Mutual Fund Research Newsletter 4th Qtr. 2006 Copyright 2006. Tom Madell, PhD Updated Oct 9, 2006 Thanks for your interest in this little known Newsletter that has thus far produced great results for long-term investors. Once again, as we have regularly accomplished in the past, if you followed our suggestions over the longer term, you likely have done noticeably better than the performance achieved by most other investors. If you could have invested in the actual S&P 500 index over the last year, your total return would have been pretty good, 10.8%, although no one can actually invest in this index without paying the fees for making such an investment. Yet, if you had invested in the stock fund categories we recommended in the proportions we suggested exactly a year ago, your 1 year return would have been even a little better, 11.4%, even after fund management fees. But even better outperformance resulted from holding our stock fund portfolio recommendations made 3 years ago. (We measure our performance in comparison to the S&P 500 after 1, 3, & 5 years.) Here, you would have outperformed the S&P index by 3.62 percentage points, earning a 15.92% return per year vs 12.30% per year for the index. This is consistent with the results from earlier Newsletter portfolios which also showed better outperformance for 3 yr holding periods for our recommendations than for just 1 year. When the final data are confirmed, it will show that our stock portfolios have now outperformed the index 23 out of 24 times over 1 year, and 24 out of 24 times over 3 and 5 years! The final 1, 3 and 5 year results from our Model Portfolios, including bond fund results as well, are posted on our web site - if you haven't already seen them, please look for them there - http://funds-newsletter.com Current Recommendations The following are our latest recommendations for an overall portfolio of mutual fund investments. These will be particularly useful if you are new to our recommendations. We recommend you hold on to these recommended fund category choices for at least a year, and preferably over several yrs, to get the best results. We believe that it will take at least this long for the outperformance we aim for to sufficiently reward your efforts. (Generally, one can see only little positive results - or none - if they try to use our research to generate profits for only a quarter or two.) You can also, if you choose, use our new recommendations to rebalance an existing mutual fund portfolio. But we usually recommend you make any changes slowly and with due caution - long-term investing typically produces far better results than short-term trading, a finding that has been confirmed repeatedly by well-established research. Recommended Asset Category Allocations For Moderate Risk Investors Stocks 52.5% Bonds 27.5% Cash 20% For More Aggressive Investors Stocks 60% Bonds 20% Cash 20% For Less Aggressive Investors Stocks 40% Bonds 35% Cash 25% Recommended Fund Categories Stock Funds (or ETFs) Category (Our recommended fund) Recommended percent of Stock Portfolio Large Blend (Janus Core Equity) 30 (or merely invest in Vanguard 500 Idx) Foreign (Vanguard Internat Gr) 27.5 Large Value (MainStay ICAP Equity) 15 Mid-Cap Blend (Vanguard Mid-Cap Idx) 15 Japan (Vanguard Pacific) 7.5 Long-Short (Hussman Strategic Gr) 5 (or instead a Large Growth fund such as Vanguard Growth Idx) Bond Funds Category (Our recommended fund) Recommended percent of Bond Portfolio Interm Govt (Vanguard GNMA) 15 Short Term (Vanguard S-T Inv Gr) 20 Long-Term Muni (Vanguard L-T Tax Exempt) 25 (or instead a LT bond fund such as Vanguard LT Inv Grade but munis are currently returning more after-tax for most investors) Interm-Term (Vanguard Tot Bnd Idx) 15 High Yield (Vanguard Hi Yield ) 12.5 International (Amer. Cent. Intl Bond) 12.5 Discussion We have raised our recommended allocation to stocks slightly to 52.5% from 50% last quarter. This is mainly as a result of our slightly reduced allocation to cash. Our allocation to bonds remains the same. Since 52.5% stocks/27.5% bonds is less than a "normal" 60 %/40% stock vs bond allocation, this means that 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, a likely end to the current cycle of moderate or better economic expansion, and the possibility of too much inflation lingering longer than expected. While bonds look a little better than they did back in 2005, we believe that the current rally is yet unproven and low to moderate bond returns are more likely ahead as opposed to the kind of returns that can be at times nearly competitive with stocks over multi-year periods. We continue to believe that large cap stocks will outperform smaller stocks, a prediction that has already started helping us over the last year. We also are continuing to keep away from the growth category since growth stocks have never really recovered from their former winning ways prior to 2000. International stock funds, including Japan, still seem better positioned than domestic funds and so we continue to recommend a combined 35% position. We have reduced our recommendation to the relatively unknown "Long-Short" category since stocks seem to be on slightly better footing than last quarter. (The Long-Short category will tend to hold up better than most if stocks enter a period of decline.) And for those who choose not to delve into this category at all, we recommend that you might put this 5% into Large Growth instead since, in spite of our comment above, Large Growth appears a little undervalued as compared to most other categories. Our bond fund choices reflect our strategy of broad bond market diversification but with a continuing avoidance of too much weight on long term bonds. However, given the possibility of steady to falling interest rates, we do recommend a long-term municipal bond position since muni bonds tend to be less volatile than ordinary bonds and currently offer yields that are often better than ordinary bonds on an after tax basis. Cash continues to offer a somewhat attractive alternative to bonds, with over a 5% return available on a good money market fund such as Vanguard's Prime MM, or perhaps even better returns on an after tax basis from a tax free money market fund. If you have been fortunate enough to have held any funds specializing in real estate, energy, emerging markets, or emerging market bonds, congratulations - you have continued to do extremely well for at least the last 5 years. I have recommended holding these funds at various times during this period, but usually only for a small portion of your portfolio. I too continue to hold on to some of such previously purchased funds (except for emerging market bonds) in amounts of about 4% of my stock portfolio for energy, 9% for real estate related funds, and 3% for emerging markets. But I dont recommend purchasing such funds right now. (Normally, you already have some exposure to these areas if you pick the specific broader funds that I recommend in my above Model Portfolio.) As stated many times before, for those who do not/cannot hold as many stock and bond funds as I recommend, you should still be able to do better than average by holding those fund categories that I weight the most highly within my Model stock and bond portfolios. As you can see, currently, my biggest allocations are to Large Blend and International within stocks, and to Long-Term tax exempt bonds and Short Term non-govt. bonds. Just to reiterate - my Newsletter is not for market timers - people who wish to jump in and out of funds in order to make short-term profits. The aim is to achieve gradual outperformance by making occasional strategic choices which will better position you going forward. So far, we have been very successful in realizing that goal. Send feedback/questions/comments to me at any time. I hope you can profit from this Newsletter as much as many readers have told me they have, and I myself have, as a result of following the recommendations. Best wishes, Tom Madell Publisher