2015 Tom Madell, Ph.D.

Aug./Sept. 2015

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"What Has Gone Up ..."

As it applies to investing, is it true that "what has gone up must come down?" And also, what has gone down must come up?

If it is, investing might be a lot simpler. Just identify those stocks, funds, ETFs, etc. that are up "too much" over a long stretch and avoid them. Instead invest elsewhere, such as in investments that may have gone up but not what appears to be way out of proportion to the rest of the market, or perhaps even better, in those that appear to have been excessively beaten down.

The above statements, if true, suggest that the best performing investments right now will likely fall back to earth, sooner rather than later, while the poor performing ones (but still with excellent attributes) should be able to eventually recapture the spotlight.

Recently, in response to my May/June Newsletter article subsequently published on seekingalpha.com, a site where sophisticated investors like to read articles about out how to perhaps outperform, but also to comment on articles such as mine that try to help investors do just that, I received the following feedback and question:

You seem to be assuming that most of aggregate differences in growth are due to investor sentiment, thus by your measure of under/over valued what has gone up, must come down (or vice versa).

But there are intrinsic forces in the world that will systematically affect an entire sector, thus fast or slow grow would not represent under or over valuing. Indeed if that factor continued to hold, then it would predict the opposite of what you recommend.

(continued, bottom of page 5)

What Analyzing Past Returns Can Tell Us

By Tom Madell

It's been a great three as well as five year span for anyone who followed the recommendations presented here in my July 2012 and July 2010 Model Portfolios. This is in spite of the fact that over the last year, that is, since July 2014, our Portfolios haven't made much progress and even trailed their benchmarks by small amounts. Is there anything that can be learned by a closer look at each of these stock and bond fund recommendations made one, three, and even 5 years ago? That's what we'll attempt to answer in this article.

Let's start first with the best of these Model Portfolio performances, going back to what we recommended in July 2010.

Note: Although investors may undoubtedly change some of their investments and allocations over a multi-year period, each of our analyses below are based on the assumption of holding our recommendations unchanged over the entire period. Therefore, our Model Portfolio data, based on buy and hold performance, might easily understate potential performance if investors made the kinds of judicious changes that we typically recommended to our quarterly Model Portfolios.

Stocks (2010)

At the time, the stock market seemed to have moved well past the financial crisis lows. Therefore, we recommended that Moderate Risk Investors have 60% of their portfolios in stocks (80% for Aggressive Risk Investors).

So how well did stocks, as broadly measured by index fund performances, do in the subsequent 5 years? To measure that, we use a fixed weighted index of 65% Vanguard Total Stock Mkt Idx (US stocks only), 30% Vanguard Developed Markets Idx (International stocks only), and 5% Vanguard Emerging Markets. The result: a 14.5% annualized return over the 5-yr. period.

(continued on page 2 below)

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(What Analyzing Past Returns Can Tell Us, continued from page 1)

Might sound hard to beat, but our recommended funds, held in the allocation percentages we recommended returned 15.0%. (Note: All 5 and 3 year performance results cited are annualized results thru June 30, 2015.)

Which of our recommendations made the most difference on the positive side? Our largest single recommendation was a 25% allocation to the Vanguard Growth Index. It wound up returning 18.5%. Our other large cap fund, Vanguard Large Cap Index, at a 20% allocation, returned 17.2%. Our mid- and small-cap funds (Fidelity Low Price Stock, Vanguard Small Cap Index, and Vanguard Small Cap Growth Index), accounting for 17.5% of the Portfolio, also did extremely well at 17.2, 18.0, and 18.6% respectively).

So what didn't do so well? Our two International choices, Vanguard Internat. Growth and Tweedy, Browne Global Value, together at 25% of our stock allocation, came in at 10.5 and 10.2% respectively. But both these beat our two benchmarks for International funds which returned 9.8% (Developed Markets) and 4.0% (Emerging Markets). Fortunately, we had avoided recommending any fund investing solely in emerging markets although Vanguard Internat. Growth does have some such exposure.

Two other funds also disappointed - T Rowe Price Equity Income, and and the much worse-performing Hussman Strategic Growth. However, they represented only 10 and 2.5% of the portfolio, respectively.


Can anything be extrapolated from these 5-yr. results? While I believe that International funds always should have a place in your stock portfolio, what should be carefully monitored and possibly altered from year to year is how high or low your allocation should go. Back in 2010, we recommended a 25% allocation that was at the low end of what we feel is a reasonable allocation. (Note: our current allocation is 32.5%.) Since international stocks can either greatly underperform or greatly outperform US stocks, and the under- and out- performances tend to run in multi-year cycles, investors should be more onboard during what appear to be potentially outperforming periods ahead.

While international stocks have lagged for over 5 years now, I believe the corner has been turned starting this year with the fundamentals now favoring foreign funds over domestic funds.

Investors also need to be ready to jettison severely underperforming funds, especially once that underperformance has gone on for several years. Such has been the case with T Rowe Price Equity Income and much, much longer with Hussman Strategic Growth. Many of such funds will be those that have special niches which have now gone out of favor.

On the other hand, some well-known, highly diversified, and good performing funds can and should be held for many, many years.

Bonds (2010)

How did our Model Bond Portfolio from five years ago this July do? Our recommended allocation to bonds at that time was 35% for Moderate Risk Investors and 15% for Aggressive Risk Investors. We use the Barclay's Aggregate Bond Index as our benchmark; it returned 3.3%. Our specific fund choices using the allocation percentages we recommended returned 4.2%.

What enabled our bond choices to outperform? Our largest commitment, at a total of 45% of the Portfolio, was to two funds, namely PIMCO Total Return Instit and Harbor Bond Fund that were being managed at the time by Bill Gross, one of the best names in active bond fund management. These funds returned 4.0 and 3.7% respectively.

Together, 12.5% of our Portfolio was invested in the somewhat aggressive categories of High Yield bonds and long-term corporate bonds, namely Vang. High Yield and Vang. Long Term Investment Grade. These funds returned 8.2 and 7.1%, respectively, or more than twice the benchmark.

Another fund which brought up our Portfolio's return was Vang. Interm. Term Tax-Exempt. While the fund itself returned 4.0%, investors in the 28% Fed. tax bracket would have received a 5.6% return, taking into consideration that the dividends received were free of Federal taxes. We had recommended a 10% allocation.

Which funds brought down our Portfolio's return? We had recommended a 15% allocation to the Vanguard Tot. Bond Market Index which is in many ways closely similar to our benchmark. It this case, it slightly trailed the return of the benchmark, coming in at 3.1%.

Our recommendation of two other PIMCO-managed funds, PIMCO Real Return Instit and Harbor Real Return, both inflation-protected bond funds, for a combined allocation of 7.5%, also hurt a little coming in at 3.3 and 2.9%. The Vanguard ST Investment Gr. Fund, at only 5% of our Portfolio, also came up short at 2.4%,

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The worst of our bond fund choices, T Rowe Price Intl Bond, but again at only 5% of our Portfolio, returned a mere 1.1%.


What might be extracted from this analysis? One conclusion is that an investor probably is wise to always put the majority of his/her bond fund investments in PIMCO and Vanguard managed funds, whenever possible. These two shops have proven down through the years that their most popular bond funds are reliably among the best, and I see no reason for that to change in the future.

As you might expect, inflation-protected bond funds will do best when there appears to be the prospect of above average inflation down the road. Over the last 5 years there has been very little inflation. But also remember that these funds will follow the general drift of intermediate US treasury bond prices - if treasuries are doing well, these funds should do well also, and vice versa.

Short-term bond funds, such as the Vanguard ST Investment Gr. Fund, will likely never do very badly, as long-term bond funds can sometimes do during times of rising interest rates. However, their upside potential is very limited too. Long-term investors should mainly focus on intermediate term bond funds, except when interest rates are high and it appears highly likely that the Fed will be embarking on a series of interest rate cuts, an environment that would favor long-term bond funds. This is just the opposite scenario as we have now.

Our biggest bond investment today remains PIMCO Total Return Instit even though Bill Gross hasn't been with the fund for approaching a year now. This reflects my belief that PIMCO Total Return, even during the Gross years, was really team-managed using all the bond expertise available at PIMCO. (Over the last year, the fund is ranked in the top 12% performance-wise against similar funds).

Stocks (2012)

Now let's look at what we recommended three years ago (July 2012) and see what one might take away from this analysis.

Our stock benchmarks also excelled over the last three years with a weighted portfolio return of 15.2% annualized. Once again, as for the above 5 year results, the lion's share of the gains came from US stocks as opposed to international/emerging market stocks.

It turns out that these great returns would have been largely captured by investors who emulated either our Moderate Risk Portfolio (with a 67.5% recommended allocation to stocks) or our Aggressive Risk Portfolio (at 85%). Even our Conservative Risk Portfolio recommended a 45% allocation to stocks. However, our Model Stock Portfolio wound up slightly trailing our weighted benchmark; it returned 14.7%

Within our 2012 Model Stock Portfolio, our biggest single investment with a 15% allocation was the Vanguard Small Cap Index which returned more than any other portfolio component, namely 18.6%.

Two other winning choices, together at a combined 17.5% of the Portfolio were Vanguard Growth Index and Fidelity Contra. They returned 17.8 and 17.4% respectively. We also included an 8.75% allocation to the Vanguard 500 Index which returned 17.1%.

Of course, even a portfolio containing as few as 5 or 6 funds is bound to have some funds that trail the market benchmark. Once again, our same two international choices as in 2010, at a combined total of 22.5%, served to bring down our Portfolio's return, although together they were in line with our international benchmarks and did not expose one very much in the highly disappointing emerging markets.

Our most index-underperforming results were for two of our three recommended sector funds, Vanguard REIT Index and Amer. Cnt. Real Est., at a combined total of 10% of the Portfolio. They returned 8.5 and 8.4% respectively. Our third sector fund, Vanguard Discretionary ETF, returned slightly above our overall Portfolio return at 15.2%.

A final disappointment, although not devastating at 8.75% of the Portfolio, was the Yacktman Fund, now called AMG Yacktman Service Fund which returned 12.1%.


Can anything be generalized from this data that perhaps might lead to better future portfolio performance? The results might suggest several things which go along with many observations from many years of investing experience:

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  • Always be highly cautious when selecting and then holding on to a fund you may not have previously followed yourself. (In other words, do not troll through lists of "best performers" and purchase a fund without at least some prior knowledge about the fund and its possible strong and weak points.) This is in spite of any highly favorable Morningstar ratings.

    In our case, we selected the Yacktman Fund based on its prior outstanding track record. But several years straight of subsequent underperformance should raise a yellow flag. The underperformance began in earnest about 2 years ago. To our way of thinking, such observed underperformance should be weighed more heavily than any Morningstar rating. (Morningstar still gives the Yacktman fund its highest forward-looking rating of "Gold").

  • Sector funds may not be your best choice. While tempting, such funds which focus on a relatively narrow slice of the overall market, will subject you to an extra dose of volatility. This will become even clearer when we look at our July 2014 Model Stock Portfolio results. (Also see my Jan. 2014 article on sector funds entitled "You May Not Need These Funds/ETFs in Your Portfolio" here.)

Bonds (2012)

Switching over to the bond market side of the 2012 Portfolio, the benchmark returned 1.8%. Our Model Bond Portfolio, on the hand, returned 2.9%.

The majority of our recommended funds outperformed the benchmark, with the biggest positive contributor being the Vanguard High Yield Fund at a 15% allocation which returned 6.1%. Our split allocation to the two funds previously managed by Bill Gross (same funds as recommended in 2010) again did moderately well, returning 2.5 and 2.6%. Three funds, Vanguard Long-Term Inv. Gr., Loomis Sayles Retail, and PIMCO Foreign Bond (US Dollar Hedged) Adm, performed quite well (returns of 3.7, 5.2, and 5.5% respectively) although their allocations within the Portfolio were only in the modest 5 to 6% range. Our municipal bond fund, Vanguard Intermed. Term Tax-Ex. (with a 12.5% allocation), was once again well ahead of the benchmark with a 3.8% tax-equivalent return.

Our worst performers (with a combined 15% allocation) were our two PIMCO-managed Inflation-Protected funds, returning -0.9 and -1.0%. One other fund, Vanguard Interm. Tm. Treas., with a small 3.75% allocation, returned a somewhat disappointing 0.9%.

Two of our other recommended funds, Vanguard GNMA and Vanguard Total Bond Market, returned about the same as the benchmark.


Is there anything that can be learned?

Many investors ordinarily don't spread their bond portfolio wide enough to include International Bonds and/or High Yield bonds. But when circumstances are right, as they were over the last 3 years, these types of funds can offer excellent returns. Relatively conservative choices such as Vanguard Total Bond Mkt. will often give you at best middle-of-the-road results.

Stocks (2014)

Finally, let's consider how our recommendations from one year ago did, that is, those from July 2014.

The last 12 months through June 30, 2015 did not produce particularly good results for our benchmark stock indices. The overall return was a mere 3.3%. But this return partially masks how much worse international and emerging market stocks performed. The index of emerging markets returned -2.6%, while developed foreign markets did even worse at -4.0%; the Vanguard Total US Stock Market Index came in at 7.1%.

Unlike in the Model Portfolios from 3 and 5 years ago where we recommended a relatively high allocation to stocks, our Model Portfolio from 1 year ago suggested a somewhat lower allocation to stocks for Moderate Risk Investors, namely 50% of one's entire portfolio. (The 67.5% allocation for Aggressive Risk Investors was also lower than in both 2010 and 2012.)

Our Model Portfolio result would have been closely aligned with the benchmark result except for our sector fund recommendations which consisted of 7.5% of the Portfolio; more on this shortly. Taken together, using our recommended allocation percentages, our Model Stock Portfolio returned 1.4%

Which funds did well? Once again, our Large Growth fund recommendations at a total of 10% of the Portfolio, Vanguard Growth Index and Fidelity Contra, were among our best performing funds with 9.5 and 10.3% returns.

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Also doing well were a 10% position in Vanguard 500 Index (7.3% return), 12.5% in Fidelity Low Priced Stock (7.1% return), 10% in Fidelity Large Cap Stock (6% return), and a 20% allocation to Vanguard US Value (5.6% return).

But similar to our benchmark international funds, our 4 international recommendations at 30% of the Portfolio also showed negative returns ranging from -1.6 for two of the funds to -7.6% for Vanguard Europe. It appears that International funds that do not "neutralize" the effect of the stronger dollar over the last year likely suffered "currency losses," depressing fund returns; our recommendation of Tweedy Brown Global Value, on the other hand, does, allowing its return to have bested the majority of its competition.

In spite of most of our US stock funds doing well, our overall Portfolio still wound up trailing the benchmark portfolio by -1.9%. Practically all of our underperformance can be attributed to our 3 sector recommendations which each returned approximately minus 25%.


This reinforces our view that sector funds should often only be selected by somewhat aggressive investors willing to attempt to boost returns with a small percent of their portfolio. Of course, as in this case, the opposite can happen. Especially if you already invest in managed funds, the manager may already be making sector "bets" by overweighting what he considers the best sectors within his otherwise diversified portfolio.

Bonds (2014)

In our July 2014 Model Bond Portfolio, we recommended a 25% allocation to bonds for Moderate Risk Investors and a 10% allocation for Aggressive Risk Investors, both of which suggested we were not expecting particularly good returns over the next several years. True to that expectation, our benchmark for bonds returned just 1.9%. Unfortunately, my Model Bond Portfolio returns were even weaker at 0.8%. In spite of the poor returns, the results still exceeded parking your money in cash.

We had expected municipal bonds and international bonds to be among the best performing categories and this is indeed what occurred. The best contributors to our Portfolio were Vanguard Intermed. Term Tax-Ex. (15% of the Portfolio) returning 3.2% on a tax-equivalent basis and PIMCO Foreign Bond (USD-Hedged) Adm (our biggest allocation at 17.5%) returning 4.1%.

Almost all our remaining choices were disappointing. Hurting our Portfolio end-result the most was Loomis Sayles Retail at a 15% allocation and returning -4.4%. Also detracting was Fidelity High Income, a high yield fund, with a 15% allocation and a -0.4% return. Investors should note that we included Fidelity High Income only because our usual favorite high yield fund, Vanguard High Yield, was closed to new investors at the time; we try not to recommend closed funds in new Model Portfolios, necessitating our move away from the Vanguard fund. The latter fund returned 1.5%.

Our previously mentioned PIMCO-managed inflation-protected funds also trailed the benchmark, returning -3.1 and -3.2% respectively. And the Vanguard Sh. Term Inv. Grade fund also trailed but not as badly, returning 1.0%. However, each of these 3 funds was only recommended with a small 2.5% allocation. Regarding the Vanguard Sh. Term Inv. Grade fund, investors should note that we suggested using it instead of a money market fund for some of one's cash position. Over the last year, that would have helped investors earn a little more than cash.


The returns for both stocks and bonds over the last year support the idea that our Model Portfolios' performance over periods of as short as one year, or even two, may not necessarily give one a superior payoff than merely investing in a weighted portfolio of benchmark index funds. Rather, to make the most of our recommendations and achieve better than benchmark results, an even longer holding period (usually up to 3 years) may be required.

("What Has Gone Up ...", continued from page 1)

So have you done any systematic backtesting of your theories, over a large range of funds? It should be pretty easy to do. Does it pan out when assessed systematically?


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In fact, the article "With The Market Overpriced, Here's What To Do" has thus far received 102 comments on seekingalpha. But with so many comments, most of its readers won't ever see my response. Since my response not only offers one viewpoint to try to answer the above perhaps impossible to totally resolve question, as well as data showing the effectiveness of constructing portfolios that often follow just such an approach, I am presenting it for readers below:

Hello Dan - thank you for your interesting and thought provoking comments.

While it might appear that my approach is "what has gone up, must come down (or vice versa)," it is actually far more complicated than that.

I have always felt that a given sector within the market can remain either over- or under-valued for years on end. Thus, I do acknowledge that either economic factors or sentiment can continue to drive certain stock prices in the same direction rather than reversing as my approach might suggest.

Yes, I agree that intrinsic forces in the world such as either fast or slow growth can continue to operate in either apparently favorable or unfavorable ways, for a given sector. But growth is not always synonymous with great stock returns. For example, while health care stocks can show better growth than other sectors, that does not mean that funds investing in health care will continue to do better than most sectors. I do believe that at some point, overvaluation sets in and serves to increase the odds of lesser returns.

To continue the example, Vanguard Health Care Fund currently has a P/E ratio of 38. I would think that anyone with a knowledge of past P/E ratios would agree that this is a serious warning signal - not that the fund will necessarily crash immediately - but that based on an historical perspective, you could easily be better off investing in a fund with a lower P/E. Such a measure of overvaluation (which highly overlaps with my own 15+% for 5+ years "yardstick"), can't closely predict future returns but it certainly increases the odds of trouble ahead.

Another factor to consider is that the economy tends to run in cycles of up periods followed by down periods. Often the up cycles tend to run in the general neighborhood of about 5 years. Since we have now surpassed that average length, we are "overdue" for a down cycle. And when a down cycle begins, funds that have gone up the most tend to correct the most.

But, while my words may not be enough to convince someone of what I am saying, I offer the following evidence that my approach works:

Had one invested in my 2000, 2003, 2006, 2009, and 2012 Model Stock Portfolios and held them for the 3 following years, one would have outperformed a portfolio of low cost index funds by an amount approaching 3% per year. This, I would argue, is a record that would have been hard to beat by merely trying to figure out the fund sectors with the current fastest growth.

Getting an outperformance of this magnitude for a period encompassing the last 15 years strongly suggests that holding a portfolio consisting of undervalued and well selected funds, while avoiding overvalued ones, over periods of three to as many as 5 years, can produce considerably superior results for investors. Of course, other factors may suggest portfolio changes "midstream" which might improve performance even more. The main article in this Newsletter back on page 1, "What Analyzing Past Returns Can Tell Us," gives some additional details.

Tom Madell, Publisher


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