Contents:

--Overwhelmed By Data? Keeping Investment Decisions Relatively Simple
--Pedal To The Floor. Will It Work?

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Overwhelmed By Data? Keeping Investment Decisions Relatively Simple

The purpose of Mutual Fund Research Newsletter, which this month marks 10 years since we started publishing, has always been to help you decide when is an appropriate time to be invested in certain types of mutual funds, whether stock, bond, money market, or any other type of specialized fund, including ETFs.

Given the sheer amount of information investors are exposed to, it's no wonder that the average person cannot decide what if anything to do at any given time, and thus frequently chooses to take no action at all. So, any method that cuts through all the information overload and helps reduce choices to a very simple clear-cut test, yet still seems to work a majority of the time, should be seriously considered.

Yet, if you are mainly convinced that buying and holding a stationary set of investments is better than making occasional adjustments to your choices, or, you feel you have too little time in your already hectic life to easily revisit your investment decisions anyway, then you will perhaps remain cool to the whole idea of making changes.

But if you do accept our basic premise that better results can be achieved by those who are watchful and know what to look for, any time can be a good time to reassess your portfolio. At a minimum, we recommend at least yearly, or even quarterly, looking at all the major categories of fund investments available to see which, if any, of your current investments you might feel confident in increasing or decreasing, or which unowned ones you might now start a position in. Note that we do not usually focus on which particular fund you should buy or sell, but rather on favorable fund categories. However, there are some particular funds that are nearly "one of a kind" that we do sometimes recommend.

We base our overall portfolio recommendations on a variety of factors too numerous to elaborate. But we tend to focus on a small number of tests discussed below which we have found, in over 25 years of studying investment results, to do the best job in determining when is a good time, or a bad time, to be invested in certain types of fund investments. As you will see, though, the tests do not always lead to the same conclusions so one must decide which test is the most prudent one to follow, given your own particular investment preferences and situation.

Using Relatively Recent Performance as a Guidepost

Let's start with our simplest test to implement: whether the investment category has produced adequate returns over the last 12 months.

Our premise in adopting this test is that different investments usually perform well or below par in multi-year cycles. If an investment has been performing adequately over the last year, it is a far safer bet than an investment that has been performing below par over the same period.

Obviously, this rule will not usually work when there is a major turnaround in market direction. So, back at the start of Oct. 2007, every category of stock fund would have appeared promising based on past one year performance. But by one year later, each of these same categories of funds had performed extremely poorly. But since investment category performance tends to run in multi-year cycles, such true turnarounds occur without a high degree of frequency. For example, in considering the overall market, stocks were basically going up without much pause between 1991 and 2000 and 2003 and late 2007. And they were going down without much pause between 2001 and 2002 and late 2007 and now.

Thus, while you have most likely heard the phrase "past performance is no guarantee of future results," which is completely true, there is more than ample data to show that past performance, especially recent past performance of broad investment categories, is a good guide to what to expect going forward. But, as you will see shortly, the relationship between past performance and future performance is not always positive. That is, eventually, an investment category that is becomes overvalued will, with a high degree of probability, falter.

To implement our simple test, merely see whether the total return over the last year from the stock, bond, or cash investment is what you would consider at or near normal for a year's time for that type of asset. For us, these returns should approximate at least 7% in all types of pure stock funds, 5% in quality taxable bonds, 3.5% in municipal bond funds, and 3% in cash.

You can always get these return figures (except for cash) by going to the morningstar.com web site, clicking on the Funds tab, and then dropping down to find the "Category Returns" under "Performance". For cash, you will need to check elsewhere to see what your investment has returned, or most likely would return if held for a year. Note that since we are not trying to evaluate how a particular stock or bond fund is doing, we use the average return of all funds within an overall fund category such as Large Blend stocks or Long Government Bonds. However, if you choose, you can merely use the return from your particular fund, such as for example, from the Vanguard International Growth Fund or the PIMCO Total Return Institutional Fund.

Returns lower than the above suggested figures would indicate the category is in at least a one year subpar trend as compared to historical expectations. If so, we consider the category to be likely, at a minimum, to underperform your goals, or even worse, potentially dangerous to buy or hold. Any fund you hold within this category is therefore a possible candidate to sell, until the 1 year performance returns to the guideline figure above. Only if this figure is equalled or exceeded do we usually consider a fund a relatively good prospect. (Note: When most or all available categories fail the above test, such as is true for stocks right now, an investor may still choose to hold, or emphasize in a portfolio, the categories with the best relative 12 month returns.)

More Stocks Anyone?

Since all stock prices have been trending down over the last year or more, 1 year returns now are deeply in negative territory. And it will take a considerable uptrend to return the 1 year trailing returns back to positive ground. By waiting to make sure the 1 year trend of a stock category has returned to near normal, you may be spared the need to take any action for a considerable period of time. However, you will certainly miss out on the early gains of any sustained bull market in that asset, which could be considerable.

But look at one of the best virtues of using this test aside from its simplicity: Given that there may be considerable volatility over the course of a year's time, and possible false promising starts within an otherwise continuing underperforming market, this strategy is geared for lessening the probability of jumping back into an investment with only relatively limited evidence of a true turnaround to a satisfactory trend. In that sense, this is a strategy that could best serve the needs of relatively conservative-minded or currently gun-shy investors.

Note: Instead of using a criterion of 1 year returns, you could opt for the less strict criterion of returns over the last 6 months. This way, you would accept a shorter period of normal returns to indicate an investment's likely future trend. There are two problems associated with this approach: 1) It is hard to find an always available source showing 6 mo. total returns, possibly requiring you to calculate them yourself. 2) Six month performance (or using an even lesser period of time), while it may appear to be a sufficent period to judge an investment trend, may be too short to reliably judge an investment category's likely trajectory. Therefore, we recommend using 12 month data unless you want to be more of an aggressive investor, or to trade over short periods of time.

More (or Less) Bonds?

The situation right now for bond fund categories is somewhat more varied. That is, there are a few categories that pass (or nearly so) this simple test while most others do not. (Performance as of 4-30-09.)

In spite of US Treasuries currently being written off by many investing experts, Long and Intermediate Govt bonds would be regarded at the top of the bond fund pack, with positive returns over the last year of 8%/4.8% respectively (The Intermediate Govt. category includes GNMA funds.) And the Muni Single State Short category passes as well with a 3.8% return.

No other bond fund category currently passes our simple test with all other category returns showing negative 1 yr. returns. (This includes Inflation bonds, as well as non-government (corporate) bonds, in spite of receiving a lot of positive press lately.)

Note: While the category averages may not come close to passing our simple test, specific funds within a given category may have significantly better prospects. For example, a bond fund we have repeatedly recommended, PIMCO Total Return or one of its variants, has returned about 4% over the last year vs a much poorer -3.3% for its category (Intermediate-Term Non-Govt) average.

Using Significant Changes from Longer-Term Performance as a Guidepost

The above performance test is based solely on the absolute value of the past 12 month's total return. A single year's trailing return, while a good test of a category's current trend, still only provides information based on a relatively limited amount of data. Our research suggests that a discrepancy in the magnitude (and possibly the direction) of returns over the last year vs. the return from the entire preceding 5 years is a more sophisticated, and therefore, a more accurate test of where the performance of a fund category is likely headed.

To understand this, look at the following examples and the explanations that follow:

Annualized Stock Fund Returns (Hypothetical)
Example	1 Yr Tot Return	5 Yr Tot Return	Likely Best Decision
a)	+ 8%	+16%	Sell
b)	+ 3	+ 9	Hold
c)	-30	- 6	Buy
d)	+13	- 1	Buy !!!

In a), while the fund category has a near normal 1 yr. return of 8%, notice that the 1 yr. return is considerably less than the average 5 yr return. In fact, since the trailing 5 yr. return includes the 1 yr. return within it, the investment category was doing more than twice as well on average during the first 4 yrs. of the 5 yr. period than during the most recent year of the period. Since such a fund category has therefore lost a considerable amount of momentum, we would suggest that such returns show a strong possibility of characterizing an investment that is "only a shadow of its former self." We would recommend avoiding adding to such an investment or even selling all or some of one's position for now.

In b), it might appear that the fund category's 1 yr. performance is quite sufficently below what we might consider normal using the simpler test described above to justify a similar conclusion as in a). But, unless you are very risk averse, my research suggests that such a deviation from otherwise previous average performance is not enough to reliably suggest an outright sell if you own such a fund. Rather, it may be more advantegeous for most investors to continue to hold a fund in a category showing such a result.

The difference between example a) and b) comes down to this: The 5 yr. fund results for a) are basically unsustainable; diversified mutual funds rarely can average performance very much above normal performance for periods much longer than 5 years because they will likely have become overvalued. The category performance shown in a) has already started to drop in the last 12 mos., but even without such a drop this category is unlikely to continue to do well too much longer. In the case of b), there is no such problem; the fund has performed pretty much as expected over the last 5 yrs. so the drop over the last year is not highly worrisome.

In c), it might appear that this category has been doing so poorly both long and relatively short-term that it should be sold if owned, or otherwise avoided at all costs. However, my research shows that in such extreme situations, there is a very compelling, although totally counter-intuitive, reason to be on board. The 5 yr. result is now so poor that it is now highly likely that the category will return to favor among astute, forward-looking investors.

Why would any investor take on an investment that appeared to be such a risk? Because it is likely quite undervalued in the sense that history suggests stocks will show a return averaging 10% per year. Since in this example, the actual cumulative (non-annualized) 5 yr. total return is - 30% (that is, 5 years times - 6%), and the 5 yr. expected return + 50% (5 times + 10%), the discrepancy between the two is so great (i.e., 80%), it is highly improbable the shortfall will continue too much longer. But highly risk averse investors may still choose to stay away since the underperformance may continue for a while longer, perhaps, I would suggest, up to another year.

In d), unlike all the other examples, the category is now showing a highly favorable turnaround as reflected in an obvious constructive change of direction between the two figures. Thus in spite the relatively poor, and likely unsustainably so, 5 yr. performance, one can be reasonably confident that this category will deliver the goods going forward. Not only has there been significant underperformance over 5 years, but there is now strong positive momentum. This is an outcome which happens very rarely, and therefore, it would be quite frustrating if one were to just sit and wait for results such as shown in d) before feeling comfortable making investments. Typically, it would only happen after a long-running bear market in some or most stock categories followed by a strong, sustained recovery. But everyone, including conservative investors, should be watchful should such results appear.

Where Are We Now?

Here is a question: Which of the above examples most closely resembles where most categories of stocks are today?

Answer: c)! Nearly all U.S. stock fund categories are down 30 to 40% over the last year. And they are down around 1 to 2% annualized over the last 5 years. While I wouldn't go quite as far as to say that all such categories are promising enough for everyone now to buy more, they are quite close to the figures that would justify such a conclusion similar to that shown in example c). Actually, around the first ten days in March of this year, they were even closer to the hypothetical data shown in c). Since then, stocks have had a huge rebound. Whether that March low will hold, no one, including me knows. But if many categories of stocks were to suffer further losses back to where they were in early March, or lower, I would become much more likely to raise my suggested allocations to these categories.

Note: In our Feb. '09 Newsletter, we did issue a buy signal for the Small Cap Growth category based on the 1 and 5 yr. performance test for category data as of Jan. 30th. Thus far, over the following 3 months, our recommended fund for that category, Vanguard Small Cap Growth Index (VISGX) has returned more than 15% (non-annualized). However, the true value of our buy signal will not be fully known until, at a minimum, a year has passed.

Back in the Fall of 2007, the typical stock fund was returning results similar to that in example a). As we now know, that would have been an ideal time to reduce or sell from most funds.

Hopefully, over the next year or so, if we're lucky, some or many stock fund categories might even resemble the data in d)! This could happen if stocks not only continue to stabilize over the next 6 months, as many categories have already done over the last 6, but show a nice positive comeback of about 15% from today's prices over the period based on our more sophisticated performance test (but perhaps a little less based on our earlier simple test.) In either case, it would make sense for almost all investors to increase their stock allocations, based on the empirical data we have studied.

"It's The Economy, Stupid" (Or, Is It?)

This phrase originated during the U.S. Presidential campaign in 1992. It certainly seemed to have helped Bill Clinton get elected, but how useful is focusing on the economy when trying to make the best investments you can?

Notice we have not mentioned the economy or the current financial crisis one time thus far in helping to decide on an investment strategy, although we frequently do mention it in our Newsletter articles. (For those who want an insightful look at some of the more important economic variables that one might consider, see Steve's article that follows.) That is not to say that these factors won't affect how your funds will perform, or whether bonds, stocks, or cash will be better investments to hold over the next few years.

But we believe it is extremely difficult for anyone to accurately and consistently predict what the economy will do next. And even if one does correctly predict certain aspects of the economic outlook, it is nearly impossible to know in advance exactly how investors will react to these outcomes in terms of which fund categories will be positively affected and which will lose out.

Year after year, investors often seem to react to the economy in almost the exact opposite way that one might have predicted. For example, on Wednesday of this week, the government reported that GDP, the most basic measure of the economy, contracted by 6.1% on an annualized basis during the last 3 months.

In spite of one of the poorest domestic economies since 1958, and with the global, financial, housing, and automotive crises still raging, the stock market has rallied considerably lately. And given the poor economy and overall severe bear market for stocks, one would have expected most bonds, except for the riskiest, to have done pretty well. But as mentioned above, most categories of bonds have not done very well during the last year.

Such data appears to strongly confirm our belief that it's not the economy per se that needs to be monitored for successful fund investing. Rather, we believe that the best time to invest seems to be when a category's fund prices have severely underperformed for periods of 5 or more years. (Actually, right now, most stock fund categories have underperformed for more than 10 years - since the late 90's - making now an even more likely good entry point. It should be noted too that during the last 10 to 12 years, the U.S. as well as the world economy has enjoyed more ups than downs - yet the major thrust of most global stock prices has been down.)

And what shows up as the worst time to invest? That has consistently been when 5 or more year annualized returns have soared, creating unsustainable numbers as they did in most of the latter half of 2007, and in 1999-2000, regardless of what the economy appeared to be doing at the time.

So, rather than "it's the economy, stupid", you might say I believe in "keep it simple, stupid" or KISS; or, at least relatively simple. It becomes almost mind-bogling to try to keep up with all the twists and turns in the economy, especially during such a period as we are going through now. Learning to regularly apply the above two relatively straightforward performance tests (which actually do incorporate everything about the economy that investors have known and reacted to during the past) is one of the best pieces of advice I can give you on what it takes to successfully invest in funds.

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Pedal To The Floor. Will It Work?

The government is going all out to break the downward slide of the U.S. economy and propel it uphill. Three metrics will help determine whether these efforts will succeed and, if so, how soon: (1) the fiscal stimulus, measured by the level of the federal deficit; (2) the monetary stimulus, measured by the growth in the money supply; and (3) the housing stimulus, measured by the interest rate on 30 year fixed rate mortgages.

The Obama administration has estimated that this year’s federal deficit will be $1.75 trillion or 12.3% of Gross Domestic Product (GDP) in order to pay for the steps being taken to assure an economic recovery. Most economists believe that this projection is too conservative and is based on unrealistic assumptions about growth in the last three quarters of this year. They estimate the deficit for fiscal 2009 is more likely to be in the neighborhood of $2 trillion, which would be 14% to 15% of the GDP. That would be more than four times as great as the prior record deficit of $482 billion in 2008, the last year of the Bush administration. Even if the deficit were to come in at 12.3% of GDP, measured as a percent of GDP that would be the largest deficit since World War II.

Seemingly a budget deficit of this magnitude should do the trick, but on closer examination there is less here than meets the eye. The $750 billion expenditure of TARP relief is primarily aimed at saving financial institutions, auto companies and others from collapse and only secondarily stimulating growth. There has been a substantial amount of misunderstanding and confusion about this. The primary aim of federal loans and investments in banks was to save them from collapse, not to get them lending more. The rationale that the federal expenditures would assure additional lending was in significant part offered up to appease the demands of Senators and Representatives. In fact, the two goals are to some degree inconsistent. Making imprudent loans was one cause for the losses suffered by financial institutions. If they are now pressured to make a new batch of imprudent loans, future failures or problems will likely result.

The money supply is also growing at the fastest rate since World War II. The broad money supply (M2) is increasing at an annual rate of nearly 15% over the past six months. Growth in the money supply as the result of actions taken by the Federal Reserve in and of itself is not enough. To assure sustained growth, that money supply must achieve velocity by increased lending and borrowing. For more than a year banks have been tightening lending requirement for a broad range of loans – homeowners’ and commercial property mortgages, credit cards, small businesses, etc. The lending restrictions are the result of significantly increased default rates and concern that borrowers will be unable to repay in a faltering economy. As lenders have tightened their lending standards, prospective borrowers have sought fewer loans. The store owner whose business is faltering is far less likely to open a new location or expand inventory. While it may be politically fashionable to blame the banks for reduced lending, the vicious cycle is due to understandable caution by both lenders and prospective borrowers.

Pumping up the money supply will only work if lenders and borrowers are confident that the economy will grow. The excessive extension of credit during the last up cycle has brought in its wake high levels of default which now restrict lending growth.

The rate on 30 year fixed rate mortgages has dropped to approximately 4.85%. That is the lowest level since 1956 – 53 years ago. The low rate has been brought about by a variety of actions taken by the Federal Reserve: (1) the effective federal funds rate is approximate 0.15% (15 basis points) – essentially zero – as the Fed has gone all out to grow the money supply; (2) recently, the Fed took the unprecedented step of buying long term treasuries to bring down long term rates; and finally (3) the Fed has taken another unprecedented step by directly purchasing mortgage backed securities as part of the TARP program.

The lowest 30 year fixed rate in over 50 years, while remarkable, must also be placed in perspective. It is only about 1% below the 30 year fixed rates for the three years of housing boom, 2003 thru 2005. According to Freddie Mac, 30 year rates ranged from 5.83% for 2003 up to 5.87% for 2005. During this period the majority of borrowers were not even using 30 year fixed rate loans. They were borrowing with 1, 3 and 5 years fixed then adjustable loans which provided even lower rates. The availability of these adjustable loans has become vastly restricted as a result of the housing collapse and, when available, the differential in the rate offered has been negligible. The net effect of all this is that while the drop in the 30 year rate increases housing affordability, thereby supporting sales and prices, there will be less benefit from the drop in the 30 year rate than in past cycles.

By lowering the 30 year home loan rate, the Fed is seeking both to prop up the housing market and to permit homeowners to refinance at lower rates. By refinancing and lowering monthly payments, the Fed hopes that home owners will spend the savings and thereby stimulate the economy.

For both the prospective home buyers and home owners who wish to refinance, the drop in the 30 year rate may be insufficient. Home owners may no longer have sufficient equity in their homes to refinance or may no longer qualify due to a drop in income as a result of the recession. For the home buyer, the no down or 10% down days for conventional loans are history. The undocumented loan has been replaced by far more careful scrutiny of the borrowers’ income flow and credit obligations. The government is taking a variety of steps in addition to driving down rates to assist buyers and refinancers. An $8,000 tax credit has been enacted for first time buyers. Conforming loan limits will soon be increased, which will help owners and buyers in high cost areas.

The biggest budget deficit as a percent of GDP since World War II, the fastest growth in the money supply since World War II, the lowest 30 year fixed rate mortgages in more than a half century – these are major steps that should not be underestimated. At the same time, they should not be taken as a sure remedy. By placing them in proper context, the investor will have a better picture the likelihood and rate of recovery.

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