Your Investing Survival Guide

This month, rather than discuss any other topic, it seems that the best thing we can do to help our readers is to focus completely on what investors might want to do to help themselves preserve the value of their investment portfolios in the months ahead. Therefore, most of this Newsletter will be devoted to describing our Model Portfolios, which we think will do just that.

It is our position that, if you haven't already done so, it is probably too late to sell stock funds to protect your portfolio from losses. As regular readers of my Newsletters should know, I have been urging them to take some money off the table for several years now. For example, had you been a regular reader, back as early as Apr. 2007, you would have seen our prominent discussion on how overpriced some funds had become as well as a very early warning of the "ticking time bomb" threatening "a serious looming blow not only to the US economy, but possibly, to most of the international markets." And, every single quarterly issue back in 2006 implied investors should not to expect "normal" 10% returns from stock funds in the next few years. (Interested readers can review these discussions.)

Oct. 2006 Newsletter
July 2006
Apr. 2006
Jan. 2006

In fact, it has always been one of the main purposes of my Newsletter to assist readers to take helpful action in advance, ahead of the crowd. This includes both action to avoid potential losses as well as to position yourself for being able to do better than most when the fundamentals for certain investments appear more attractive than usual.

But especially with regard to avoiding losses, it is essential to act pre-emptively or at least near the beginning of a potential problem, rather than to think about acting once the problem has become so widespread that any advantage of selling is likely only going to be at best short-lived; quite likely, you will be selling at just the wrong time.

Of course, if you have remained frozen like a deer in the headlights, or at least unmoved to take action because you are too busy or prefer to get "involved" in your investments only once every year or two (or even less often), you are not alone. One of my biggest frustrations as a Newsletter editor is to find that out of hundreds of people who read my newsletter every month, it does not appear that many of these readers, including people who I know quite well, want to act in a proactive fashion. Most would rather wait and see how bad (or good) it gets before deciding to take any action. But by then, it is usually far too late!

In our Jan. Newsletter of this year, we specifically focused on warning signs of a bear market and suggested that investors take action to protect their portfolios. If you did not do so, it should have been because you regarded yourself as a long-term investor, prepared to ride out market volatility in the years ahead. To decide to sell stock funds only now would suggest that you no longer are taking that long-term approach, but rather, reacting to market volatility by abandoning what you previously advocated.

But if you are truly afraid of what the next few months, if not longer, will bring in terms of downward stock fund prices, then perhaps you may still want to bring your portfolio down to the overall allocations shown under our Model Portfolios below.

It is important to realize, though, that you do not necessarily need to sell your stock funds to approach our recommended stock allocations. For example, suppose your portfolio had approx. 50% in stock and 50% combined in bonds and cash as of less than 6 mos. ago. Because stock funds have done so poorly lately, your current stock portfolio may already be near or below our recommended 42.5% allocation (as shown below) for moderate risk investors without taking any action at all! Since many stock funds have lost at least 20% over that period, that means that your overall stock allocation will be around 40%, assuming your bonds and cash positions are not changed much from before. (This might even suggest that it may be a good time to add a little to your stock funds to bring them back to our recommended 42.5% - see our Sept Newsletter for thoughts in this regard.)

Overall 4th Qtr '08 Model Portfolio Allocations

Moderate Risk Portfolio

Aggressive Risk Portfolio

Conservative Risk Portfolio

Specific Fund Category/Fund Recommendations

Stock Portfolio

Bond Portfolio

Discussion of Our Choices

Now, more than ever, it is particularly important to invest in the "right" types of funds, not just a stock or bond fund. Since we are recommending, for the foreseeable future, that most investors keep the majority of their investments in bond and money market funds, let's start with these types of funds.

Bond Funds and Cash

For quite a while, I have emphasized that people faced with the current chaotic investing environment should be investing in high quality bond funds. These include funds that are comprised of government bonds, investment grade bonds, and possibly, high quality municipal bonds. They do not include corporate bonds or municipal bonds that are less than investment grade. To check on the quality of the bonds in your fund, go to the morningstar.com web site, type in the 5 letter fund symbol in the Quotes area and look for the 3 x 3 grid under the heading "Morningstar Style Box". (You can look up fund symbols by typing in the fund name in the search box.)

If the black box isnt on one of the 3 top boxes (labeled High), do yourself a favor and get out of that fund! At this dangerous time within the credit markets, no one should currently own bond funds of Low or even Mid quality.

The majority your bond funds should probably be invested in government bond funds. These include US Treasury funds, GNMA funds, and municipal bond funds. Also, inflation protected bond funds are generally invested mainly in government bonds, although you can check to be sure under Sector Breakdown for a given fund on morningstar.com

Should you keep your cash in investment co. money market (MM) mutual funds or in bank MMs and/or CDs? I have always favored mutual fund MM funds over bank products and continue to do so. This is because you usually get a better return and more flexibility with mutual funds. However, I highly recommend that you invest, if possible, in MM funds offered by any of the top 10 major mutual fund companies, such as Vanguard, Fidelity, T Rowe Price, etc. In the highly unlikely event that there are problems with your MM fund, investing with a big company will increase the chances that the fund co. will step up to the plate and reimburse your losses.

Incidentally, the government is about to offer a program to temporarily guarantee the account values of shares held in participating money market funds. If you want the security of knowing that your fund is guaranteed, check with the co. within the next few days as Oct. 8th is the deadline for determining whether a given fund will participate. Note though that the guarantee will only apply to funds within the account as of Sept. 19th.

Investor Alert: Are you aware that most tax-free money market funds are now paying a return of anywhere from 4 to 6%? For example, both the Vanguard New York Tax-Exempt Money Market and the California Tax-Exempt Money Market are paying over 5% which is tax-free (for Fed. & State tax for NY and CA residents.) as compared to the Vanguard Prime MM which is paying only 2.28% and is fully taxable. Even if you cant find a MM fund for your particular state, you might consider Vanguard's Tax-Exempt Money Market which is paying 5.51%, or a similar fund; here you avoid Fed. tax but you might have to pay State tax.

What's the catch? None, although these high rates of interest may not last. If and when the credit market crisis starts to improve these rates will drop down below that of taxable MM funds. But tax-free MM funds are nearly always a better investment than a taxable MM fund for investors with a combined Fed & State tax bracket of 28% or above.

Comments on Specific Bond Funds/Categories

Vanguard Interm. Treasury and Vanguard Long Term Treasury seem to be the best and safest places to be. These funds are as secure as any and should continue to provide a nice rate of return (ea. over 11% for the past year) as long as the financial environment remains turbulent. An alternative is GNMA funds which have a higher dividend, but less opportunity for realizing capital gains. Municipal bond funds are also paying relatively high tax-free rates but haven't been very stable in price for the last few years.

Inflation protected bonds (TIPS) have been good investments, but we're not worried now about inflation. This means ordinary treasury bonds will probably do better. Eventually, the "bailout" package just signed into law may lead to inflation as the US has to offer higher rates of interest to keep foreigners investing in our bonds. But this does not seem to be a problem now.

Short term treasuries will likely also do well, esp. if the Fed has to lower interest rates further. But dividend yields are extremely low and interest rates cannot fall significantly from here.

If you are a more aggressive bond investor, consider investing in American Century Target Maturities Trust bond funds. Our current favorite is the 2015 Portfolio (BTFTX) with a return of approx. 12% over the last 12 mo.

International bonds are no longer particularly attractive, although foreign central banks will likely drop interest rates soon, helping these funds. The problem is that most funds are subject to currency losses since the dollar is now strengthening due to being the currency of choice in the rocky times likely ahead.

Finally, see the discussion of the Hussman funds below for a possible new bond fund investment idea.

Stock Funds

Now let's get to stocks.

Granted we agree this is a time for extreme caution, and this would seem to suggest not making any stock fund purchases at "bargain prices" until some degree of stabilization appears.

However, on the opposite side of the coin, our lastest research, never previously published, indicates the following when examining end of quarter data going back over 12 1/2 years beginning in Apr. '95, that is over a total of 50 calendar quarters:

1. There has been a moderate relationship between large cap stock prices over the prior 1 year and the level of prices the following year.

   This suggests that since large caps have declined 27.1% over the last year (thru 10-3), it is somewhat more likely than not that they will continue to perform on a sub-par basis over the next year.

2. There is virtually no relationship between how large cap stock prices did over the prior 5 years and how they will do over the following year.

   Thus, just because stock prices have done very poorly (3.2% annualized, thru 10-3) since Oct. '03, this does not suggest they will necessarily do any better between now and Oct. '09. However, neither will they necessarily continue to do poorly. In other words, there is basically an equal chance that they will do better than average than worse.

3. Here is the most important finding: Going back to Apr. 1995 through July '03, there has been a high degree of negative relationship between how well large cap stocks did in the previous 5 years and how well they did the following 5 years, and vice versa. High or low prior 5 year returns suggest the opposite subsequent returns over the following 5 years. (For those who are knowledgeable about statistical correlation, the actual degree of correlation shown was -0.61: A correlation of -0.0 implies no relationship; a correlation of -1.0 implies a totally predictable one.)

   Thus, for 15 straight quarters beginning with the start of 3rd Qtr '97, stock prices were showing average annual returns over the previous 5 years of nearly 20% or more. For each and every subsequent 5 year period, stock annualized returns hovered around 0 or less! Then, when prior 5 year annualized returns starting dropping precipitiously in mid-2002 as a result of the 2000-2002 bear market, subsequent 5 year returns started returning to normal, defined as an annual return in the range of 10% . So, for example, by the end of the 3rd Qtr '02, the 5 yr. ann. return on the S&P 500 was -1.6%. Rather than being a foreboding of danger for investors, over the next 5 years. thru the end of Sept. '07, stocks returned an annualized 15.5%

Taken as a whole, then, these 50 quarterly data readings suggest that while stock prices may not do well over the next year (see 1 and 2 above), they have a very good chance of showing above normal returns over the next 5 years.

Since all the major US stock fund categories (except utilities) have done poorly over the last 5 years, our research suggests that they, especially Large Cap Stocks and all categories of Growth, should do better than average in the next 5 years. Which categories should do poorest? Funds focused on emerging markets, Europe, and Asia-Pacific excluding Japan look the most vulnerable.

Although 5 years may sound like a long time, this should be the time frame for long-term investors to consider when making their stock fund investments.

Comments on Specific Stock Funds/Categories

We generally do not endorse "bear market" funds, which aim to profit in falling markets, as we consider them too risky and short-term oriented, although we recognize that some investors may want to go with them during this bear market. For a list of such funds, go here.

We also do not generally think that "Long-Short" funds are for most investors. However, we do make exception for the Hussman Strategic Growth Fund. Over the last year, while the S&P has dropped 27%, this fund has returned 3%, for a 30% outperformance. And over the last 3 yrs, the outperformance has been 4.7% ann., although the total return has been only 3% ann., less than you would have earned in most high quality bond funds. However, during the 2000-2002 bear market, Hussman did particularly well and I suspect that he may be able to duplicate that strong absolute performance this time too. Even if this fund's returns prove to be just low positive, if you are going to stay invested in the stock market, low positive is a lot better than at times sharply negative returns. He also invests heavily in the Large Growth category, another plus. We have recommended this fund many times before going back over the years.

Another interesting Hussman fund is the Hussman Strategic Total Return Fund. While this fund is categorized a stock/bond blend, it appears to be currently invested only in a conservative mixture of bonds and cash. For the last 5 years, it has outperformed all funds in its category including even most of the high quality bond funds mentioned above. It is certainly a fund that is worth checking out further.

As far as stock funds go, we continue to favor funds that have a relatively small or even no investments in the poisoned financial sector. This weights us toward Large Growth. Our Vanguard Growth Idx fund reports only 6% in financials.

For our Large Blend investment, we will go with the Vanguard 500 Idx. Normally, we do not like to include this fund in our Portfolio because we attempt to do better than this Idx. But these are not normal times; the Idx has been beating more and more managed funds lately.

Investing in a stock fund that pays higher dividends than treasuries makes sense if you are a long-term investor intending to ride out the bear market. That is why we are currently recommending Vanguard Equity Income. The current dividend is 3.79% which is subject for favorable tax treatment as compared to intermediate treasuries which are paying approximately 1% less.

We would avoid most small cap exposure at this time. However, growth small caps seem a better choice than value small caps, again with regard to exposure to the financial sector.

Our international stocks have taken a severe beating lately (see below). As a result, we have been making gradual adjustments to our own portfolio and our Model Portfolio. Although long term, we think these stocks will still likely outperform US stocks, we have trimmed down our recommended allocation from our previous 32.5% to 27.5. We now re-recommend you consider a conservatively run international fund, Tweedy Browne Global Value. This fund has been doing considerably better than most international funds over the last 3 years. One reason appears to be its minimal exposure to emerging markets, which we consider will be one of the most dangerous areas to remain invested in over at least the next year or two. And this fund hedges its exposure to foreign currencies, which may be a better strategy than it was when the dollar was consistently weak.

While investing in Asia/Pacific has remained one of the most difficult categories to sort out, we have personally remained steadfast in holding on to Vanguard Pacific Idx. We suspect it will continue to do relatively better over the next year or so than the significantly worse performance shown by the related categories of Pacific/Asia ex-Japan, or even Diversified Pacific/Asia over the past year.

Brief Review of Our 1, 3, and 5 Year Model Portfolios

Data now shows that neither our 1 yr nor 3 yr Model Stock Portfolios ended the 3rd qtr. beating the S&P 500 Index, while our 5 yr portfolio continued to do so. (So, you see, we don't only report our successes.)

This was only the 4th time over the last 32 quarters (8 years) that we failed to do better than the Index over a 1 year period. And unfortunately, it was the very first time over the life of our portfolios involving 24 quarters, that we missed the mark for a 3 yr period by what appears to be a slight amount. However, we maintained the perfect record of our Stock Portfolio beating the S&P 500 5 yrs after issuing it for the 16th straight time. More details will be published on our web site within the next week or so.

If it is any consolation, most portfolios have had trouble beating the S&P 500 over the last year. In our case, our biggest shortfall was a result of our International position which did significantly worse than US stocks. We had correctly anticipated that stocks in general were vulnerable, but we thought that since the credit crisis was centered in the US, it would hurt US stocks more than those abroad.

In spite of our Stock Portfolio's lagging 1 and 3 yr. performance, it is important to look at the overall performance of our recommendations, including our bonds and cash too. One yr. ago, we recommended a 45% position in bonds and cash for most investors. This far exceeded the percent of such investments by most investors at the time - most investors tend to keep the great majority of their investments away from bonds and cash. Three yrs ago, we had an even more cautious recommendation of 47.5% away from stocks. As a result, the total return of our 1 yr overall portfolio was approx. -12% vs -22% for the S&P 500. This is a huge difference in terms of tamping down our losses. Similarly, the total return of our 3 yr overall portfolio was approx. several percent better than the S&P 500. Once again, a well-diversified portfolio, balanced by the addition of bond funds, proves to have helped tame the ravishing effects when stocks underperform.

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