Contents:

--Volatility? It's Even More Than You Might Think
--How Our Specific Fund Recommendations Have Done
--Investors Beware! The Markets May Not Behave as History Suggests

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Volatility? It's Even More Than You Might Think

Many investors appear to have reacted with complete surprise and near disbelief to the huge drop in the value of their stock funds between Oct. 2007 and March of this year. As you are surely aware, losses in value from the highs, which were at a record level, to the lows, were typically around 60% over a wide range of stock funds. (As of 5-30-09, the losses in the S&P 500 Index have been trimmed to about 40%). Individuals so affected might have felt that losses such as this "just weren't supposed to happen."

But when we look back over the history of the stock market's up and downs, you will see that extreme multi-year volatility has always been part and parcel of stock investing.

If you protest by saying there have hardly been such extreme drops since the Great Depression, remember that volatility refers not only to drops in stock prices but also to large gains. And, whenever the stock market goes up a great deal, there is no reason why it can't come down a great deal as well.

A look at the following table shows that extreme downs and ups happen frequently enough that they are likely to impact most investors every few years.

Bull markets rallies can occur within secular (very long) bear markets; likewise, bear markets can occur in on-going longer-trend bull markets. These reversals are included in the above table. Without them, some bear/bull markets would appear as even greater losses/gains, such as during the 2000-2002 time period when the S&P 500 dropped a total of 49.1% from top to bottom, even though the table shows the period as two less severe bear markets with a bull sandwiched in-between.

As you can see, a downward or upward change of 20% or more (or nearly so) happens relatively frequently. So, since 1946, there have been 30 major changes of direction, occurring on average every 2.1 years. These changes eventually lead to some pretty big gains or losses. While the gains have been bigger than the losses, if we just look at the absolute size of the change, you can see that the 51.9% loss suffered recently beginning in Oct. 2007 (and -56.8% if measured through March) is about in line with the average losses or gains during the 30 periods of change.

The bottom line? Investors in the stock market need to be aware of the extremely volatile nature of the stock market. While the very long-term trend of the market has always been positive, getting through any period of time less than 5 to 10 years years has always been fraught with danger. There is frequently the possibility of a big drop. Not only that, there is no rule of investor safety saying that if the market gained 100 or more percent as in did between 2002 and 2007, that it can't give up such gains, and even more so in a subsequent bear market. This is what happened recently and has happened before.

Given such volatility, any investor must accept the fact the such risks are ever-present. It is to ignore history to assume that one can be invested in the market and be able to skate free of these dangers.

Thus, unless you are a trader, you always need to be able to stay at least 5 to 10 years in your stock investments, if necessary, to be reasonably assured of not suffering from the worst bear markets can dish up.

And, as this Newsletter has always stressed, you should always be more willing to invest in the market when valuations are relatively low vs. when they are relatively high.

When you put money to work in the market makes a big difference. You can't just assume that any time is a good time; you should be extremely patient, waiting as long as necessary for periods of market underperformance before investing more. We also believe that once it appears that the market, or pockets within it, are too highly valued, you should be willing to take profits, seek out areas of under-valuation, or even retreat to alternative investments such as bonds.

Looking at the big picture, we think that stocks in general are closer to being under-valued than they are over-valued. Or, put otherwise, if you were willing to invest more (or remain fully invested in stocks) during the years 2005 through late 2007, you shouldn't have nearly as many qualms about doing so now as you might have had back then.

How Our Specific Fund Recommendations Have Done

We have typically not put a great deal of emphasis on our recommendations for specific funds. Rather, we chose to concentrate our Model Portfolios' recommendations on broad categories of funds which seem to offer the best prospects.

Why? Mainly because we know that many of our readers have their funds invested in 401(k)s or IRAs where they may not have available the specific funds we mention. Also, many investors already have selected funds they trust and have researched (which may prove to be just as good or better performers than the ones we recommend). Lastly, given the thousands of funds out there, we don't think we can possibly research them all to tell you which ones of all the funds in a given category are "best". So, instead, we merely recommend those funds which we usually do have some personal knowledge of, or which have received highly positive recommendations from a variety of sources.

Actually, unlike other newsletters that sometimes recommend perhaps hundreds of funds over a given year, over the last 5 years, we have recommended or mentioned only a limited number of specific mutual funds for you to consider. In spite of our hesitancy to make our specific fund selections the primary target in tracking the usefulness of our advice, we thought it would be helpful to take a look at how all our specific choices of funds over the last 5 years have done compared to both the S&P 500 Index and their category averages. The data shown below will help you to answer the question of whether one would have been better or worse off in our choices of funds as compared to other funds. This data may also prompt you to consider how your own specific fund choices have done. (All data were as reported on morningstar.com thru 5-28-09.)

The data show returns for our recommended funds, but most importantly, where each fund stands in percentile terms for the past 5 years as compared to all other funds within its category. Thus, the last column is perhaps the most important. Thus, a fund with a rank of 10 is in the top 10 percent of similar funds in terms of 5 yr. performance. As you can see, our specifically recommended stock and bond funds have generally performed above average as compared to similar funds. We are particularly proud of our bond fund choices, nearly all of which have considerably outperformed other similar funds. This has been particularly important during the last 5 years, since bond funds have been pretty much the best way to maintain decent positive returns as opposed to remaining solely invested in stock funds.

Stock Funds

Bond Funds

Comments, feedback to: funds-newsletter@att.net

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Investors Beware! The Markets May Not Behave as History Suggests

If there was an uncertainty index to measure forecasts of the United States macroeconomy, it would now register 85, assuming the norm would be 50 and a reading of 25 would reflect periods of exceptional economic stability.

Economists rely on models of past behavior to predict and foretell the future. There is a popular critique “that models work until they don’t.” The current housing crisis provides a telling example. Financial institutions used models to extend loans which were based on the assumption that housing prices on a national level would not fall. Why? They had not fallen in any of the recessions following the Great Depression. On an annual basis, home prices had remained steady or gone up for over 60 years. This time they fell and what followed was a severe and unpredicted blow to our financial institutions and economy.

Among the numerous reasons that the past macroeconomic models may not now provide a sound basis for predictions of future economic activity are: (1) the blow to the nation’s financial institutions brought on by the housing crisis; (2) the end of a 28 year interest rate cycle that is forcing the Federal Reserve to rely on non-traditional means of implementing monetary policy; and (3) a possible shift to frugality in consumer behavior, which has driven more than two thirds of Gross Domestic Product (GDP).

The current crisis in our financial institutions is acknowledged by economists to be the most severe since the Great Depression. Before it occurred, Bill Gross – the chief executive of PIMCO, which runs the world’s largest bond fund – accurately predicted that a tsunami would hit the financial industry. When a major tsunami or earthquake hits, the entire structure of the area is profoundly shaken. This was a 7.0 plus Richter financial shock. After the severe earthquakes that hit San Francisco, Lisbon and Santiago, the cities that re-emerged were substantially different than their predecessors. Bill Gross now predicts this shock will usher in years of financial deleveraging following recent decades of increasing leverage. The result will be an extended period of tighter credit.

The Treasury tells us that it has stressed tested our major financial institutions and they are good to go after certain key adjustments are made. Some critics contend that the tests were designed to be easy in order to bolster economic confidence. Even assuming the humpty-dumpty banking system will be successfully reassembled, a period of sustained deleveraging would provide a very different backdrop on which to make economic forecasts.

The Federal Funds rate has now reached the end of a 28 year megacycle. In 1981, the Funds rate peaked at 20%. After numerous mini-cycles, it is down to 0.25%, or essentially zero. Rates on 30 year fixed rate mortgages have fallen from 16% plus in 1981 and 1982 to under 5% for the first time since 1956. Monetary policy has been the primary vehicle used by the government over the past quarter century to stimulate the economy out of recessions. Lowering the Funds rate has been the principal tool used by the Federal Reserve to achieve that objective. That traditional tool is now exhausted and the Fed is turning to non-traditional alternatives such as direct purchases of long term treasuries and mortgage-backed securities. An economy operating in an environment where there is no prospect of future cuts to the Funds rates may function in materially different ways.

This also may be the dawn of “a new age of frugality,” the current catch phrase for the sharp drop in consumer purchases. Consumer spending skyrocketed over the past decade, so much so that consumption rose from its historic level of about two-thirds of the U.S. economy to make up nearly 72 percent of the nation's Gross Domestic Product. At the same time, the U.S. savings rate plummeted. Historically amounting to about 10 percent of income, savings fell into the low single digits. Thanks to the spending of borrowed money, net savings actually dipped below zero in 2005. Some eminent economists predict that consumer spending will revert to its mean. A reversion to the mean generally means a dip below the mean, perhaps for some time. This suggests that consumer spending may account for around 60% or less of GDP in the next few years. A shift to thrift obviously could have a profound impact on retailers, wholesalers, distributors, and manufacturers, who would be forced to adapt to the new, more frugal marketplace. And given how important consumer spending is to the overall economy, the shift also could lengthen the time it would take the economy to recover.

Only time will tell whether we have entered a new age of frugality or have merely been on a short term diet after which we will revert to our prior consumptive patterns. If this is a new age of frugality, the models of economic behavior based on old consumption patterns will be less reliable.

Commentator John Mauldin summed up the current situation, “It has long been my contention that we are entering an extraordinary period of time in which using historical analogies to plot market behavior is going to become increasingly problematical. In short, the analogies, the past performance if you will, all break down because the underlying economic backdrop is unlike anything we have ever seen. It makes managing money and portfolio planning particularly challenging. Traditional asset management techniques just simply may not work. Buy and hope strategies may be particularly difficult to navigate.”

Alert investors recognize that the stock and bond markets are constantly impacted and buffeted by the weekly output of economic reports and the overall direction of the economy. Whether the prediction is for a quick, slow or no recovery, the investor should view it with an even greater level of skepticism than would ordinarily be the case. The uncertainty level is simply too high for any other course to be prudent. Wise investing will require careful attention to the flow of economic data and the agility to move with the waves as they come ashore. It will also require constantly keeping in mind the high level of economic uncertainty in which we are now operating.

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