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The $64,000 question on investors' minds is "Have we now seen the worst of things?" And if so, will the next year or so be a return to profitable times, or just relatively flat?
Looking at the one-year trendline for stocks, we still basically see an overall market in decline with a small uptick of late. We would become more confident if the current recovery period extends over at least several months rather than just several weeks. On the other hand, advisor sentiment remains relatively pessimistic, suggesting that stock prices may get better rather than worse. I put more weight on the longevity of an ongoing trend than on the sentiment indicator which mainly reflects short-term psychology. As a result, I'm not totally sold on the current rally.
If you won't need the money you are investing for quite a number of years, this rally might be worth playing on a fairly long-term basis. If, on the other hand, you're adverse to the possibility of even further losses, I would wait for more of a solid technical foundation: If indeed the tide has turned, there will be plenty of time to grow your assets.
Regular readers of this newsletter know that I rarely try to predict the direction of the overall market, although I have been fairly negative on the S&P 500 and the Nasdaq Composite for over three years now. Rather, I try to focus on selecting those fund groups that look promising in the months and years ahead along with stock vs. bond/cash allocations.
So how do the different asset categories stand comparatively speaking over the next 12 months?
Growth vs. Value: Value has shown an advantage based long-term trends although that may be leveling out now. Recommendation: Stick to a balance between the two. We are adding Janus Core Equity, a large blend.
Large-Cap vs. Small: Here, too, while long-term trends have favored smaller caps, recent trends seem to show that larger caps are turning things around. Recommendation: Tilt toward larger caps. We like a fund such as Fidelity Contra which is mainly large cap with mid- and small-cap exposure as well.
Domestic vs. Foreign: Foreign funds have underperformed on a 10-year basis. However, the balance has been gradually tipping toward outperformance and this should continue especially if the dollar continues to weaken. Recommendation: A 20 to 30% (or more) allocation to foreign funds will likely enhance returns. Also, some exposure to emerging markets seems promising in spite of a poor last few months. We are sticking with Tweedy Browne Global Value.
Real Estate Funds: While much of the pop these funds have shown over the past few years has already come, we still think holding a small (5-10) percent of your stock fund portfolio here may prove worthwhile at least for a while.
Regarding bond funds, which many investors have traditionally hated (but may be learning to like more if the bear market continues), there are three main categories that we think hold above average promise, in spite of the fact that sooner or later interest rates inevitably will start rising:
International Bonds: This category is relatively undiscovered by most investors and has been out of favor for many, many years. Yet, lo and behold, the average such fund is up about 10% over the last year. Why? Mainly because of the dollar's fall. We think that after its long cyclical bull market, the dollar is due for an extended rest, which will give these funds additional upside potential from here. Make sure that the fund you choose does not hedge its currency position; we have been recommending American Century International Bond.
Inflation Protected: It seems out of sync that inflation protected bonds should be doing well during a time of little inflation, but that indeed has happened. The problem with ordinary Treasuries is that interest rates are already so low, so there appears to be little chance of further capital appreciation along with relatively puny dividends to boot. Although an uptick in inflation appears well off in the distance, many investors are being attracted to the conservative nature of these bonds, and to the dividends, inflation guarantees, and good prior returns over the last few years. (Example: Vanguard Inflation Protected Securities).
Corporate Bonds: Significantly better yields than Treasuries now, but stick to shorter maturities. (Example: Vanguard Short Term Corporate). For those who can hold their fund for as long as it takes to ride out current fears and anger about corporate "dirty tricks", high yield funds may be offer some appeal; you will get a good income stream while you wait although NAV's may take quite a while to reverse course. Stick to higher quality funds such as Vanguard's High Yield Corporate.
The following is only a general guideline since your allocation depends on so many personal issues that only you can determine. Also, I am aware that many fund investors shun bond funds regardless of how stocks are doing or interest rate fluctuations.
Overall, we think that bond funds will continue to perform considerably better than cash, so long as interest rates remain on hold or even fall somewhat, in coming months.
Recommendation:
Aggressive portfolio: 0 - 15% bonds/cash
Moderate portfolio: 20 - 30% bonds/cash
Conservative or income-oriented portfolio: 35 - 50% bonds/cash
There is a clear schism between the feelings of the average investor and what many government officials and economic forecasters are telling us. The typical person on the street has little confidence that stocks are posed for a recovery, contradicting the relatively more optimistic pronouncements for the economy one still reads on a regular basis in the press.
Just yesterday (Aug. 14), for example, I read in the Wall St. Journal that private forecasters still see growth averaging 2.8% in the second half of this year. 2.8% growth, while not great, would represent an economy not very far from its long-term average. If this prediction is correction, it would seem to suggest that the risk of further of subpar growth like we saw during the recent recession is minimal, and therefore, an ongoing recovery in stocks is a reasonably likely event.
So who has a more accurate read: the man on the street, or, the government and economic "experts"?
Here is one caution about accepting literally most of the comments being issued by government officials, including Alan Greenspan: These officials undoubtedly realize that the economy is likely perched at a turning point that could go either way. They also are aware that confidence on the part of the American public (that is, their state of mind, or psychology), is probably the key to which way the situation eventually resolves itself.
If people remain reasonably optimistic and don't change their mental attitudes toward their own and the overall country's prospects, the economy could likely weather the current malaise without further setbacks. If, on the other hand, people begin to feel as though their personal finances and even job security are being threatened by poor growth prospects ahead, they may actually begin to hunker down, which they haven't done thus far, resulting in a self-fulfilling prophecy.
So in many ways, the future direction of the economy probably depends on whether we as consumers are "unphased" enough about current conditions to continue our normal consumption activities. Given the importance, then, of what people think will be the impact of the current economic scene, it is not surprising that these same government officials are trying to avoid instilling a sense of discouragement. Rather, they portray a brighter side they hope we will latch on to instead. And, don't forget too that with elections coming up in several months, those in office who might have the most to lose politically are also trying to keep people from downgrading their opinions of how things are going, at least until fall elections are over.
As far as some optimistic forecasts by economists are concerned, although we hope they are correct that the most likely path remains one of continued growth, many have been incorrectly forecasting a stronger rebound for quite a while, only to subsequently downgrade their prior forecasts. And many of the economists that are most quoted in the media are inevitably employed by the main Wall St. brokerage houses that naturally have a vested interest in a return to better days for stock investors. But, rather than suggesting that such economists might be deliberately distorting their forecasts, it is certainly possible that they are being subtlely influenced in their views by their own deeply held wishes and desires. Psychology, in other words, can certainly be the deciding factor when one is faced with forming an opinion within a situation that could readily go either way.
Although only time will tell who is right, the man on the street or the government and economic experts, the above factors are reason enough, in our opinion, to take what some of these quoted authorities tell us with less than complete assurance.
Tom Madell, PhD