Mutual Fund Research Newsletter
Copyright 2010 Tom Madell, PhD, Publisher
Aug. 2010

Summary of Contents:

-Some Investors Getting "Fed Up" with the Fed? By Tom Madell. (below)
The Fed is sending signals that investors will continue to get virtually no returns on cash. Therefore, investors should opt for bonds and even stocks instead.

-Selling Stock Funds: Smart in 2007-2008 But Not Now. By Tom Madell. (below)
Two years ago our research suggested selling some or all of the major categories of stock funds. This has proven to have been worthwhile advice. Today, however, our research suggest most of these categories are buys.

-The Housing Depression and Why It Suggests Improved Future Economic Growth. By Steve Shefler.
Housing has suffered, yes, a depression. But as the market for new homes improves over the next few years, as expected by economists, it should drive economic growth higher, and the stock market along with it. Steve's article should not be missed.  (on separate page - to view, click here)


Some Investors Getting "Fed Up" with the Fed?

As returns available on CDs, T-bills, and money market accounts continue to hover at minuscule levels, conservative investors with large sums in these accounts who currently live off the interest or expect to grow their investment for the future, are likely finding the low rates intolerable. Therefore, we suspect that many are more and more biting the bullet in their search for higher yield and stepping up to investments in bonds and even stocks.

Late in July, Fed Reserve Chairmain Ben Bernanke, in testimony before the Senate, again suggested that interest rates would remain low for an "extended period." But given that growth is currently weaker than desirable, and given that interest rates near zero cannot be cut any further, the Fed would still like to be able to respond if the economy softens from here. However, their remaining options have drawbacks, including increasing their own level of bond purchases which means they would be taking on more debt themselves, something they would rather start unwinding than increasing.

So, one action they are considering is further emphasizing that interest rates will remain low for a long time. In fact, according to the Wall Street Journal, the Fed is already "evaluating its public communications, ... exploring how to underscore to the markets and the public that it plans to keep interest rates low" (italics added). Why would the Fed be evaluating this action beyond what they have already done? Well, aside from the obvious attempt to be "transparent," they may be attempting (although only people who have actually attended their meetings might be able to 100% confirm this) to indirectly sway the direction of the markets by getting investors to take actions that the Fed deems will be helpful to the economy. In other words, the Fed might be using its position of power to "nudge" investors into bonds and stocks.

The longer interest rates remain close to zero, the more investors will likely begin to cast aside their low yielding MM accounts, CDs, or even short-term Treasury bills in favor of investments that pay a higher dividend. As a result, theoretically at least, interest rates on longer term bonds, which the Fed has no direct control over, will continue to drop since greater demand means higher bond prices, and lower yields. This will further stimulate the economy without the Fed having to do anything else. In fact, one of the weakest segments of the current economy, housing, can potentially improve as interest rates determining new mortgages and refinancings go even lower.

Of course, we likely all have come across the important notion in investing that dropping interest rates are good for stocks. This makes sense in that as returns on non-risk investments fall, investors are more willing to take on greater risk in stocks. If the stock market can get back on track, the entire economy will likely start to improve, and importantly, companies will likely be more willing to hire. Since full employment, along with low inflation, are the twin objectives of the Fed, it can be seen that by getting more investors to invest in stocks, a Fed policy of keeping interest rates low for quite a long time would help to meet the full employment objective.

And since deflation, rather than inflation, remains a scary possibility to economists as well as the Fed, an improving housing, job, and stock market, and overall economy would help to ensure that it just doesn't happen. Improvements in each of these areas would be mutually reinforcing to the others, as better employment leads to more houses sold, higher stock prices to more spending by consumers, etc.

So once again, as I believe has happened before, it appears the Fed may be subtly encouraging all of us to seek out higher returns, especially those who are in low yielding investments that do not enable one to earn any sort of satisfactory return. If so, how should one react to this enticement, whether you believe it is being done deliberately by the Fed or not?

I believe that there are several forces at work which have created, and will continue to do so, a very good opportunity for bond investors. These are: a) a new "conservatism" among stock investors as a result of virtually no, or even negative returns, over the last 10-plus years for those who bought and held; and b) investors in the above low yielding investments having become more and more "fed up" (an apt phrase given the Fed's stance) with near zero returns, now showing a willingness to convert over to bond funds which sport a higher yield.

As a result, as more money continues to flow into these investments, apparently even further encouraged by the Feds' statements, bond funds' total return prospects appear reasonably good so long as these trends continue. (Remember that total return is the sum of not only the dividend payments but also any potential capital gain that comes from an increase in the price of the investment that results from a greater demand for the underlying bonds.)

Should investors reach for incremental yields that are available by investing in long-term treasuries and/or corporate bonds? Perhaps to some extent. But especially for investors who tend to buy and hold their funds, it would probably be wiser to stick to intermediate, rather than long-term bonds. After all, eventually interest rates will go up and holders of longer-term maturities will then get "hit" by dropping prices. But we do not anticipate that happening for quite a while. After all, if the Fed is right, interest rates will remain low for an "extended period."

Of course, whether one chooses to go out of conservative investments into stocks merely to achieve their usually higher dividends as well depends a lot on one's degree of risk tolerance. Prices of stocks can be influenced by a lot more than just these kinds of switchovers, such as, corporate profitability, international developments, unforeseen catastrophes, etc. Therefore, while we think that prospects for stocks could very well be improved by the Fed's pronouncements, cautious investors perhaps will want to think twice before accepting the bait.


Selling Stock Funds: Smart in 2007-2008 But Not Now

Long-term readers of our Newsletters are likely aware that we have a very good long-term record of successfully recommending stock fund categories which we believe will subsequently outperform the S&P 500 Index. As a result, going back to the start of 2000, our recommended Stock Model Portfolios have continuously beaten the S&P by an average of around 3 to 4% per year. In fact, remarkably since we started these portfolios, in no instance have they underperformed the Index when measured exactly five years later.

Note: As reported in our July Newsletter, our stock category recommendations from 5 years ago did eke out a slightly better performance than the S&P when held over the entire period. This kept our streak of 23 consecutive outperforming 5 yr. stock portfolios alive.

Two years ago, we set out to create an even more practical source of help for investors: Using research on past fund category performance, we wanted to develop what we hoped would be an effective way to identify when the time was right to either buy, sell, or just hold various types of stock funds within one's portfolio. For more information on how we did this, you may want to see the following Newsletters:

-Buy, Sell, or Hold? What Our Research on Performance Shows (Aug 2008)

-Making Buy, Sell, and Hold Decisions During Times Like These: A New Approach (July 2008)

At the conclusion the Aug. '08 article, we began using our new BUY, SELL, or HOLD recommendations. Here is what we said:

"At the present time, unfortunately, all the major fund categories would be classified as SELL, and the majority of them have correctly (thus far, showing double-digit negative performance) been SELLS since last Oct. (2007). This appears similar to the first two quarters of 2000 when nearly all categories were also SELL. (The performance results after those signals were indeed poor with just a few exceptions.)"

Editor's Note: Although our BUY, SELL, or HOLD recommendations were indeed new, we applied them to earlier data as well to see what they would have predicted at earlier dates.

In other words, we predicted that stock funds from all popular categories would not be rewarding for likely at least a year from that Aug. '08 date, and should perhaps be sold or lightened up on within investors' portfolios.

Let's take a look at how the 10 major categories of stock funds have actually done over the two years since we made our SELL recommendation: (Note: as reported in our May 2010 Newsletter, we had already called 8 of the 9 US categories as "unattractive" in a Jan. 18, 2008 Alert, 7 months earlier. This, too, was prior to our Aug '08 research and proved to be a highly accurate "warning" for our readers.)

Net Asset Values (NAV) for 10 Vanguard Index Funds
Representing the Major Fund Categories
Over the Last Two Years
(Fund Symbol)
on Aug 1, 2008
on July 30, 2010
Large Growth
29.69 26.90
Large Blend
23.04 20.28
Large Value
21.71 18.56
Mid-Cap Growth
22.25 19.75
Mid-Cap Blend
18.23 17.11
Mid-Cap Value
18.59 18.39
Small-Cap Growth
18.64 17.68
Small-Cap Blend
30.43 29.05
Small-Cap Value
14.51 13.88
16.87 13.99

As the table shows, each of the 10 funds, serving as proxies for their category, has declined in price, confirming the validity of our Aug. '08 SELL signal over the subsequent two years. (You should note that each of the shown funds pays out a relatively small dividend, and perhaps a small capital gain, which resulted in a reduction of the NAV when distributed. Thus, the performance of each of these funds, while still poor over the period, might not be quite as bad as it might appear. For example, VIGRX representing the Vanguard Growth Index, paid quarterly dividends only, adding approximately plus 1% per year to the loss shown in the NAV.)

But as you likely are aware, all stock fund categories have enjoyed a huge rebound since March 2009. Yet, in spite of the nearly one and a half years of rising prices since then, our SELL signal from 2 years ago still proved to be accurate! Had one adhered to its advice, one would have remained better off than merely holding these funds throughout the period.

But should the Aug. '08 SELL signal still be regarded as in effect today? In a word, "No."

What Our Signals Suggest Now

Our BUY, SELL, or HOLD classifications change periodically as fund categories become either under- or over-valued, or, reasonably valued enough to be included in one's portfolio. As a result of a shift away from over-valuation brought on by the 2007-2009 bear market, the above SELL signals are no longer in effect.

In fact, all of the above 10 categories have now become what we consider a BUY, with the following exceptions which are now just HOLDs: Large Growth, Large Blend, Large Value, and most International funds. This is an updating, then, of our Nov. 12, 2009 Alert where all 10 categories were BUYs. And for those who did make some purchases as a result of our previous Alerts, results continue to appear favorable as described in our May 2010 Newsletter, although all 10 categories have been in a corrective mode since late April. To meaningfully evaluate the long-term effectiveness of our Nov. '09 BUY signals, it will be necessary for at least a full year to pass.

So, all told then, over the first two years since we devised our BUY, SELL, or HOLD recommendations, they have proven thus far to have been a highly valuable tool for anyone interested in occasionally adjusting their portfolio, which includes "rebalancing," as opposed to merely buying and holding. While the signals should only be regarded as a guide, rather than a "can't miss" predictor, we believe that the reason they will likely continue to be successful is that they help investors avoid buying/adding to their stock portfolios when fund prices are unusually high relative to a consideration of both prior market ups and downs.

To the contrary, investors are most likely to achieve good returns when they can identify when chosen fund categories are moderately or unusually low priced, and often accompanied by an improving price trend.

Note: Our BUY, SELL, or HOLD signals do not cover bond funds. Generally speaking, we are positive on all types of bond funds for investors who are willing to settle for returns we project will average about 4-6% over the next few years depending on which type of bond fund. See our Model Bond Portfolio in our July 2010 Newsletter for our current specific category preferences.

New Recommendations Regarding Sector Funds

For those investors who opt to go beyond our current Stock Model Portfolio with stock "sector" funds which concentrate within specialized areas or industries, our research suggests that the following sectors would also be considered BUYs: Financials, Consumer Discretionary, Communications, Real Estate, Industrials.

The following sectors we consider to be HOLDs: Health, Technology, Consumer Staples, Utilities, Energy, Natural Resources, Diversified Emerging Markets, Diversified Pacific/Asia, Japan.

The following sector fund category we regard as a SELL: Precious Metals.