered far more than they would have had these investors been more able to part ways with the consensus, and by so doing, more accurately see what were detectable warning signs.

In fact, on these very pages, we had already fully made the case for danger during the period beginning as early as July 2006. In order to have done that, it was important to have been able to free ourselves from some of the firmly held, but essentially wrong, views that are frequently held by investors. In what follows, we will use quotes from selected issues of this Newsletter to illustrate some of the events that transpired, what the consensus view was, and then update what subsequently transpired. We will also add other updates for helping investors decide where we think things will likely go from here.

Note: Almost all forecasts we make in our Newsletters (unless we specifically state differently) refer to our opinion as to what might happen over the following several years. Given that some time has passed since we wrote the direct quotes shown below, each preceded by ***, the quotes allow you judge for yourself as to the usefulness of what we consider our "outside the mainstream" approach. You can click on the dates to review the entirety of each specific Newsletter.

July 2006

*** "Clearly, during the last yr. and a half, US domestic stocks have been disappointing. ... Does recent stock weakness...mean you should continue to be cautious about US stocks? My sense is yes. And should you continue to load up on cash? Yes ..." (Note: Our July '06 recommended allocations to non-stock investments for moderate risk investors were EQUAL to that for our stock investments, specifically Bonds 27.5%, Cash 22.5%.)
*** " ... if you think you can make better returns by just being 100% in stocks, you may be right. But you should at least be aware of the risks you are taking, esp. if you are investing to achieve a specific goal such as an assured minimum level of retirement funds." (emphasis added)
*** " ... many investors are being far too speculative and optimistic about the favorable prospects for stocks in the year or two ahead."
*** "Invest in a 'long-short' fund [such as Hussman Strategic Growth - see our current recommendations below] if the market indeed turns bearish (or you believe it will)." (Update: While the S&P 500 Index has lost more than 8% per year over the last 3 years, our recommended long-short fund has a slightly positive return over the same period.)

Oct. 2006

*** " ...we feel that neither stocks nor bonds will do as well as normal over the next few years. Why? Because there are too many risks out there, such as above average valuations, [and] a likely end to the current cycle of moderate or better economic expansion..." (Update: While stocks did continue to do well for another year, the following Oct. (2007) marked the end of the line for rising stock prices. Bond prices had their ups and downs over the 2 years after we wrote this, although they have improved a good deal since Oct. 2008.)

Apr. 2007

*** " ...there appears to be too much confidence, most likely bred by 4 straight years of almost continually rising stock prices. ...[Not a place] where long-term investors should be buying. Yet, the latest reported data shows that apparently ordinary investors are pouring money into both stock and bond funds, especially international stocks."
*** "We have continued to highly recommend the international stock category raising our stake over the last few years. But we think a little caution is now in order. That's why we're reducing our recommended allocation here a little from last quarter. We have not specifically included emerging market funds in our model portfolios since the 4th qtr. of '04 although we have occasionally referred to them as a good place for a rather small percentage of your portfolio." (Update: Emerging market funds and most international funds also topped out in Oct. 2007 and are currently down ranging from about 20% to 33% cumulatively from when we first wrote this.)
*** "If and when the Fed actually starts to lower rates, we will likely become much bigger bond enthusiasts since they will likely only do so, with inflation now still a threat, if they start to sense that the economy could be trouble. That would be an environment that is bad for stocks but very good for most bonds."
*** "And what form might that [above] trouble take? For approximately the last 2 years, ... [Steve Shefler, who seriously studies the housing market and who now writes columns for us; see below] has been telling me that the housing market will indeed cause significant trouble to the overall economy - far beyond what most people realize. Two years ago, it seems, not many people were even aware of a potential ticking time bomb. While a few now are, most are still not ready to acknowledge a serious, looming blow not only to the US economy, but possibly, to most of the international markets, due to the tendency for all markets to follow the presumptive leader in determining global economic health, that is, the US." (emphasis added)

Update: The Fed made its first cut of the current cycle in late Sept. 2007 and the stock market's demise followed less than a month later. Since then bonds have been a pretty good place to be, especially as compared to the stock market. As we now know, and warned you about well before the bear market began, the housing crisis did turn out to be the "ticking time bomb" that precipitated the crash of stock markets all around the world.

July 2007

*** "...what goes up like a rocket can (and usually) does come down like a rocket. And so, while my recommendations may not appeal to some aggressive investors, we feel we have a better chance of coming out ahead in the long run by helping people steer past the kind of investments that have the potential for serious corrections which can easily wipe out years worth of prior gains."
*** "[Investors should] continue taking some profits out of funds that have been going up at an annualized 20 or 25% rate over the last 4 to 5 years. These include, for example, emerging markets and European stocks. (Note: This, essentially, was a repeat of the warning given (above) in Apr. 2007, but also would have included other fund categories such as Energy.)

On our Alerts page, we stated:


*** "As of July 2007, ... we [now believe] that "high yield" (also called junk) bonds [are] entering into an extended period where returns will be minimal, or worse, even leading to outright losses. Investors who want to avoid possible poor returns ahead might want to sell or reduce any current holdings." Update: Since that time, these bonds have indeed shown negative returns and proven to be the poorest performing bond category to be invested in. Although these funds have bounced so far this year, we are currently advising waiting at least several months longer before possibly recommending them again.

Oct. 2007

Background: This was the month during which the market topped out, although the actual top occurred about a week after we published the Oct. newsletter. The Newsletter was headed "Change Is Upon Us" and focused on our outside the box view that "future fund category performance [eg. Large Growth, Small Value, etc.] is more predictable than the overall market." This led us to state:

*** "[The Large Growth category] (LG) is now likely to do significantly better than [Small Value] (SV) (and small cap in general) in the years ahead ... regardless of the market's overall direction..." (Note: To get some idea of how this prediction has played out thus far, you can click here. The chart displayed shows that, in spite of bear market losses for both funds, Vanguard's Large Growth Index (VIGRX) is ahead of the Vanguard Small Cap Value Index (VISVX) cumulatively by about 14% over the last 2 yrs. Interestingly, while the Value fund did actually do better year over year between Oct. 2007 and Oct. 2008 during the worst of the bear market, since then, the Growth fund is now the one doing significantly better. We continue to favor the Large Growth category (as shown in our Model Portfolio below) and will likely favor it over the Small Value category and small stocks in general for at least more several years.)
*** "... you would likely do best of all if you can reduce your stock allocation upon correctly recognizing what turns out to be the start of a prolonged bear market, putting the transferred funds into either cash or bond funds, whichever appear to have better prospects. Right now it appears that bonds, esp. short-term high quality ones, would have better prospects if repeated Fed action takes place to reduce interest rates due to the housing crisis, financial market instability, and the possibility of recession."
*** "We are considerably more positive about bonds than we have been for quite a while because it appears fairly certain that the US economy will slow down which is good for most categories of bonds."

Update: At the time all these quotes from the Oct. '07 Newsletter were written, as mentioned above, the stock market was still in the 2002 - 2007 bull market and our current recession had not even been born. The US recession was only officially declared and announced to the world on Dec. 1, 2008, a full year after it was now acknowledged to have begun. (So much for counting on the reported news alone to help one decide about the appropriateness of one's investments!) By "thinking outside the box," well ahead of the crowd, we were better prepared than the consensus for the new investing environment that lay ahead.

Jan 2008

Background: Right near the top of this Newsletter under "Topics Covered", we wrote "2007 Returns Show Potential Warning Signs of a Bear Market." The gist of the article: "...the falling off in consistently positive performance in 2007 from 2006 may indicate that the best days of the 2003-2007 bull market are now history." Some further quotes:

*** "We think that this reversal of fortunes, if sustained, could carry over to international stocks as well."
*** " ... a bear market ahead seems to be a real possibility."
*** " ... if you don't think you will be able to comfortably accept the possibility of losses ... over a one or more year period, then perhaps it would be wise to begin making some adjustments to your portfolio." (emphasis added)

On our Alerts page dated Jan. 18, 2008, we stated:

***" ... we believe that that virtually all 9 major categories of US stocks funds, with the possible exception of Large Growth, are unattractive based on the valuation data we monitor." (Update: By 2008 year's end, as you are probably well aware, ALL categories of stock funds were pummeled by the bear market with an average loss of approximately 40%. However, since the start of 2009, Large Growth stocks have rebounded well and have been nearly at the top of the above 9 categories, second only to Mid Cap Growth, and significantly ahead of the S&P 500 Index.)

March 2008

Background: After dropping consistently since mid-2003, unemployment began edging up again in mid-2007 and has been rising ever since. As stated above, stocks had started falling in early Oct. 2007. This led us to uncover and make the following non-mainstream observations:

*** "EVERY recession since 1948 or earlier has occurred not long after unemployment began rising, and additionally, ended shortly before unemployment started to fall back again (emphasis added). All of this appears pretty ominous to me since ... it does not appear that we are near the end of that rise."
*** "... it seems likely that the unemployment rate will continue to rise over the next few years ... Bottom line: higher unemployment will lead to reduced consumer spending, both likely contributing to a longer than average (average being 6-9 mos.) period of recession." (emphasis not added)
*** "Some of the most highly regarded experts we follow suggest that the current downturn could last easily into 2009 or even longer.
*** " ... investors should not be ready to snatch up so-called (stock) "bargains" until the one year trend reverts from negative to positive and stays positive for many months, if not considerably longer." (Note: We were correct in worrying the onset of a recession, and a long one at that - it too did start less than 6 months after the pickup in unemployment, although at the time we wrote this Newsletter, it was still too early to be picked up by mainstream economists; see the "Update" above under Oct. 2007.)

Update: Since unemployment has continued to rise with no end currently in sight, unless a fall in the unemployment appears close, the implication is that the recession is not likely to end as soon as some now anticipate. Stocks, however, after hitting their lows on Mar. 9, 2009, appear have priced in that the recession will end within the next 2-3 mos. since stocks typically begin to recover as much as 6 months or so before a recessionary downturn ends. If the recession doesn't end by Sept., it would follow that stocks could fall back to their March '09 levels.

Apr 2008

Background: In March '08, the market seemed to be stablizing from its near 5 month drop, leading many to believe that the skies were clearing. We said:

*** "In spite of the emerging consensus that stocks may be set to climb from here on out, we are still in a negative period with many stock categories perched near a bear market, if not already in one."
*** "... the stock market appears likely to continue its downward trend."

Are we still in a secular, long-term bear market? I don't know. Only time will tell, but IF the S&P 500 drops back down to where is was in mid-March (that is, around 764; it is currently at about 919, as of 6-30), we would again have dropped 20% into, at a minimum another temporary bear market, which would confirm that, very likely, we are still in a long-term bear market.

June 2008

*** " ... we think it somewhat more likely that the nascent positive bond trend reversal that started in 2007 will continue to survive, perhaps for another year or more." (Update: Over the last 13 months, many high quality bond funds have shown returns for the period in the vicinity of 9% cumulatively.)

July 2008

Background: A year ago, we discussed on-going research to identify criteria for making successful BUY, SELL, or HOLD decisions regarding the major mutual fund categories. Although our research followed the start of the Oct. '07 bear market, we applied what we learned to judge what one might have done had they been able to use our current findings in deciding what to do at the beginning of Oct. 2007, a time when stock prices were touching new highs. Here's what we said:

***"Last Oct (2007), our new approach would have identified all the major categories as SELLs, except Large Growth and Large Core which would have be classified as HOLDs. No categories would have been recommended as BUYs." (Note: Our recommended allocations to non-stock investments for moderate risk investors in the July '08 newsletter EXCEEDED those to our stock investments, specifically Bonds 35%, Cash 20%.)

Update: Obviously, stocks have been down considerably over the last year, many bonds up nicely, and cash only minimally positive. (See our comments about Large Growth performance above under the Jan. '08 Newsletter.)

Using our newly designed research tool, all the major categories of funds are, as of the end of June 2009, classified as HOLDs, except Energy, and most International stock funds, esp. Emerging Markets, which are currently viewed as SELLs.

Model Portfolios

Overall Asset Class Allocations

Given the small to moderate improvement in the economic outlook, and the fact the our research suggests that most stock categories have become safe to HOLD for investors with a relatively long time horizon, we have somewhat upped our stock allocations.

Of course, since cash appears so minimally attractive to us, this, along with some sense that bonds, esp. government bonds, may have no longer have much appreciation potential, also helps to push us a little more back into stocks

For Moderate Risk Investors

Asset	Current (Last Qtr.)
Stocks	50% (45%)
Bonds	45 (47.5)
Cash	5.0 (7.5)

For Aggressive Risk Investors

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

For Conservative Investors

Asset	Current (Last Qtr.)
Stocks	25% (20%)
Bonds	65 (70)
Cash	10 (10)

Specific Category Allocations

Stock Fund Categories Currently Viewed as Having the Best Prospects for the Next Several Years

We retain our focus on Large Caps. Since we believe that the International stock category is not as well positioned as previously, with most sub-categories having re-entered SELL territory, especially funds with heavy doses of Emerging Markets, we are cutting our position slightly. We are also diversifying our international exposure by investing in a International Mid/Sm Value fund.

Bond Fund Categories Currently Viewed as Having the Best Prospects for the Next Several Years

As mentioned above, Treasury bonds are looking less attractive now that interest rates will probably not rally much further. And, over the next several years, it is more likely that interest rates will go up rather than down, especially hurting funds investing in Treasuries

The wild card in the bond market would appear to be muni bonds. Even without their tax exemption, they are currently paying more than Treasuries of similar maturities. But the potential negative is poor state finances, with the risk of lowered credit ratings. Therefore, we are substituting intermediate non-single state munis for our previous 25% Long Term Treasury position. A non-single state (national) fund reduces one's risk's within a single state fund (eg California, to name but one) whose bonds might be downgraded. Looking at the muni category as a whole, in spite of the problems, we still think it is an attractive area within the bond market.

We still do not fully embrace the consensus view that Inflation Protected Bonds (TIPS) are going to outperform most other bond categories. In fact, TIPS have been one of the poorest performing bond categories over the last year, and until that poor performance turns around and starts to confirm that the category is ready for more positive gains ahead, we advise only maintaining a small position.

How Our Recommendations From 1, 3, and 5 Years Ago Have Been Doing

(Note: Since we first published this July Newsletter on June 30, there were changes to the performance data we initially showed.)

Our Stock Portfolio from 1 year ago underperformed the S&P 500 Index by relatively small amount. However, our 3 and 5 year Stock Portfolios both outperformed the Index. Since our portfolios are geared to show outperformance over relatively long periods, it is assuring that while we do not always outperform over 1 yr, we more consistently have outperformed over 3 and 5 yrs.

In fact, our 5 yr portfolio continues its string of always beating the Index, based on 19 straight comparisons. The final tally of performance has now been posted on our track record website page.

It should be noted that over the last year, there was very little variation among the 9 major morningstar.com US categories in terms of performance, with most returns clustered around the Index's return of -26.2%. Additionally, nearly all International stock fund categories performed well below the Index. Within this severe bear market environment, it becomes extremely hard to beat the Index and still have a diversified portfolio. (In order to beat the Index, one has to have invested in categories which performed significantly better.) Note that had one invested in our recommended long-short fund, Hussman Strategic Growth, as opposed to the average performing long-short fund, our overall stock portfolio underperformance would have been reduced to less than 1%.

Limiting our outperformance from 3 years ago was our position in Large Value funds. These funds usually invest to an above average degree financial stocks which were hit harder than most other categories by the banking and housing crises. However, similarly as for the 1 yr portfolio, our long-short recommendation was a plus.

Our 5 year outperformance was broad-based with 5 out of 7 recommended categories beating the Index. It was helped the most by our relatively large International stock position, which while performing sub-par recently, was mainly the best place to be over the entire 5 yr. period.

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Is the Index of Leading Economic Indicators Signaling a Recovery?

In order to design a wise investment strategy, it is important to have a good sense of where the U.S. economy is headed, especially within the next three to six months. The Index of Leading Economic Indicators (LEI) is the best tool to make that determination. It is widely used by government and private economists. It has been steadily improving in the past six month but remains in negative territory. There are, however, reasons to be cautious about the improvements.

Economists at the Conference Board developed the LEI to predict business cycles. Over the past 50 years, it has proved highly reliable in predicting where the economy is headed. This makes sense in that the index is a combination of ten key economic measurements that have been shown to forecast future economic activity. By taking the economy’s temperature at ten interrelated points, the index has been used to predict whether the economy is heating up or cooling down. By analogy, consider the advantages of a full medical workup with its various tests to determine the health of a patient.

Components of the index include such things as building permits, factory orders, the current level of the S&P 500, and unemployment claims. By focusing on ten key data points, the LEI has the advantage of not placing excess weight on a single factor (e.g., whether the yield curve is inverted). While one factor may give off a false signal, it is unlikely that a composite of ten leading indicators will mislead. The ten components check and balance one another. The index has the further advantage of being objective. As Warren Buffett has observed, most economists have either an optimistic or pessimistic subjective bent that distorts their observations. In addition, the LEI is relatively unaffected by current economic headlines.

The May and June reports of the Conference Board can be summarized as follows as reported on their website:

May Report: The LEI for the U.S. rose sharply in April, the first increase in seven months, and the strengths among its components exceeded the weaknesses for the first time in one and a half years.

June Report: The LEI for the U.S. increased sharply for the second consecutive month in May. In addition, the strengths among its components continued to exceed the weaknesses this month. Vendor performance, the interest rate spread, real money supply, stock prices, consumer expectations, and building permits contributed positively to the index, more than offsetting the negative contributions from weekly hours and initial unemployment claims. The index rose 1.2 percent (a 2.4 percent annual rate) between November 2008 and May 2009, the first time the index has increased over a six-month period since July 2007, and the strengths among the leading indicators have become balanced with the weaknesses during this period.

It is useful to look back at year over year (YOY) changes in the index since 2000. Starting in 2000, the index YOY was plus 4%, reflecting the dot-com boom. In early 2001, it fell to minus 3.5%, forecasting the dot-com bust and recession that followed. The index then surged to plus 9% in 2004, forecasting the boom years that followed from ultra-low interest rates and the housing bubble. In early 2006, it had fallen just below zero from its plus 9% high. Investors who focused on the index were in no way surprised by the subsequent stock market correction.

The index’s YOY change dropped to minus 4% in late 2008. The Gross Domestic Product (GDP) followed downward as the index predicted. The picture is now changing for the better. The index YOY has jumped rapidly from minus 4.8% in October to plus 2.4% in May. This change indicates that in the next six to twelve months, GDP is likely to turn positive. GDP is likely to be quite positive (plus 3% or more), if this rate of LEI improvement were to continue over the next year. The increase of this index and most of its components has propelled the stock markets forward in recent weeks. With each improved result in the monthly or weekly reports of the ten index components, the S&P 500 and DOW have surged higher.

One of the reasons to be cautious about the good news from LEI index is this: During the index’s YOY decline from plus 9% in 2004 to minus 4% late in 2008, there were two periods where the index made jumps similar to those experienced over the past half year. (The last such jump was in mid-2007.) In each case, economists and the press rejoiced and stock markets rallied strongly. The duration of the uptick was limited, however, and the index thereafter continued on its four year path of decline. Of course, the level of fiscal and monetary stimulus being applied to bolster the economy is now far greater than it was when those two upticks took place.

In economic cycles, "good news brings bad news" and "bad news brings good news". That is part and parcel of what economic cycles are all about. The bad news in the current upswing includes rising interest rates on home mortgages, and rising prices for gasoline and agricultural commodities. The potential adverse consequences of these negative factors should not be underestimated. Low interest rates are crucial to a sustained housing recovery, which Alan Greenspan says is essential to an economic recovery.

While it is very useful to heed the progress in the LEI and each of its components as they are announced in the financial press, it is also important to heed the negative consequences the good news brings in its wake.

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