Change Is Upon Us

This is a time of many unfolding developments, several that could have a significant impact on your investment portfolio. In fact, I am quite confident that investors who are able to use history as a reliable guide to their understanding of the potential impact of these developments can successfully use the information contained in this quarter's newsletter to maximize their returns in the years ahead.

Why Future Fund Category Performance Is More Predictable Than the Overall Market

Choosing fund investments with an eye toward maximizing your returns may seem more uncertain than ever. In spite of a barrage of bad news on the housing market, subprime loans, an obviously weakening economy, and record oil prices, the major stock indices, except the NASDAQ, remain within a stone's throw of their all time highs! No wonder many people are perplexed as to what they might do, if anything, with their existing investments as well as any new money they have available to invest. Looking back, though, one should realize that these kinds of contradictions are not really unusual with regard to the behavior of the stock market.

I don't want to give the impression that I, or likely anyone else, truly understands the multitudinous indiosyncracies governing the markets. That is one reason I have learned to rarely even try to predict where the market is going next. But, to me, this does not mean that one should simply put one's investments on hold indefinitely, or at least until there is "greater clarity". Why? Because the overall market is rarely ever clearly either a buy or a sell, and even when it appears to be, any such gains achieved (or losses avoided) are probably more likely than not to be of limited duration.

Even though I believe there is little usefulness in trying to predict the overall level of the stock market, I believe a strong case can be made for the possibility of determining where pockets of strength and weakness lie within an otherwise unknown future level of the market as a whole.

Why should one expect to have better success in predicting where, for example, large cap funds (and say "Large Growth" in particular) are going over the next few years vs, for example, small cap funds (and "Small Value" in particular)? Well, merely because history has shown that when a category such as Small Value becomes so popular among investors, eventually those investors will start showing fear of a loss of their built-up profits and begin to search for alternative choices - i.e. those types of investments (eg Large Growth) that "have less to lose", and equally important, the potential for bigger future profits vs. a category that is beginning to appear increasingly risky.

What causes such a shift is largely open to conjecture. One might think of it as merely a cyclical phenomenon- that is, investors, aware that the market, and specific sectors within it, tends to go up and down every so many years, merely start to position themselves for that turn. Anticipation of a new cycle may therefore become a self-fulfilling prophecy. But given how long certain sectors of the markets sometimes remain in either bull or bear markets while other sectors have already reversed, we doubt this explanation is sufficient.

We think a more likely explanation is this: One or more specific events occur that fundamentally change the outlook toward a currently favored category. Perhaps we are seeing some of these events right now - the bad news referred to above is making investors worry enough about the economy that they are now seeking out large, well known companies with well known products (eg technology) as opposed to those small, relatively unknown companies that might now be seen as too risky if the economy stagnates.

A Look at 2001 as Compared to Now

Nearly the reverse of this is what happened at the beginning of 2001. Small Value (SV) funds had been going almost nowhere from a 3 year perspective, showing gains averaging not much more than a mere 4% per year. Back then, Large Growth (LG) funds as well as all funds in the "Growth" category, were still viewed with an almost near reverence, while many other categories, including SV, were simply not viewed as the place to be. Despite the onset of the dot.com bear market in 2000, LG was still showing a 3 year annualized return of 16.7% at the close of Dec. 2000.

Back in Dec 2000, when our Newsletter looked closely for which categories were showing the best prospects, we saw the signs that value stocks, particularly mid-cap value and SV stocks had indeed morphed into what should have been recognized as some of the favored investment categories for forward looking investors. (Click here to see the archived copy). During that turnaround year "in the making" of 2000, the tables had indeed turned: The average return that year for SV was now trouncing LG +17.8 to minus 16.3. This 1 year sustained turnaround for both SV and LG had become a clear predictor of things to come. And so we did not recommend any allocation at all to the growth category. We continued to emphasize the smaller, value oriented funds over LG for many, many years as it became an established outperformance trend which would wind up continuing over the next half dozen years.

But now this trend too appears to be shifting gears, as 2007 tries to become a new turnaround year in the process of making itself visible. LG has turned around from being one of the most poorly performing categories in prior years to one of the best, while just the opposite has happened to SV. During the last 12 mos., LG has outperformed SV on average about 21% to 9%. The bottom line: LG is now likely to do significantly better than SV (and small cap in general) in the years ahead. More on this below.

Other examples of the same phenomenon were also apparent at the start of 2001, giving you further insight as to what is now likely to happen next.

Note: Back in Dec. 2000, we listed our top forward-looking categories as value, real estate, Europe, and bonds. Our listed categories to avoid were technology and Japan. All of these choices subsequently moved in the direction we foresaw for a number of years.

• Real Estate (RE) funds had an average annual return of a mere 0.4% for the 3 years prior to 2001. As you may know, they wound up soaring during the following 5 years and are still currently showing 5 yr. ann. returns in excess of 21% in spite of a far less sterling performance averaging about 6.9% during the last 12 mos. Here too, there was a significant tipoff that things were likely to be changing: During 2000, RE funds had completely reversed course, returning over 25.5% in spite of previously being a category going nowhere. Back in Dec. 2000, this Newsletter therefore predicted that things appeared favorable for this category. (Again, go to the above web page to see the Dec 2000 archived copy.)

  What was the trigger that led and sustained this turnaround? Perhaps among other factors were favorably low interest rates, very high dividends, while less verifiable, perhaps a feeling that not only was non-residential real estate undervalued, but stood to be a alternative place to try to make money (along with single-family homes) as compared to traditional stocks during a time when most other Wall Street stock investments were starting to be viewed as Paradise lost.

• Emerging market (EM) funds were truly dogs at the start of 2001 with a 3 yr. ann. return averaging minus 5.3% and an abysmal 2000 return of minus 30.6%. Certainly one would have been correctly reticent to call for opportunity there. Although EM funds had apparently become undervalued along with SV and RE by the start of 2001, most people who might have bought EM funds then would still have had to wait more than 2.5 yrs before even breaking even! It was only by the latter half of 2003 that there was a sustained 1 yr. turnaround sufficient to allow one to be quite confident that this category was indeed back on it's feet.

  Our Model Portfolios avoided this category altogether until the 2nd Qtr. of 2002 when we began to anticipate a recovery - the actual bottom for this category occurred during the following qtr. Since our 1st recommendation, the category has averaged an annual return well in excess of 30% (go here to see our archived Apr. 2002 recommendation.) For the last 5 yrs, EM has been the top fund category in terms of performance. Obviously, it too has to reverse itself like the others above at some point, but unlike SV and RE, it has not yet shown sustained signs of so doing. Therefore, anyone might be well advised to keep at least a small amount in this category.

Looking Forward

It should be pointed out that just like the uncertainties in predicting the overall market, one should not overconfidently predict that LG, for example, is sure to rise over the next few years. However, given the kind of data I have cited above showing that uncovering relatively undervalued categories that have clearly started to turn around and holding them long-term until there is new evidence of a reversal in the opposite direction, is one's best chance to succeed in investing, one can pretty confidently predict that LG will do better, in a relative sense, than SV (and other small caps) over that period. ((Editor's note: As of 8-22-08, the average LG fund's return over the last 12 mos. is relatively better than the average SV fund's return by about 5%, although the returns for both categories are negative.)

Will it take mettle to invest in LG at a time when many people still remember how badly growth stocks crushed investors during the 2000-2002 bear market? You bet'cha. Would so doing seem to defy one's intuition that in volatile and rocky times such as now, one should steer clear of growth funds? You bet'cha. But we can derive courage from the fact that in spite of having similar apprehensions about investing in out of favor small caps and RE the start of 2001, and EM a year or 2 later, this proved to be hugely profitable for those who did.

In fact, my research clearly supports the idea of choosing a different path from that of most investors, so long as you have sufficient evidence that the previously out of favor category has already started to shift gears. It will also require strong desire to win and long-term patience winning out over possible fears of losing. Will increasing your allocation to LG pay off in a few years? You bet'cha again. Or, at least that's what we're very confident we'll be able to say in one of our newsletters a few years hence! Stay tuned!

Note though that if a bear market hits, it is unlikely that any of my recommended stock categories (below) will do particularly well over the period that includes the bear market. In that case, they may not even show positive returns. But we can be pretty confident that any undervalued category will at least do better than the overvalued ones. Unfortunately, there are few undervalued categories right now other than LG and Japanese stocks; Large Blend appears to be close to fairly valued.

Suppose, in what I think is an unlikely event, the overall stock market suffers an annualized loss of minus 5% over the next 2 years. Obviously, some categories will lose even more than 5% but others will do relatively better. So, hypothetically, SV (or Small Cap in general) stocks could lose around 10% ann. while LG might still show small gains, or lose relatively less, say about minus 1 or 2% ann. While these figures are in no way my specific predictions, they do reflect my judgment that regardless of the market's overall direction in the next few years, LG funds appear to be clearly the place for better returns. (In fact, over the last 12 mos., LG has outperformed all of the other main categories of US and international stock funds thru 8-22-08.) Thus, if you are going to be invested in stock funds at all, you are better off with more of your assets in LG than SV. For this reason, we currently do not recommend any new investments that are in the small cap category at all.

Obviously, though, 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. ((Since a bear market began shortly after this 4th Qtr. '07 newsletter was published, bonds and cash have significantly outperformed just about every other category of fund.) Although this newsletter cannot claim to be able to predict when a bear market might occur, we well certainly tell you when the time might be ripe to cut your overall stock allocation and specific allocations to the most vulnerable stock categories.

Overall Portfolio Allocations

For Moderate Risk Investors

Bonds ----- 30% (22.5)

Cash ------ 15% (22.5)

For Aggressive Investors

Bonds ----- 25%

Cash ------- 5%

For Conservative Investors

Bonds ----- 40%

Cash ------ 25%

Note: Yields on Money Market funds will be dropping below 5% soon and will continue dropping if the Fed makes further interest rate cuts as we do anticipate.

Last quarter, we raised our stock allocation for moderate risk investors from 52.5 to 55%. This has been a successful move so far as most stock funds have shown nicely positive returns over the qtr. Although our choice of overall portfolio allocation percentages is something that is much more subject to individual preferences by each investor, we still think that it provides a useful guideline. As I've stated before, if you are willing to hold on to what start as good investments for 10, 20 or more years, and have the ability to ignore a number of intervening bear markets of unknown length, other or investment crises, perhaps even a 100% allocation to stocks can make sense. But our guidelines are intended as strategic advice to be either more or less focused on stocks, bonds, and cash.

In spite of the apparent "schizophrenic" market, that is, some of the worst signs of economic deterioration in years coupled with near record stock prices, our analysis indicates that the bull market trend for most stock categories remains intact. The main exceptions are in the outlooks for the two categories mentioned above - Small Value and REITs.

How can one justify remaining somewhat sanguine in the face of all the negative economic news? It comes down to, we think, the belief that the US economy will surely slow down but likely avoid a recession in the near future. If so, while the Fed may be forced to lower interest rates further, the cooling off in the US economy (as well as the likely "contagion" in many of the world's developed markets), may prove to be the "pause that refreshes". Lower short term rates and a more sane housing market may help to move the economy back to a more normal track, so long as they don't go so far as to show the economy has really lost its way.

While no one can be sure that a recession can be avoided, the data we follow does not suggest enough strength in the bond market, enough weakness in stocks, and enough impact on the overall economy from the housing crisis that the economy will totally stall out or worse yet contract. Slow growth in itself should not be greeted unfavorably by investors, and so far, even with all the negatives already, it hasn't. Stocks, especially in our favored categories, have been doing quite well despite a shaky July and August. Bonds, while reflecting the hope of lower rates at the short end, are not showing that investors seem to expect a severe drop in interest rates as would be likely if a recession were on the horizon. Additionally, stocks did finally register a 10% correction in mid-August which served to remove some of the more nervous nellies from the market, a definite positive in that it reduces future selling pressures.

Our Specific Recommended Categories, Allocations, and Fund Recommendations

Regarding changes to our recommended categories and funds:

Remember, our quarterly portfolios continue to outperform the S&P 500, doing even better after 5 yrs from the date first published than when measured on a short-term basis (see the link at the bottom). Also, we often change some of our recommended funds from quarter to quarter. Such changes do not necessarily mean we suggest that if you own one of our previously more highly recommended categories or funds from the same category, you should feel it necessary to always shift towards our latest recommendation.

Rather, these new recommendations are mainly for new investment dollars or investors who are completely new to our Model Portfolios. They should also be seriously considered by those investors who wish to be quite forward looking and proactive with their portfolio.

Our current recommendations may be slightly better positioned for the next few years as compared to our previous ones. And for the kind of reasons already given above, we do not expect our recommendations made back around 2000 and 2001 to remain as your best current choices. Incidentally, we compute our long-term performance results from the average performance of all funds in that category, so the specific fund we recommend is not nearly as important as which category we recommend.

Favored Categories - Recommended % of Stock Portfolio - Our Current Recommended Fund
----------------------- (last qtr's %) ------------------------ (Comments)

Large Growth ------------ 22.5% (12.5%) ---------------- Janus Fund (Old favorite whose mgr has
-------------------------------------------------------------- outperformed Vang. Growth Idx by
-------------------------------------------------------------- about 5% since 2-06)
Large Blend ------------- 25 (27.5) ----------------------- Vanguard Large Cap Index (Doing slightly
-------------------------------------------------------------- better than Vang. Growth and Income
-------------------------------------------------------------- & S&P 500)
Large Value ------------- 10 (12.5) ----------------------- MainStay ICAP Equity (A previously
-------------------------------------------------------------- recommended fund.)
Foreign LB -------------- 25 (25)-------------------------- Vanguard Intl Growth (This fund as well as
-------------------------------------------------------------- the last 2 will give you a modest exposure
-------------------------------------------------------------- to emerging mkts.)
Mid Cap Growth ---------- 7.5 (15) ------------------------ Vanguard Mid Cap Growth (Previously
-------------------------------------------------------------- recommended fund.)
Diversified Pacific/Asia - 5 (7.5) ------------------------ Fidelity Pacific Basin (Or, stick with
-------------------------------------------------------------- Vanguard Pacific Idx which has a greater
-------------------------------------------------------------- allocation to one of the few undervalued
-------------------------------------------------------------- Asian markets - Japan)
Foreign LG --------------- 5 (0) -------------------------- Janus Overseas (We previously recommended
-------------------------------------------------------------- this aggressive fund for additional
-------------------------------------------------------------- exposure to Asia ex-Japan. If you are
-------------------------------------------------------------- uncomfortable with this, add the 5%
-------------------------------------------------------------- allocation instead to your Large Blend
-------------------------------------------------------------- choice.)

Bonds

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. An exception is High Yield bonds which we feel are already showing signs of going from the best US bond category over the last 5 yrs. to one of the worst this year.

Favored Categories - Recommended % of Stock Portfolio - Our Current Recommended Fund
---------------------(last qtr's %)-------------------- (Comments)

Short Term ------------- 35 (30) -------------------- Vang. ST Treasury (Does better in a slowing
------------------------------------------------------- economy than corporate bonds)
International ---------- 15 (10) ---------------------- Amer Cent Intl Bd (Raising the allocation
(non-hedged) ------------------------------------------ due to possible slowing ahead for non-US
------------------------------------------------------- economies and because will do
------------------------------------------------------- particularly well if dollar continues to
------------------------------------------------------- fall)
Interm Term ------------ 25 (25) -------------------- PIMCO Total Return (Old favorite that has
------------------------------------------------------- returned to being one of the best bond funds)
Long Term -------------- 15 (25) ------------------- Vanguard LT IG (You want a small allocation
--------------------------------------------------------- to LT bonds in case there is a steep
--------------------------------------------------------- slowdown. LT Muni bonds haven't been
--------------------------------------------------------- doing well but may pick up during expected
--------------------------------------------------------- economic slowdown)
Inflation -------------- 10 (0) ----------------------- Vanguard Infl Protected (Although inflation
--------------------------------------------------------- seems not to be a big problem now, this
--------------------------------------------------------- category currently doing well and
--------------------------------------------------------- should remain a safe place to be.)

How Have Our Model Portfolios Done Between 2000 and 2006?

We recently published the 1, 3, and 5 yr. performance results for all of our model portfolios for stock funds since we began in 2000. Our outperformance of the S&P 500 continues to average a rate of about 4% during the 1st yr and about 5% per yr when the Portfolio is held for 3 or 5 yrs. Go here to see this newly added page.

Note: Preliminary results from the just completed 3rd qtr. continue to show 1, 3, and 5 yr. outperformance at similar levels. Final results will be posted on above web page as soon as available within the next week or so.

We have recently been improving our web site so that it is easier to read and to find what someone might want more quickly.

If you find our service valuable, consider recommending it to others. Thanks!

Please send any feedback on how you think we are doing or could improve our service to funds-newsletter@att.net

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