© 2014 Tom Madell, Ph.D.

Feb. 2014

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Mutual Fund/ETF Research Newsletter


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Likely Dimmed Prospects for a Favorable Year

by Tom Madell

There is the feeling among many investment professionals as well as investors themselves that "as goes January, so goes the year." What this means is that in years when the stock market performs relatively poorly at the start of the year, there is a tendency for the market to underperform its norms over the entire year as well. Since the stock market has performed poorly this January, this would appear not to augur well for 2014. But is there any truth to this belief in the importance of January?

In a recent analysis reported in January on Forbes.com, a positive start for stocks in January has proven to be predictive of a positive return over the entire year. However, a negative overall January shows no relation to what happens for the rest of the year. But when both a negative result for all of January is combined with a negative first week of the year for stocks, as we had at the beginning of this year, then approximately 73% of the time the result for the entire year was indeed negative. In other words, there now appears to be a nearly 3 times greater chance of a negative year than a positive one! This adds further credibility to the higher probability of a poor year for stocks for this year.

Much more subjectively, it does seem strange that given the bull market we have been in that the S&P wouldn't have done better than the approximately -3.5% return this month. After all, January is the month that many investors are more active than usual, sometimes even putting any extra they might have received into the market, especially after seeing how lucrative last year turned out to be.

Likely Dimmed Prospects for a Favorable Year, continued on page 6

Planning for the Winding Down of the Bull Market

In recent articles, I have tried to make the case that stocks are now more likely than not to either do relatively poorly over a year's time or perhaps longer, or short of that, have disappointingly flat returns. While no one can be certain that this will happen, the question becomes whether investors should prepare themselves for this possible eventuality, and if so, how.

While the typical investor usually doesn't create a step-by-step road map to guide their investing decisions, I believe that making such a plan to deal with such uncertainties can be highly beneficial.

Wait and See, or Take Precautions?

Most investments are made to achieve financial goals. How is this end result best accomplished? After choosing one's investments, does one simply wait to see progress toward reaching these goals, continuing on the same path so long as things are going reasonably well, and only switching course once trouble is clearly confirmed? Or, should one consider adjusting their plans before actually knowing how his or her investments will fare in the months or even years ahead?

Planning for possible future contingencies may not be for everyone. Due to time constraints, but more likely, fear of acting on a plan that may go against the current prevailing direction of the market, or perhaps, admonitions that merely holding on works best, it seems that such planning will only be considered by a minority of investors.

But failing to make such a plan, it is easy to lose sight of one of investing's most sage principles - "buy low, sell high." While many may be content with whatever the market "gives" them, especially in the midst of an extended bull market, will the same apply once the market either no longer provides stellar returns as in the case of a flat market, or once the market turns decidedly lower?

When markets turned down as they did between 2000 and 2002 and in late 2007 through early 2009, many investors were no longer content. As the extent of the drops became ever more severe, it was only then that in many cases quickly devised plans were enacted to either reduce holdings or exit the market altogether.

continued below

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(Planning for the Winding Down of the Bull Market, continued from page 1)

Likewise, more recently, more and more investors, upon seeing the magnitude of the past gains achieved since 2009, revised their prior thinking, "planning" if you will, to participate more, especially beginning in 2013 according to fund flow data. A similar phenomena occurred in 2000 as the extended bull market continued, before it had morphed into a bear.

While no one can be certain of what will happen in the future, making a plan only after something happens, that is, becomes fully known, might be compared to beginning to plan for earthquake safety only after a big one hits. While most residents of earthquake country (myself included) tend to become complacent in the absence of damaging quake activity, the few who bother to develop and take necessary precautions will likely suffer less once the inevitable happens. But human nature, it seems, dictates that minimal interventions should be made, in spite of potentially harsh consequences, until such time that a near-crisis situation actually emerges.

Any one who examines the history of stock prices is aware that stocks have both good years and bad. And such periods last, in many cases, for several years running, with mediocre, flat, or even opposite performing years sometimes interspersed.

For investors who have participated in most or all of this current exceptional bull market, returns have been so good that it makes sense to me to plan on actually realizing some of these gains in the belief that they will not last forever. For investors who more recently entered the market and whose gains are not nearly of the order of magnitude of these longer-term participants, the picture may be less clear. However, even these shorter-term participants might want to consider making sure that they aren't like some initially lucky casino patrons who hit a jackpot upon first arriving: Does it make more sense to leave the casino right away with profits in hand, or, keep playing with the house's money until it likely is frittered away, given that the odds always favor the house?

Note that while the remainder of this article focuses on the details of developing a plan for the eventual winding down of a bull market such as the one we have been experiencing since 2009, a similar kind of step-by-step plan likely would be in order once a bear market has actually occurred. In the latter case, however, the particulars would be reversed: the essence of such a plan would be to prepare for the eventual return to better days ahead.

With this rationale in mind, here are the steps you can take right now to prepare ahead of more potential trouble:

Step 1: Assess which investments in your portfolio are relatively risky.

Not all stock mutual fund/ETF investments are created equal. Some, even within the same fund category, are actually considerably more risky than others. While risky investments tend to do well in bull markets, by the same token, they will likely do more poorly in bear markets. And they will probably lose their advantage in flat markets, making them not worth the added risk of holding on to.

How can one determine which fund investments are more risky than others? There are many ways to do this so let's highlight just a few:

a. Use some commonly accepted notions of higher risk to estimate level of risk:

  • Small/Mid-Cap funds tend to be riskier (and more volatile) than Large Cap funds;
  • funds that consist of stocks only tend to be riskier than Balanced or Target Date funds that have some investments in bonds;
  • Foreign funds (and Emerging Market funds in particular) tend to be riskier than most US-only funds;
  • sector funds tend to be riskier than non-sector funds;
  • many Growth funds are typically riskier than Value funds;
  • finally, High Yield "junk" bond funds as well as long-term bond funds are riskier than most other bond funds.

Note that many investment company web sites will show a graphic under the fund's description or objective that estimates the riskiness of the fund. But, as shown below, simply using a fund's category to judge risk won't always match other more objective data.

b. Since determining how risky a mutual fund is by analyzing statistical data is a difficult task for the typical investor to accomplish on his/her own, I suggest using the ratings of fund/ETF risk provided free by morningstar.com.

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Funds are rated as either Low Risk (the lowest), Below Average, Average, Above Average, or High Risk as compared to other funds within its identical Morningstar category for funds in existence at least 3 years. Data are examined over several intervals when possible and on an overall basis. (To access these ratings, enter the fund symbol on the Morningstar site. Then click on the "Ratings & Risk" tab.)

As noted, these ratings are most useful in comparing a particular fund you own to other possible choices of funds within the same category you might choose instead. For example, one Small Growth fund might be shown to be High Risk while another Below Average.

c. Compare how a given fund performed under adverse conditions to performance for the S&P 500 index.

Once again, using freely accessed data from the "Performance" and then "Expanded View" tabs on Morningstar, you can see how any fund which has been around since the beginning of 2008 did during that bear market year as compared to the S&P 500 index which itself dropped 37%. Any drop meaningfully greater than 37% shows the fund wasn't able to shield itself well during 2008. The assumption to be made is that it might also suffer a great deal in the next bear market. A fund with a drop meaningfully less than 37% implies that it might fare somewhat better than the index in the next bear market. (Note: the usefulness of this data assumes the manager and objectives of the fund remain essentially the same now as in 2008.)

Of course, while potentially "less" losses can still be serious losses, use of this data more or less assumes you are a long-term investor and will find less of a loss more tolerable, enabling you to stay the course rather than bailing out at low prices.

Let's look at some examples that illustrate the use of these guidelines:

Among the following three funds in our Model Stock Portfolios recently, which would you rate as riskiest and which least risky?
-Fidelity Low Priced Stock (FLPSX)
-Tweedy Browne Global Value (TBGVX)
-Vanguard 500 Index Fund (VFINX)

Superficially, at least, one might guess from a. above that the foreign fund, TBGVX, is the riskiest, followed by FLPSX (mid-caps), and least of all, VFINX (large US stocks).

However, looking at the Morningstar risk ratings for overall risk, we find that VFINX is rated as Average in riskiness which is just middle-of-the-road. But FLPSX is rated as Below Average, while TBGVX is Low. But remember that Morningstar risk is defined in terms of risk within its identical fund category, not compared to funds across the board. So, TBGVX may only be low risk as compared to other foreign funds but still somewhat more risky than a domestic fund.

So, perhaps most revealing of all may be to examine how each of these funds fared in 2008, in the midst of the last bear market. Obviously, VFINX lost nearly the same -37% as the S&P 500 index it mirrors. FLPSX lost slightly less but not meaningfully so, that is, -36.17%, but 2% less than comparable mid-cap funds. But TBGVX lost slightly more, -38.31%, but more than 4% less than the average for funds within its specific category. Thus, while the differences in bear market performance between these three funds are small, one might prefer emphasizing the one with the the least prior bear market losses, that is, in this example, FLPSX.

The fund within my current Model Stock Portfolio which would have suffered the least during the 2008 bear market year turned out to be the Vanguard Consumer Staples ETF (VDC); it lost "only" about 17%, suggesting it might be a good choice for those who want to remain invested in stocks but with likely significantly less risk than most other funds.

Overall, one might conclude that each of the above four funds should not be among the most risky to own during the next downturn. By comparison, what might one find for funds/ETFs that invest in the smallest of companies, the so-called micro-cap stock funds? The best performing Small Cap Growth fund during 2013 according to the Wall Street Journal was Oberweis Micro-Cap (OBMCX). It returned 64.9% last year (through Dec. 31). Sound great? Not according to our three risk-assessing guidelines above. Not only is its Morningstar risk rating classified as High, but its long-time manager suffered a 52.98% loss during 2008, making it among the worst performers against its Small Growth peers that year.

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Step 2: Decide whether your current percent allocation of your portfolio to stocks is still appropriate given the apparent mounting risks to stocks.

Suppose that your current allocation to stocks is 60%. While such an allocation is often considered an "ideal" one for many Moderate Risk investors, it may not turn out to be ideal over the next several years if the market undergoes a serious drop or merely underperforms somewhat as a result of overvaluation. Put otherwise, while a 60% (or more) allocation may have served investors well over the last five years, such an allocation would have drastically hurt most investors during the last two bear markets. While no one can be sure when the next bear market might emerge, research has shown that bear markets occur about once every 4 1/2 to 5 years with an average drop of 38% according to the Leuthold Group.

My Model Portfolios, updated every 3 months, present my opinions as to what might be considered an "ideal" risk-adjusted allocation to stocks taking into consideration a variety of factors. Among others, these range from economic data such as interest rates, growth forecasts, historical cycles, Fed policy, and my own measures of under/over-valuation.

Currently, my recommended allocation to stocks for Moderate Risk investors is 52.5%, having dropped from as high as 67.5% for an entire year beginning in Apr. 2013, along with an even higher allocation for Aggressive Risk investors. While I can't pretend to provide an allocation percentage that's suitable for everyone, due to differences in age, risk tolerance, and even such factors as one's prior personal investing experiences, my Model Portfolio allocations are meant to help investors decide whether it makes sense to maintain the perhaps typical allocation they have maintained in the past, or whether it might be more profitable to either raise or lower the percentage.

The jury may remain out on the wisdom of making such changes since a lot depends on how long one is willing and able to hold on to their investments: Over periods of 20 or more years, holding on to appropriate stock fund investments will nearly always beat returns from non-stock investments. But guess what? Holding a low cost S&P 500 index fund over the last 15 years still trails holding a statistically middle-of-the-road performing bond fund such as Vanguard Total Bond Market Index by about 1% annualized - about 5.1% vs. 4.1% - data through 1/30/14).

However, if you conclude as I have that the risks to stock investors are now greater than they have been for at least several years, you should probably reduce (and certainly not increase) your stock holdings from the levels you might have recently had.

Step 1 above should help you choose which stock funds are the most likely candidates for making these reductions. If, however, you decide not to reduce your allocations to stocks at this time, you should at least consider switching from your higher risk investments into stock funds that have lower risk characteristics. This will allow you to maintain your current allocation percentage to stocks while hopefully putting your portfolio's risk profile at a lower level. At the same time, you may want to consider doing the same for your higher risk bond positions, such as high yield bonds or any long-term bond funds that you own.

Step 3: If changes are decided upon as a result of Steps 1 and 2, implement those decisions.

Once you have determined if any of the investments you own are considerably riskier than others, or have risk characteristics that suggest you might be better off lightening up on them in the event of poor stock market performance ahead, you could either a) sell some of these funds outright or b) exchange some or all of your shares into a fund that seems less risky and more likely to hold up in the event of a negative change in the market's direction.

Depending on the size of your portfolio as well your confidence that your more risky funds will indeed be likely to suffer for a long enough period to make taking action worthwhile, you may want to make your overall percent allocation and particular fund allocation changes gradually rather than in one fell swoop. This will give you more time to assess whether risky investments are indeed going to suffer more than less risky ones as the year progresses.

Here is a concrete example. Suppose you do decide to reduce your current allocation to stocks from 60% to 50%. Also suppose that you now have $60,000 in total in your stock funds. This would mean selling $10,000 worth. But rather than assuming that a market correction, or even worse a bear market, is just around the corner, you might decide to proceed gradually and cautiously. Thus, your plan might be to sell $2500 or 2.5% immediately, with the remaining amount possibly over three intervals of say a month or two each.

Using this gradual strategy will permit the possibility of considering a more lengthy pause in completing the sales, or even cancelling the plan completely if the market does not wind up being in a further corrective mode at this time. You might apply the same gradual strategy if you decide to transfer funds from a relatively risky, but currently quite profitable fund, to a less risky fund.

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If, on the other hand, there start to be more concrete signs that the market is indeed faltering, you might want to stop using such a gradual approach and accelerate, or even complete the entire 10% sale as you initially decided upon. Many a regrettable investment decision is based on an appraisal of the market's apparent potential at one moment in time. By permitting yourself to start with a gradual reduction of risky investments, you are spreading your appraisal over a longer period allowing for the possibility that the appraisal might have been wrong, or perhaps, too early.

Step 4: Decide what, if anything, may cause you reverse this defensive stance.

As implied by the quote at the end of the companion article, by adopting this plan, you are essentially giving up on the idea of making as much money as possible by retreating on the notion that being as fully invested in high power stocks as you can, especially during a bull market, is almost a no-brainer.

But stepping down one's risk level isn't likely to be a foolish move. Rather, it is an effort to adopt a defensive stance in order to protect yourself from what might in hindsight appear as greediness and over-assurance that all will continue to go well. It further helps to assure that you won't be faced with making potentially unwise sell decisions when accumulated returns have already turned considerably less favorable.

As you assess where you are on the continuum to reaching your financial goals mentioned at the start of this article, if you are among the fortunate, you may possibly decide to cut back on your portfolio's risk level permanently. If, though, you are more like the great majority of investors who still have a ways to go to their financial nirvana, you should regard yourself as merely pausing a bit at this lofty juncture.

If this is the case, therefore, you will want to consider planning in advance what conditions will likely cause you to reverse this posture. If, for example, you agree with me that the overall market is pretty much overvalued at this point, you would want to see that overvaluation reduced to fair evaluation, or even down to undervaluation, before undoing your defensive stance.

In this regard, some people use mathematic measurements to judge how fairly valued the overall stock market is, such as the price/earnings (PE) ratio of the S&P 500 index. This figure is currently nearly 19. However, the average ratio going back to the 1870s is 15.51. This makes it 18% more highly valued than average. Other investors use a more conservative price/earnings ratio calculation called the Cyclically Adjusted PE Ratio (CAPE), devised by 2013 Nobel Prize winner Robert Shiller. It shows a current ratio of 24.75 vs. an average of 16.51 over approximately the same period. That represents a 50% increment over its long-term average!

I personally use a research-based approach to determining over-, under-, or fair valuation, which I have discussed in detail in many of my prior Newsletter articles. Even simpler, I have found through my own research that when either the market as a whole or any particular mutual fund exceeds returns of 15% annualized over 5 years, the odds are high that the market or that particular fund will perform considerably below average over the following years. (See, for example, Aug. 2008 and Sept. 2013.) Since the S&P 500 index currently shows a 5 year annualized return of about 19%, this agrees with those who use the above PE ratios in assessing the market as rather highly overvalued.

When using the annualized 15% threshold as a dividing line between more reasonable valuations or overvaluation, one will note that the great majority of stock mutual fund category averages as well as mutual funds themselves are currently too high to pass our test of fair valuation.

So, if one accepts any of these three measures of valuation, one might decide to only become less defensive once these measure drop down to below their long-term averages. Or, perhaps simpler still, one might wait for a substantial correction in stock prices. Perhaps a drop of at least 15 to 20% or more might be enough to induce some value conscious investors to reverse the above process, tiptoeing back into a more aggressive stance. For others, it might even be an extended period of bear market returns of -20% or more.


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(Likely Dimming Prospects for a Good Year, continued from page 1)

But a barometer I have frequently used with some success in the past that requires much more evidence to suggest possible serious trouble ahead is that stocks, from any point during a given year, go negative for at least a full 6 months. I have noticed that when this happens, more frequently than not, stocks may be in for an extended period of further rough sledding. Since the S&P 500 reached 1700 approximately 6 months ago, a further drop of about 5 to 6% would bring us back to that point, so anything more than that would push the return for 6+ months in negative territory.

Taking action ahead of only possible trouble ahead may seem to many people to be premature. After all, reducing your allocation to stocks, or even exchanging out of funds considered risky into less risky ones, while we still remain in one of the strongest bull markets ever, may be like predicting that the "sky is falling," as described in the fable "Chicken Little." But there is a difference: As mentioned in my main article in the right column on page one, stock markets do suffer not so infrequent setbacks, while the kind of hysterical outcome described in the folktale has never happened.

But why not just "go with the flow," taking action only if a serious correction or even bear market is confirmed to have hit?

The problem is that once the above negative events are confirmed, an investor will have already suffered a serious falling off in the value of his/her portfolio. And under the pressure of a falling market, an investor may be tempted to make some quick, emotional decisions which may not turn out in his/her best interest. For example, he/she may oversell his/her portfolio, or wind up selling near the bottom of a correction, only to see stocks bounce back soon after. Or, he/she may continue to stick with a high allocation to risky stocks in the hopes of them soon getting to their prior levels, something that may not happen.

While taking a pre-emptive approach may be hard to do psychologically, and not an "ideal" solution, one's other options may subject one to the possibility of a shriveling of the gains one has already made.

One must recognize that there is really no "ideal" solution to the dilemma since stocks, after all, are inherently unpredictable. Selling with gains, even if not near the top, is considerably better than selling at a later point with lower prices, or even losses.

To quote Jonathan Burton, investing editor of Marketwatch.com and prior contributing editor at Bloomberg Personal Finance, Mutual Funds and Individual Investor magazines, and author of two books on investing:

Over time, trying to shoot out the stock-market lights is a recipe for shooting yourself in the foot — or worse.


Capital preservation is key for any investor. If you are fortunate to have enjoyed above-average investment returns in the past couple of years, take some profits off the table. The worst thing for an investor is being shaken out of the market at precisely the wrong time, as people who dumped stocks in 2008 and early 2009 have learned the hard way. With a diversified, risk-controlled portfolio, market corrections won’t be as scary, and you’ll have money to buy stocks when others are selling cheaply.

I couldn't agree more. Our main article gives investors a game plan for how to accomplish this without requiring indiscriminant selling.


If you haven't already seen it, our Jan. 15th performance update was published on that date.


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