Contents:

-2009 Was One of Our Most Successful Years, But Can the Good News Continue?

-The End of the Federal Funds Megacycle
  by Steve Shefler

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2009 Was One of Our Most Successful Years, But Can the Good News Continue?

As 2010 begins, we start the new year with perhaps more optimism than usual. However, our optimism is not based upon the sanguine view that the markets are now going to be completely in recovery mode. Nor is it based upon the wishful, but often disappointing, supposition that your rewards when investing will always justify your efforts, especially over relatively short time periods. Instead, our optimism springs from the increasing amount of evidence that our unique investment strategies we have evolved over approximately 25 years (and especially those formulated over the last 10 years plus we have been publishing this Newsletter) can consistently help investors do better than the overall market.

How many times do we hear the following kinds of statements from acquaintances or relatives? - that they haven't paid any attention to their investments in over a year, that they are mostly giving up investing altogether, etc., etc. You, on the other hand, have probably given considerably more thought as to how to proceed, including having taken the trouble to seek out reliable sources of information such as found in this Newsletter. While your extra efforts may not always seem to pay off, success, as in any endeavor, tends to come to those who remain active and involved as opposed to those who for whatever reason cannot, or will not, apply themselves more fully.

2009 has proven to be one of our most successful 12 month periods, both in absolute terms, as well as in relative terms as compared to mere "safe" investing in the S&P 500 Index, or in money markets or CDs. In fact, one would have to go back to our Model Stock Portfolio at the beginning of the 3rd Qtr of 2003 to see 1 year returns as good as those which resulted from merely holding our Jan. 2009 stock fund category recommendations over the entire year, while also outperforming the S&P 500 Index.

Additionally, our recommended Model Bond Portfolio from the start of 2009 was also moderately successful (with the exception of our allocation to long-term treasuries which had a particularly poor year), although it proved hard to beat the return for just investing our benchmark, the Vanguard Total Bond Market Index, which returned nearly 6%.

Prior to December, the bond benchmark was doing even better, with a year-to-date (ytd) gain of about 8%. December's bond slump may prove to be a warning sign that bonds may not deserve as much of a place in your portfolio as we have given them over the last year or so - see "Model Portfolios" below.

Thus, all told, we had our best 12 consecutive month period since near the start of the previous 2003-2007 bull market. (See "How Our Recommendations From 1 Year Ago Did" below for more specific information on our 2009 performance.) Of course, no one knows for sure how long this current bull market will last, although we are generally positive on the entire stock market right now.

Things obviously change during the course of a full year, so that our recommendations made at the start of '09 changed as well. As 2009 progressed, many investment ideas we posted on our website and in our Newsletters turned out to be highly advantageous for us, and presumably, for those investors who followed them. In an atmosphere filled with fear and uncertainty about stocks, too little appreciation of bonds, and much reticence about following investment advice from whatever the source, we managed to steer a highly positive course in spite of a high degree of investor skepticism from the public at large, and even from some of our own readers.

At the start of '09, we urged most investors to hold their stock positions and to add to their bond positions. As we now know, investors who did indeed hold, or even add to their stock positions, as we made a strong case for doing a few months before the start of '09 in our Nov. 2008 Newsletter, have fared extremely well. And investors who followed our advice on bond funds, in particular our view that bond funds were a far better place to be than cash, likely outperforming by cash by better than 11 times! (for example, a 0.53% return for Vanguard Prime Money Mkt vs 5.93% for Vanguard Total Bond Mkt.)

Our Alert at the end of Jan. '09 and in our Feb '09 Newsletter, further reinforced our view that stocks were in position to deliver decent longer-term returns. The Small Growth category was also flagged as a Buy at that time. As we approached midyear, we twice raised our stock positions and lowered our cash, specifically advising readers in April on the non-productivity of holding cash. All these actions are proving, thus far, to have been correct calls. We also drastically reduced our recommended positions in treasuries from 55% in Jan. to 25% in April and 0 in July. (As of Oct., we again recommended 20% in treasuries; for our new Bond Market Portfolio (see below), we are again not recommending holding a treasury-specific fund.)

Then, on Nov. 12, we issued a Buy signal for all the remaining major fund categories which will continue to remain in effect until further notice. While only a short time has elapsed since then, each of these categories has had some positive movement.

Although it might at times appear like it, our occasional Alerts and Model Portfolio allocation changes are not about trying to time the market for short-term gains. Rather, our changes are meant to suggest the best investments over at a minimum over the next year, but more likely, over at least the next several years.

Finally, in wrapping up our discussion of our 2009 successes, it is important to mention that we have added many new subscribers to our site in 2009. Further, we have continued to enjoy the added value of our new columnist, Steve Shefler, who has helped readers get a better sense of the bigger economic picture that affects investments.

While 2009 was a very good year from our perspective, we can probably do even better in the years ahead if we get your suggestions and feedback, directed to either me or to Steve. Send your comments, either good or bad, to our email address and we will try to address your concerns and incorporate them into new Newsletters.

Model Portfolios

Overall Asset Allocations

In keeping with our Nov. 12 Buy signals, we are now recommending an increased allocation to stocks. This is true regardless of whether you are a conservative, moderate, or aggressive risk investor.

By the same token, we do not expect bonds to do particularly well going forward, although some positive surprises may develop, such as for example, a possible unexpected turnaround for long-term government bonds in the face of their poor performance in 2009.

For Moderate Risk Investors

Asset	Current (Last Qtr.)
Stocks	57.5% (50%)
Bonds	37.5(45)
Cash	5 (5)

For Aggressive Risk Investors

Asset	Current (Last Qtr.)
Stocks	75% (65%)
Bonds	20 (30)
Cash	5 (5)

For Conservative Investors

Asset	Current (Last Qtr.)
Stocks	30% (20%)
Bonds	55 (65)
Cash	15 (10)

Specific Category Allocations

Stocks

Comments: The above represent our favorite categories ordered by recommended portfolio weightings. We suggest that at a minimum, investors should diversify (and therefore, hopefully, obtain maximum returns with less overall risk) by owning a minimum of 3 funds: Large Cap, Small Cap, and International, with a continuing tilt toward large-cap and growth-oriented funds as opposed to small-cap and value-oriented funds.

Bonds

Comments: In keeping with our Oct. '09 Bond Portfolio, we are leaning more toward going with the biggest, and likely, the best run diversified bond funds instead of solely trying to select our own outperforming bond categories. Our experience has shown that it is usually too hard to beat the bond expertise of the PIMCO gurus (which is also available through the Harbor Bond funds shown above).

Important Strategy Considerations

We especially recommend that if you plan to increase your stock allocations from your current levels, you consider buying mainly on weakness. After the big gains since March, it might not be the wisest move to add large new investments immediately. Although stocks could continue without much of a correction, and therefore, eventually "force" you to make your desired purchases at even higher levels, our instinct suggests that you should wait to see if you can make any new purchases until there has been a drop of at least 5-6% from the recent highs. And if you are a relatively conservative investor, perhaps you should consider waiting until at least a 9-10% correction.

In fact, I have heard from several readers who indicate that they are going to move from being totally out of stocks back into an allocation similar to that I am now recommending. At first, it would seem as though these individuals would be merely "catching up,", i.e. putting themselves on an equal footing to someone (such as myself) who has held on to his positive stock allocation as well as many of his funds over a number of years. After all, a 50%+ allocation to stocks might seem to be the same for someone who bought his/her position a week ago vs. someone who has held their position for quite a while.

But there is a hidden danger for the person who bought recently vs. the longer-term holder. Here it is: If you are just now buying into a fund, for example the Vanguard 500 Index, your cost basis will be about the same as the current price. However, if you have generally followed my Model Stock Portfolios for many years, your cost basis may be considerably less. For example, VFINX currently sells for about 103 per share. However, over the last 15 yrs. the price has been below 100 about 1/2 of the time. If you were fortunate enough to have accumulated much of your position during the times the price was lower, you would currently be sitting on some profits.

In the event that the market does another dive, having a lower cost basis will afford you some protection: As long as the lower-basis investors are not yet losing money, just getting some of their profits trimmed, they will likely be more tolerant of any downdraft. But if you bought more recently, without such protection, you will go underwater fairly quickly. The longer-term investor, then, may have a psychological advantage in being better able to withstand whatever the market throws his way. This is in contrast to the person who has bought fairly recently who may be more likely to sell to avoid further losses.

Our recommendations are usually based on the fund categories and funds we think are likely underpriced relative to other available funds. But if you add a large amount of stocks when the price turns out to have been relatively high, you may be tempted to sell upon the first sign of a serious correction. If you do, you will not only incur a loss, but you will once again be out of the market. An in our experience, we would estimate that somewhere around 95% of people cannot get ahead by being out of the market, only by being in it, despite its at times near horrific ups and downs.

Additionally, aside from waiting for small corrections before buying, you may want to edge into a new stock allocation gradually, rather than all at once. That way you wont be buying your entire position at a time that your fund turns out to have been high-priced. This will protect you more than if you simply establish, say, a 50% position in stocks from a much lower position, or even 0% position, in one fell swoop.

How Our Recommendations From 1 Year Ago Did

Now that a full year has passed since we made our Jan. '09 stock fund choices, we can report that they wound up far exceeding what seemed possible in the midst of what was then an extremely severe bear market.

Here are how our recommendations did, based on preliminary data from Morningstar.com: (For comparison, the S&P 500 Index returned 26.5%)

Category Performance (Total Returns)
Category (Percent of Portfolio)	1 Yr Return
Large Blend (27.5%)	+28.2%
Large Growth (22.5)	+35.7
International (20)	+31.3
Large Value (7.5)	+24.1
Small-Cap Blend (7.5)	+31.8
Long-Short (7.5)	+10.2
Asia/Pacific (7.5)	+34.7

The entire Model Stock Portfolio, invested in the percentages we recommended, returned 29.6% using the preliminary data. Thus, it outperformed the S&P 500 Index by +3.1%.

Our biggest disappointment of the year turned out to be our recommended Long-Short fund, Hussman Strategic Growth, which returned only 4.6% over 2009. Note though that by early March '09, it was outperforming the S&P 500 Index by around 25%. And even by early July, it was about 7.5% ahead. But since then, the fund has lagged badly. On the positive side, for those who invested in the fund when we earlier recommended it back in July '08 and have continued to hold it, they are still better off than having invested in the S&P Index instead. (That is, the fund lost less since then vs. the S&P 500 Index by +12%, not annualized.) So, it did provide diversification protection during the bear market period it was most needed.

Given the fund's poor showing, we have removed it from our new Portfolio. However, if you continue to own it, you might consider retaining at least some or all of your position as a type of "insurance policy". (The fund has also outperformed the S&P 500 Idx. over the last 3 and 5 years: it tends to do well when the rest of the stock market does poorly.)

The following table shows how our Model Bond Portfolio recommended categories did (data thru 12-29) vs the approximate 6% return available on our benchmark:

Category Performance (Total Returns)
Category (Percent of Portfolio)	1 Yr Return
Interm Govt (30%)	+4.7%
Long Govt (25)	-18.0
Interm Non-Govt (20)	+13.8
Inflation (10)	+10.6
International (10)	+13.7
Long-Term Non-Govt (5)	+15.3

Thus, had one avoided the long government category, one would have done quite well.

The above data, as well as how our Model Stock Portfolios did over 3 and 5 year periods will be posted on our website when more data becomes available.

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The End of the Federal Funds Megacycle

While there are many uncertainties concerning the economy going forward, one thing is certain: The federal funds rate is essentially zero and the only possible future direction for the rate is up.

The Federal Reserve has progressively lowered the federal funds rate over the past 28 years from a 21 percent level in 1981 to effectively zero at present. The rate at the end of December was 12/100ths of 1 percent (0.12). It is, as if, we had a 21 gallon gas tank that is now on empty.

During this 28-year cycle, monetary policy has been the primary tool the government has used to stimulate economic growth. Lowering the federal funds rate in an effort to lower interest rates for borrowers has been the principal vehicle used by the Fed.

Lower interest rates have provided a powerful tailwind for the economy during this quarter century megacycle. Home mortgages and their impact on home prices illustrate this impact. Freddie Mac data indicate that the average 30-year fixed rate mortgage for 2009 was approximately 5 percent. In 2000, it was 8.05 percent. A decade earlier in 1990, it was 10.13 percent. At the height of the interest rate cycle in 1981 and 1982, the annual rate exceeded 16 percent. In short, the 30-year rate is now less the a third of its peak level and half of where it was 20 years ago. It would take a 60 percent increase in the 30-year rate just to reach its average level at the beginning of this decade.

As the 30-year rate has fallen, home prices have climbed sharply. Lower borrowing rates were the most important contributor to the housing price boom between 1981 and 2007. Homes have been by far the biggest investment for most Americans. As they climbed in price, Americans built nest eggs on which to retire out of the accumulating equity. In recent years, home price appreciation has also been used as a piggybank for a wide variety of expenditures as homeowners took out equity loans.

Mortgage rates and home prices illustrate the larger picture of overall asset inflation as interest rates have been repeatedly lowered. Lower rates make shopping centers, office buildings and industrial facilities more affordable and jack up their prices/book values.

This long period of ever lower federal funds rates is over. It has gone on for so long that many have taken it for granted. We are like pilots who have been flying for more than 25 years with a strong tailwind. It is imbedded in our expectations. It is imbedded in our economic history and the models that economists use to predict future levels of economic activity. Even if you acknowledge that there will be no tailwind going forward, you may be so conditioned to its presence that it will influence your decisions nevertheless.

There are two take-aways for investors going forward: (1) Without the powerful tailwind of ever lower federal funds rates, economic growth and asset appreciation are likely to be significantly less than they have been for the past quarter century; and (2) Be skeptical about models and economic projections that rely on data from the era of ever lower rates.

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