Contents:

-Will This Year's Rally in the Stock and Bond Markets Continue?
-An Update on Our 2009 Recommendations
-Get An Answer!
-Money Market Rates: A Look Forward

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

Will This Year's Rally in the Stock and Bond Markets Continue?

Over the last nearly 11 months, the stock market has shown a "V" shaped performance. Specifically, between early Oct. '08 and early March of this year, stocks continued their downward performance intially begun in late 2007. And almost symmetrically, between the rest of March through the end of Aug., a period of nearly 6 mos, subsequent performance has entirely retraced the prior 5 mo. period's losses. As a result, the S&P 500 trades (as of Aug. 28) at about exactly the same level as it did during the day on Oct. 6th, around 1030.

So what will happen next? Obviously, no one can be sure. Therefore, the wisest course of action would seem to be not to make big bets in either direction. Such big bets would include not only those which go overboard in assuming the worst is over, as well as those which, through continually assuming a risk averse position, are possibly letting opportunities for growth in asset values continue to slip by.

In truth, forecasting the overall levels of the stock and the bond markets, nor when they will reach or drop to certain levels, is not a central ingredient of my overall approach to achieving success in investing. I simply can't determine for myself, or anyone else, what the next leg after the current V will be. But the reason I don't concern myself very much with that issue is because I accept the fact that in investing, there will be some manner of "V's" as well as "upside down V's" (that is, downward trajectories that can essentially wipe out prior short-term gains) within almost any 5 year period. While hopefully these V shaped patterns will be smaller on the downside and larger on the upside, to me it's where you are after a full 5 years or more that's far more important. If you can get that right, you really shouldn't have to worry too much about the possible upside down V's that might occur over shorter periods.

But, of course, the questions posed by this article's title are interesting and tempting to try to answer. At the risk of contradicting my statement that I simply don't know, I can at least try to give a very "iffy" sense of whether I think the current stock and bond market rallies will continue thru the remainder of 2009, and more importantly, for a significantly longer time.

One of my favorite approaches to investing is the contrarian approach, entailing going against the crowd. Given what might appear to be the direction the markets will take, based too often on the less than well-thought out expectations held by many investors (especially those typically relying too heavily on short-term thinking), the contrarian approach usually suggests that just the opposite outcome is more likely to happen.

And indeed right now, it looks like a near-perfect opportunity to apply our contrarian bent. Some investors are apparently "chomping at the bit" to get back into stocks. At the same time, as discussed last mo., even more new money is going into bond funds than stocks. If these two phenomena are a result of the last 5+ months of momentum in the case of stocks, and in the case of bonds, the aftermath of generally good past 12 mo. performance, both these investor proclivities may be setting up for a fall. But to be honest, I actually have a slightly higher level of agreement with the stock crowd here than the newly adoring bond crowd, while feeling they both may be going too far overboard.

Stocks, while in a huge upswing that appears very ripe for correction, should be at least somewhat more of a favorite to the contrarian thinker than bonds. Why? Because stocks have been underperforming for more than a decade and are therefore more likely, in my opinion, to surprise on the upside than bonds, which have been overperforming, although not to an extreme, for nearly just as long. Thus, while John Q. Public is now more willing to see bonds in a favorable light since any period I can remember, a truly contrarian view would suggest that stocks will likely have a good decade ahead while bonds may suffer a somewhat poor one.

But let's get back to what to expect for the remainder of this year. My short answer would be "more of the same." That is, I expect stocks to continue their current upward trend, but at a slower pace than the typical fund category's 15 to 25% gains shown thus far in 2009. (It wouldn't be surprising to see a 10 to 15% correction before year's end.) I also expect bonds to do reasonably well (or perhaps better in the case of Treasury bonds) for a while longer too, with such performance most likely continuing to at least the end of the year.

While many investors, although not everyone, seem to currently think that a decent recovery is baked into the cake with the futures market recently predicting a Fed funds rate rising to about 0.75% by next June, the contrarian position would be that such a recovery, while still likely, will leave most ordinary citizens (as opposed to just stock investors) not much better off. As a result, while we likely won't retrace to the low level of economic activity previously hit, we are not going to recapture anything near the pre-crisis levels for many years. Perhaps things won't even return to where they were for at least an entire decade.

So long as the majority allows itself to continue to feel relatively sanguine about a recovery, probably thru much of the remainder of the year, the stock market too will continue to recover. But once the "new normal" (as the folks at PIMCO have termed the likely subpar retrenchment of next decade or so) becomes more obvious, returns in the stock market too are likely to be more muted than previously. We have already gone on out on a limb and expressed the view, in last month's Newsletter, that stock prices are likely to average gains in the range of 5 to 8% per year for perhaps the next 5 or so years, not the "old normal" figure of around 9 to 11%. Looking out over such a long, and what we agree will be a transitional period, is fraught with uncertainties. While our "heart" might suggest even worse stock market performance, our "head" (including many years of research data) suggests only somewhat reduced returns.

Longer term, we also expect bond prices, in general, to be more moderate than what has been seen recently. With interest rates hovering near secular lows, if not already having past the lows, investor returns will show less than what now appears in past performance tables. Of course, these past performance tables are what has likely helped make bond funds currently so enticing to many of the new converts. And as can be inferred from Steve's article below, with money market rates so low right now, many investors are turning to bonds as a relatively safe way to achieve a better yield. While we agree that bonds will certainly outperform cash, and are a rather obvious alternative at that, we expect the level of bond performance, especially for Treasuries, to be disappointingly low.

An Update on Our 2009 Recommendations

So far in 2009, it's been a great year for followers of our Stock Model Portfolios; likewise for our single BUY recommendation for Small Cap Growth. In fact, in our Feb. 2009 Newsletter, our data showed that all the major fund categories should be regarded as HOLDs in addition the suggestion to buy Small Cap Growth.

I have been stressing for quite a long time now that this Newsletter is not about trying to time the market for the purpose of achieving short-term gains. Therefore, I am somewhat reluctant to focus on how our recommendations have done for periods of less than at least one year. But, right now, our Stock Portfolios have been doing so well since the beginning of the year that I think some mention should be made. It is a good illustration of how just when the market may look the bleakest, it may actually prove to be one of the best times to be invested.

Here, then, are tables showing how our Stock and Bond Model Portfolios from Jan. 2009 have been doing year-to-date (all data thru 8-28). We will continue to track our Jan. '09 Model Portfolios to see how they have done after a full year and beyond has elapsed.

For comparing how well these recommendations have done, here are the year-to-date results for our Benchmarks:

• S&P 500 Index 15.9%
  
• Vanguard Total Bond Market Index 4.5%
  
• Vanguard Prime Money Market Fund 0.5%

Stock Portfolio

Had you held the categories we recommended at the beginning of 2009, with the allocation percentages we suggested, your Stock Portfolio return year-to-date would have been 18.7%.

Bond Portfolio

Had you held the categories we recommended at the beginning of 2009, with the allocation percentages we suggested, your Bond Portfolio return year-to-date would have been 2.4%.

Note: See our July '09 Newsletter for our most current Stock and Bond Portfolios. Long-term government bond funds, our only negatively performing category, were eliminated from our new recommendations as of that date.

Our BUY Recommendation

Likewise, our single strong BUY "Alert" for Small Cap Growth published on our web site on Jan 31 of this year, has thus far been a very profitable move for anyone whom followed our advice.

On that date, the category was at that point down -7.1% for the year. As of 8-28, the category has bounced back sharply, recording a 22.6% gain year-to-date. Thus, had you bought the average small cap growth fund on the day of our recommendation, your return over the last approximately 7 months would have been 29.7%! We don't make such strong buy or strong sell recommendations very frequently, but when we have, the results thus far have been quite good. We still think that the SC Growth category is a solid "Hold", but it is not as good a "Buy" now as it was back then because it has already moved up quite a bit.

Get An Answer!

Well over a year ago, we added a section to our Web site which we called a "Blog". For those who might think of a blog having many and frequent comments, our "blog" only posted comments occasionally and might have been better labeled as "Get an Answer" or "Get Personalized Advice". It publishes our answers to questions we receive that we think are likely of general interest to many, many readers.

We think the foreward-looking advice we already have provided since we started these postings have turned out pretty much on target. (Let me know if you disagree.) However, perhaps due to a many months where we received few questions and therefore posted few answers, people have not been going to this section very often.

We encourage you to continue to send in questions (or feedback) and to go to the Get An Answer portion of our web site to get additional advice that usually doesn't appear in our monthly Newsletters. We would like to make fuller use of this portion of our site, but need your help to do so. Our contact address is: funds-newsletter@att.net

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

Money Market Rates: A Look Forward

In August, money market fund rates fell to their lowest level since they became alternative saving instruments for the public. The current average yield on money market funds for the week ending August 4 was 0.08 percent. Almost a quarter of the 1,180 funds had no yield that week. The average yield was equal to an $800 annual return on a million dollar deposit. Approximately $3.5 trillion is invested in money market funds.

Money market and Federal funds rates have fallen to historical lows. According to Standard & Poor's, these rates are more than 95 percent correlated. Critical questions for investors going forward are when will these rates climb from their abysmally low levels, how fast will they ascend ,and to what rate. More specifically, what will happen to these rates over the next two years?

As a benchmark, consider what happened the last time the Federal Reserve started the cycle of Fed funds rate increases and how that process unfolded. On June 25, 2003, the Federal Reserve lowered the funds rate to 1 percent, the low point in the last down cycle. It took the Fed over 22 months and 8 rate increases before the funds rate reached 3 percent. Then-Chair Alan Greenspan has been repeatedly criticized for holding rates at such a low level for such an extended period of time. Notwithstanding that criticism, a 2 percent increase in rates from their current near zero level is likely to take longer this time.

We have come through a very frightening and challenging economic cycle. The damage done and fear engendered in this Great Recession is far greater than during the dot-com recession. In their wake, the Fed will make rate increases cautiously. The Fed will likely take more time than in the previous cycle before making its first rate increase and will likely move more cautiously in making subsequent increases. A combination of complex and interrelated factors makes this caution especially likely this time around.

There is considerable speculation among eminent economists that the economy may dip down again before it has achieved a sustainable recovery – the so-called double dip. Ben Bernanke has been reappointed Chairman of the Fed. Bernanke is an expert on the Great Depression, having authored a leading text on the subject. Bernanke is well aware that in the Great Depression there was a second dip in 1937. High profile economist Nouriel Roubini has stated that there is a “big risk” of a double dip this time around and that risk is growing. The concern is not simply that the GDP will slip back into negative territory but, alternatively, that the growth rate could fall back merely to an uncomfortably low level. While the risk of increasing rates too fast is always a concern of the Fed as it begins tightening, the perceived risk of a double dip is far greater now than in the aftermath of the dot-com recession. The result will be slow progress in beginning and executing a cycle of rate increases.

In addition to concerns about a double-dip recession, most economists expect the recovery from this Great Recession to be unusually tepid. If they are right, there will be little pressure in the near term to raise rates in order to avoid inflation or another potential bubble. Inflation for 2009 is running flat to slightly negative with little reason to expect much change in the coming months.

The Fed’s rate cutting arsenal is now empty. The funds rate is effectively zero. In the long run, the Fed will want to restock its rate cutting arsenal so it has the ammunition needed to assist in a recovery from a future recession. At present, however, the Fed will be especially cautious in the early stages of the rate raising cycle because it would have extremely limited rate cutting ammunition if a double dip occurred. For instance, if the economy tipped back into decline when the Funds rate was at 1.5 percent, little would be available in the way of rate relief to aid in an economic rescue.

Avoiding a violent reaction is another reason that the Fed will move gingerly. Former Fed Governor Laurence Meyer in his book “A Term at The Fed” said that changes in the funds rate occasionally provoke “a violent reaction.” This is especially true at tipping points in rate cycles. When the Fed increases rates for the first time after an extended period of rate decreases, or decreases rates after an extended period of increases, it has uniformly ushered in a new cycle of rate increases or decreases. The immediate reaction to such a shift is hard to predict and manage. But the Fed will try to manage the reaction. It will not risk an adverse reaction until the economy has sufficient buffer to absorb such a shock.

Raising interest rates and tightening credit always have adverse economic effects. There are some special reasons for concern at present. The failure of the financial system was at the heart of this Great Recession. The Fed came to the rescue with extremely low borrowing costs for commercial banks. That policy contributed to bank stabilization. Raising those costs will take away some of the banks’ indirect subsidy and potentially endanger their new found stability. Adjustable rate loans are another concern. Home owners with adjustable rate mortgages were major contributors to the collapse of the housing bubble. Their rates went up steeply as the Fed funds rate climbed from 1 percent in 2003 to 5.25 percent in June, 2006. Many defaulted on their loans. The subsequent drop in the Funds rate to zero has provided adjustable rate borrowers very significant relief. If the Funds rate was to go up again, and as a result, loans were to reset at higher levels, trouble is sure to follow. 13 percent of home loans are currently delinquent or in foreclosure. The Fed will be reluctant to undertake interest rate hikes that will materially increase that number.

Unemployment is a core factor in the Fed’s decisions on the Funds rate. Most economists predict that unemployment will continue to increase well into 2010. From both an economic and political perspective, the Fed will be highly reluctant to increase rates if the unemployment rate crosses the double digit line to 10 percent or more. Most economists and the White House Office of Management and Budget expect the unemployment rate to exceed 10% in the next few months.

Putting these factors together, the Fed will not make its first rate increase until it is confident that the economy is clearly in lift off. It is likely (more than 50 percent probable) that the Fed will first increase the funds rate in mid-2010. The first rate increase is almost certain to be a conservative .25 percent move. After the start of the last up cycle under Greenspan, each of the Fed’s subsequent increases for the entire cycle was .25 percent – a slow, steady path. Bernanke’s Fed will likely follow this game plan, only hesitating if growth slows or the economy goes into reverse. The Fed will probably not undertake bold .50 percent or .75 percent increases. As a result, the Fed funds rate and money market rates are likely to first reach the 2 percent range approximately two years hence. If the double dip feared by some economists takes place, that timetable could be extended.

For the investor, the bottom line is that money market funds are likely to pay very low rates for the next two years. This will impact the investment mix for individual investors and the market as a whole.

Accesses: