Contents:

-New Model Portfolios
-How Our Recommendations From 1, 3, and 5 Years Ago Have Been Doing
-The Recovery: Robust or Subdued?

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New Model Portfolios

To us, little appears to have changed since our last allocations were made in July. While stocks may appear riskier on a short-term basis as a result of the huge gains since March, our mission has nothing to do with steering you out or into the market based on short-term considerations. So, when we suggest keeping your portfolio allocations nearly the same as where you were in July, it is because our longer term outlook remains nearly the same. We still slightly favor stock funds over bond funds looking out over the next several years and we still would keep the amount allocated to cash as pretty minimal. (The main advantage of any money kept in cash would be to use any 10 to 15% correction in stocks as a buying opportunity.) However, acknowledging the wariness out there for stocks, we have recommended moving a small amount away from stocks, but only for conservative investors.

That said, for those investors who are willing to adjust their portfolios on a regular quarterly basis, you may need to reduce your stock holdings somewhat from last quarter in order to maintain the percentages in each asset class we recommend. This is because since stocks have done so well over the last quarter, you will have incurred an increase in your stock position vs bonds and cash since July even if you have not made any new stock purchases.

Overall Asset Class Allocations

For Moderate Risk Investors

Asset	Current (Last Qtr.)
Stocks	50% (50%)
Bonds	45 (45)
Cash	5 (5)

For Aggressive Risk Investors

Asset	Current (Last Qtr.)
Stocks	65% (65%)
Bonds	30 (30)
Cash	5 (5)

For Conservative Investors

Asset	Current (Last Qtr.)
Stocks	20% (25%)
Bonds	65 (65)
Cash	15 (10)

Specific Category Allocations

Even with regard to which types of funds we think will be best to own over the next few years, we are not recommending major changes. However, we do have a few new ideas to suggest.

Stocks

We continue to favor the entire realm of growth-oriented funds over value-oriented ones. Therefore, we are adding a small position in the Mid-Cap Growth area, along with our existing Large and Small Growth positions

Bonds

Which category of bond funds you own, as well as the specific fund you are able to choose (eg., perhaps some of our recommendations are not available within your 401(k) program), remain crucial factors in how likely you will do well.

Like in our July Bond Portfolio, and going back to our earliest Portfolio in Jan. 2000, we continue to recommend getting your hands on the Pimco Total Return Fund (or one of its several variants, including the Harbor Institutional Bond Fund with the fund symbol HABDX, as mentioned recently in our site's "get an answer" section). But choosing this fund really means that you will be selecting a diversified portfolio of bonds since the fund is free to cross category lines to search for the best opportunities within the fixed-income sphere. (Another good, but likely little less rewarding fund is the Vang. Tot. Bond Market Idx, which we use as our bond benchmark.) We think that which areas of the bond market will be a good investment can change fairly rapidly; therefore, if you invest in a fund specializing in only one type of bond, you can easily miss out, or worse, get hurt. Being invested in either of these funds will help prevent that from happening.

We are now recommending a position in Intermediate Term Treasuries. This is a change from July when we favored GNMA funds for the government bond category. You will still get exposure to GNMAs in the above two diversified funds. The rest of our choices remain similar.

Finally, we suggest waiting a little further before investing more than a percent or two of a bond portfolio in High Yield bond category.

How Our Recommendations From 1, 3, and 5 Years Ago Have Been Doing

Our web site data will be updated within the next week to give precise information on how our Model Stock Portfolios have been doing since we began publishing them in Jan. 2000. However, we are pleased to report that, once again, over the last 1, 3, and 5 years, a buy-and-hold investment in each of these Portfolios would have beaten the S&P 500 Index.

--One year ago, in our Oct. 2008 Newsletter, we recommended a portfolio for Moderate Risk investors that was only 42.5% in stock funds. Almost an equal amount was allocated to our Bond Portfolio, while the remaining 17.5% was in cash.

Since the S&P 500 Index returned -6.9% over the following 12 mos., while our bond benchmark, the Vanguard Total Bond Market Index, returned +10.5%, you can see that while most people with larger allocations to stocks did relatively poorly over the following 12 mos., our overall portfolio performance remained in positive territory. Our cash position was also helpful in preventing overall Portfolio losses.

Six out of 7 of our specific choices of stock fund categories beat the S&P 500 Index, with the greatest degree of outperformance coming from our relatively large International Stock position.

--Three years ago, we recommended a 52.5% position in stocks, with the remainder in bonds (27.5%) and cash (20%). Once again the positive returns for the latter two classes came close to cancelling out the negative returns of stocks. As a result, long-term holders of our Portfolio would have had hardly any losses as compared to the annualized 5.4% losses (per year) for the S&P 500 Index. Five out of 6 of our recommended stock categories beat the Index.

--Finally, 5 years ago we recommended an allocation of 60% stocks, 35% bonds, and 5% cash. Over the entire period, the results for the S&P 500 Index have been only +1.0% annualized. But 6 out of 7 of our then recommended stock categories have done better, roughly by a few percentage points per year each. During this period, our 35% bond recommendation benchmark did approximately 4% per year better than stocks. Thus, while our overall Portfolio 5 year results are only tepid at best for Moderate Risk investors, we got through the period in decent shape, far better than many investors.

Our bond fund category recommendations have been somewhat disappointing, tending to underperform our benchmark to a small degree. But, our specific, recommended choices of which funds within bond fund categories to invest in have generally outperformed, so that if you were able to choose them, you would have frequently outperformed the benchmark. For example, our selection of the PIMCO Total Return funds over the years, as well as mainly Vanguard bond funds, have shown, we believe, that you need some of the best bond fund managers and low fund fees in order to really do well as a bond investor. If you do not have these funds available within a given investment account, then it might make sense to try to invest in them in an outside account, eg., if not available within your retirement plan, invest in them by opening a taxable account.

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The Recovery: Robust or Subdued?

A debate is emerging among economists whether over the next year the economy will have a robust or subdued recovery, with a third group arguing that no recovery will take place. Investors can better judge the dispute and make investment decisions if they understand the basic arguments each group is making.

Robust Recovery

Economists projecting a robust recovery make three core arguments:

1. steep recessions usher in steep recoveries;
2. the vast and unprecedented amount of fiscal and monetary stimulus will produce the desired results; and
3. indexes of economic indicators point to a sharp recovery.

The robust recovery group is in the minority. Understanding their contrarian perspective provides a more balanced understanding of the economy’s future prospects. Let's examine their three arguments.

Steep recessions usher in steep recoveries: Following each of the five steep recessions (1948, 1954, 1958, 1974, and 1981) since World War II, there was a steep V-shaped recovery. Going back even further, the same pattern applied for the entire last century, with the arguable exception of 1937, which was eight years after the stock market crash. In the immediate aftermath of the 1932 recession, the 1934-35 recovery was vigorous. These economists argue that a robust recovery is normal and without exception. They argue that the burden of proof is on those who claim that the recovery will not be robust.

They are especially skeptical about the “new economic era” arguments being made by numerous economists in the subdued recovery camp. Pointing to the new economy arguments made in support of the dot com boom that failed to pan out, they are dismissive of the claim that “this time will be different.” But as we learned from the nationwide fall in housing prices, there are times when “this time is different.” If this turns out to be the first time in more than a century that a steep recession is not followed by a steep recovery, it will mark a significant turning point in our nation’s economic history.

The stimulus effect: James Grant in a recent lead article in the Wall Street Journal summed up the bulls’ case that the stimulus will have a major impact:

In the post World War II era, the government has attacked recessions with an average fiscal stimulus of 2.6% of GDP and an average monetary stimulus of 0.3% of GDP, for a combined countercyclical lift of 2.9%. (Fiscal stimulus I define as the cumulative change in the federal budget, monetary stimulus as the cumulative change in the Fed's balance sheet, both measured from the peak of the boom to the trough of the bust.) This time out, the fiscal stimulus is likely to measure 10% of GDP, monetary stimulus 9.5% of GDP, for a combined pick-me-up equivalent to 19.5% of GDP. Our Great Recession would be marked for greatness if for no other reason than by the outpouring of federal dollars to repress it.

The fiscal stimulus will exceed a trillion dollars and more will be passed if it is deemed necessary. Consider pending legislation to extend unemployment benefits. Proposals have been made both to extend the home purchase tax credit and increase it from $8,000 to $15,000. Moreover, the Fed is unlikely to take its foot off the monetary stimulus pedal until it is convinced that a recovery is firmly underway. The government’s mantra, “We will do whatever it takes,” should not be ignored.

Economic cycle indicators: The key indexes of economic indicators all point to a sharp recovery. Over the last 50 years the Conference Board’s Index of Leading Indicators has been highly predictive of performance in the following year. It tracks 10 inter-related measures of future economic activity. On an annual basis, the Index is up a robust 4.4% over the past six months, after falling at a rate of minus 2.4% for the prior six months. And the rate of improvement is accelerating. The index fell for 20 months straight before turning positive last April and has remained positive for the past five months. As Aaron Smith of Moody’s observes, "Viewed in isolation, this kind of performance would imply an explosive rebound and a traditional V-shaped recovery.” Notwithstanding this impressive performance, however, the Conference Board’s chief economist Kenneth Goldstein has cautioned, “The intensity and pattern of the recovery is uncertain.” But confirming the Conference Board’s index, the Long Leading Index of the Economic Research Cycles Institute is at a 26-year high.

Beyond the theory and predictions, the advocates of robust recovery also point out the impressive increases in housing starts, new home sales, and industrial production since their cyclical lows. For example, New Home Sales were up 30% in August from their January lows. They argue the economy has surprised to the upside and will continue to do so.

Subdued Recovery

The most common opinion among economists is that this recovery will be unusually subdued. Ben Bernanke summed up the current wisdom in a mid-August presentation at Johns Hopkins:

But the general view of most forecasters is that that pace of growth in 2010 will be moderate, less than you might expect given the depth of the recession, because of ongoing headwinds, including still ongoing financial and credit problems, you know, deleveraging by households, the needs for adjustments in the economy, sectoral adjustments in the economy, the need for a fiscal exit at some point, many, many factors that will likely, at least based on current information, make the 2010 recovery moderate, and in particular, not much faster than sort of the underlying potential growth rate of the economy…. [Emphasis added]

It is sobering to consider that most economists believe that this recovery will be abnormally subdued. This includes a number of highly respected economists such as Kenneth Rogoff, Stephen Roach, and David Rosenberg who predicted the current bust well before its arrival.

Following is a summary of key points made in support of a subdued recovery.

Reduced consumption: The U.S. consumer has been the driver of the world economy for the past 25 years and that pattern is now changing. The savings rate among U.S. consumers declined from 12% to 0% during that quarter century before showing signs of recovery this past year. We have reached a tipping point. From here forward for a sustained period, the subdued camp argues, the U.S. consumer will gradually increase savings and decrease consumption. However, it is open to question how long this new frugality will last if or when employment and income rebound. It seems likely that consumers with stock holdings will again loosen their purse strings given the 50% plus rise in the stock market since March.

During the boom period of 2000 to 2006, consumer spending rose to 72% of GDP from its historic 66% level. Now it will revert and may even fall lower in the short run. Home equity withdrawals rose to an amount equal to 9% of personal income at the peak of the boom. Such withdrawals have turned to a negative 1.5% as consumers pay down loans. The concept of a home as a piggy bank to support a wide array of consumer spending no longer exists and is not about to return any time soon. Credit card availability and associated high borrowing limits are also being trimmed due to high default rates in this recession. In August, the credit card charge-off rate reached a record high of 11.5%. Moody’s predicts it will climb to 13% before peaking out.

Excess capacity: During the boom years excess capacity grew throughout the U.S. economy and has not yet burned off. It will take at least a year or two to return to normal. In short, there are too many homes, too many shopping malls and retail stores, and too much industrial capacity. The housing inventory illustrates the problem. The inventory of new homes has fallen to a still above average 7.5 month supply, which is a considerable improvement from the 10.4 month supply earlier in the year. However, most housing economists believe that the recovery from here on will be far more subdued than would ordinarily be the case. They cite competition from the current excess inventory of resale homes, the shadow inventory of foreclosed and investor-owned homes yet to be put on the market, and further foreclosures likely in the coming year. In the past significant increases in new home construction has been a key component of economic recoveries. If the excess inventory holds back a vigorous rebound, this time will be different.

Deleveraging: There will likely be conservative lending by financial institutions resulting in less borrowing and leverage throughout the economy. Banks, burned by bad loans with more losses likely, are tightening their credit standards. Regulation will diminish the large role played by unregulated lenders during the last boom. Absent government guarantees, the private sector will be less likely to take on securitized debt.

A jobless recovery: Businesses, especially publicly traded corporations, will hire back employees at a very slow pace in order to keep costs down and earnings up– a repeat of the early recovery following the dot com bust. There will be no offsetting construction boom. As a result, employment growth will not gain sufficient traction to become vigorous. A steep economic recovery requires a steep employment recovery and the consumer spending it generates. In order to replicate the steep job recovery from the last steep recession (1982), the economy would need to create 400,000 jobs a month in the next year. Even with job growth resulting from government spending, such vigorous growth will not occur because of a variety of factors such as excess capacity, and, many jobs lost in the recession will not be refilled due to diminished consumer demand.

A recent article by Rex Nutting of CBS Marketwatch summed up the employment problem:

Unlike the temporary layoffs that defined the deep recessions in 1958, 1975 and 1982, most people who are unemployed now have lost their jobs permanently. They won't be quickly recalled back to work at the factory, as in past recoveries. Instead, they'll have to find a new employer, maybe even find a new industry or occupation. That will take time. It could take years for the unemployment rate to drift back into the 5% range.

Non-Existent Recovery

Another minority view is that over the next year the economy will slump once again after a brief recovery period (perhaps as brief as one quarter) – in short, no recovery will take place. These economists cite the same reasons articulated by those in the subdued camp. In addition, they argue that the fiscal stimulus will play out earlier than expected and interest rates may increase, thereby constraining further progress.

My own view is that there is significant doubt about both the robust and subdued scenarios. For the macroeconomic-oriented investor, sorting out the complex array of countervailing factors is challenging. In formulating an investment strategy it will be important to stay focused on developing data that confirms or negates the key points discussed above.

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