2016 Tom Madell, Ph.D.

Jan. 2016

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Most Stock Markets Forecasts Hover at Only 50% Right (At Best)

A little over two years ago (Sept. 2013), this Newsletter attempted to give investors something that might seem nearly impossible to accomplish with a reasonable degree of accuracy: a peek into the future.

Such forecasts, which are fairly common at the end of each year, don't seem to be deterred by the sheer difficulty of what they are attempting. Investors, and pundits of all sorts, are always trying to get an edge regardless of the fact that most investment forecasts eventually prove to be essentially worthless. In fact, I just searched google.com for the words most investment forecasts are worthless and came up with 383,000 hits!

Now don't get me wrong: I don't claim to be "all knowing all seeing." Any investment forecast coming from me will, in almost all instances, only turn out, at best, to be partially right and partially incorrect. But if my historic forecasting average is judged to be at least moderately better than 50% correct (with 50% right reflecting no real value since the "rights" are totally offset by the wrongs), then one should regard my forecasts to be considerably helpful. While it would be inappropriate for me to be the judge of my own work, the many readers who have stuck with me down through the years would probably weigh in favorably on that question.

So getting back to the Sept. 2013 Newsletter, I ventured at that time to present investors with my views as to which stock fund categories appeared most promising and those least promising looking forward.

Now that some time has passed, you may be interested in how things turned out.

(continued bottom page 6)

Contents:

-Most Stock Markets Forecasts Hover at Only 50% Right
  (At Best) (see left column)

-Most and Least Promising Stock Funds Categories
  (begins below)

-January 2016 Model Stock and Bond Portfolios
  (begins middle page 5)

Most and Least Promising Stock Funds Categories

By Tom Madell

I'll start with the good news. The overall market, including nearly all subcategories of funds, especially international funds, is no longer at what I previously felt was a dangerously high level.

One year of relatively flat, or even negative returns, have helped restore fund performance to more sustainable levels. (However, more traditional measures of stock valuation, such as forward-looking price to earning ratios remain elevated - over 17, vs. the long-term average of about 14 for the S&P 500, according to bloomberg.com).

I look at both stock valuations and on-going momentum as important yardsticks in judging the relative attractiveness of a particular stock fund and its overall category. While over- vs. under-valuation tend to arise as a result of long-term factors, momentum (relatively positive or negative) can be regarded as more short-term in nature. Given this, I place somewhat more importance on valuation issues than momentum in determining which stock fund categories look the most and least promising over the next several years at any given point.

Now for the not-so-good news. Unfortunately, most stock fund categories, while not appearing excessively overvalued, don't appear particularly undervalued either. Of course, any time stocks are undervalued, they can be assumed to have much better prospects than if they are overvalued, or even fairly valued. At the same time, virtually every category of stocks has lost the momentum they exhibited earlier in 2015.

(continued on page 2 below)

Page 2

Jan. 2016

(Most and Least Promising Stock Funds Categories, continued from page 1)

My most favored and least favored stock category selection procedures do not employ the use of economic variables, such as GDP, level of interest rates, etc. However, since stocks often become over- vs. under-valued or momentum-impacted based on investors' reactions to such variables, my procedures do, in a sense, indirectly reflect such variables.

Using my proprietary selection procedures has resulted in my specific fund selections outperforming an equivalently composed portfolio of benchmark index funds over the the most recently available 3 year period, 10.9 vs 9.6%, as well as the entire 5 year period, 11.1 vs 9.6%. (Data annualized thru Sept. 30, 2015; see here to review the data. Note: One, 3, and 5 year data that includes the just completed 4th quarter will be published during the 2nd week of Jan.)

Based on current valuation and momentum factors, the best that can be said is that the majority of fund categories are what we consider to be HOLDs. There are very few categories that exhibit the characteristics we consider as meriting a BUY designation, along with a few REDUCE/SELLs; for specifics, see the tables below.

All categories designated as HOLDs are expected to be worth holding over the next 3 to 5 years, generating decent returns if held over the entire period.

Here, then, are my current category recommendations for the nine most recognized U.S. fund categories starting with those with the most positive longer-term prospects near the top to those with least promising prospects near the bottom:

Fund Category Recommendation
Large Growth HOLD
Mid-Cap Growth HOLD
Large Blend HOLD
Small Growth HOLD
Large Value HOLD
Small Value REDUCE/SELL
Mid-Cap Value REDUCE/SELL
Mid-Cap Blend REDUCE/SELL
Small Blend REDUCE/SELL

Note that none of the above basic fund categories show up as having particularly strong prospects over the next several years according to my research. While not currently overvalued, each of these categories have run up considerably over nearly the last 7 years, limiting, in my view, their future prospects.

International Funds

The following table shows my current category recommendations for five international fund categories starting with those with the most positive longer-term prospects near the top down to those with least promising prospects:

Fund Category Recommendation
Emerging Markets HOLD
Japan HOLD
Europe HOLD
Diversified Pacific/Asia HOLD
Diversified International HOLD

My research shows that the first 4 out of the 5 international stock fund categories shown above show better prospects than any of the above U.S. fund categories. International stocks have had their problems in recent years, but looking ahead, I believe that prospects, including the economic fundamentals not directly considered in the above recommendations, will improve going forward.



Page 3

Jan. 2016

Sector Funds

While I am not a big advocate of sector funds, I present this data for those relatively aggressive investors who might be. Note that because sector funds can be highly volatile and relatively unpredictable, even when considered as longer-term investments, there is an above average risk that any sector forecasts, including mine, will not turn out as expected.

Additionally, while you may not choose to invest in sector funds at all, you may find that the non-sector funds you do invest in (or are considering) can have a sizeable proportion of their holdings within one or more sectors. To learn what the sector breakdown is, enter the fund symbol at morningstar.com and look for "Top Sectors." If the fund overweighs sectors that show up near the lower end in the table below, you may want to factor in this information when considering your ownership of this fund.

For example, PRIMECAP Odyssey Growth (POGRX), a fund highly recommended by Morningstar (see my Dec. Newsletter), has about 36% of its investments in the Health sector. Since this sector is one that my research does consider highly overvalued and a REDUCE/SELL sector, one might want to be cautious about owning this fund.

The following table shows my current recommendations for 14 sector fund categories starting with those with the most positive longer-term prospects at the top to those with least promising prospects near the bottom:

Fund Category Recommendation
Precious Metals BUY
Natural Resources BUY
Energy BUY
Commodities BUY
Technology HOLD
Communications HOLD
Consumer Defensive
(Consumer Staples)
HOLD
Consumer Cyclical
(Consumer Discretionary)
HOLD
Global Real Estate HOLD
Real Estate (US) HOLD
Financials HOLD
Health REDUCE/SELL
Industrials REDUCE/SELL
Utilities REDUCE/SELL

--------------------------------------------------------------------------------------------------------------------------

January 2016 Model Stock and Bond Portfolios

Stocks May Be a Slightly Better Bet in 2016

In spite of the perils of forecasting, I am raising the overall allocation to stocks, but just a tad. The main reason is merely because, although I don't anticipate much better returns for stocks in 2016, using a 3 to 5 year horizon (our target range), stocks present a more favorable outlook than for bonds, and certainly, than for cash.

The ongoing trend one-year trend for stocks, something I watch carefully, is now negative. While one year's returns likely don't show much of relationship to the following year's performance, the high returns observed between 2009 and 2014 have led to a highly priced market. As a result, future returns are more likely, in my opinion, to be somewhat subdued.

Here are my overall allocation recommendations, as subdivided into 3 rough categories based on one's self-estimated tolerance for risk.



Page 4

Jan. 2016

For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 52.5% (50%)
Bonds 35 (35)
Cash 12.5 (15)

For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 67.5% (65%)
Bonds 22.5 (22.5)
Cash 10 (12.5)

For Conservative Investors

Asset Current (Last Qtr.)
Stocks 20% (15%)
Bonds 50 (50)
Cash 30 (35)

January 2016 Model Stock Fund Portfolio

Value vs. Growth Categories

Okay, fans of Large Growth funds, you've been consistently beating Large Value funds when looking at annualized past five year returns every January going all the back to Jan. 2010. That's quite a string. This means if you overweighted the average Large Growth fund as early as Jan. 2005 and held that overweighted position throughout, your returns would have exceded the average Large Value fund by about 2% each year, and the average of all U.S. diversified categories of funds by about 1% a year. What gives, and can the streak continue?

Large Growth funds tend to contain heavy doses of Technology stocks as well as Consumer Cyclical stocks. Large Value funds are particularly attracted to Financial Services stocks, with more of a commitment toward Energy and Utility stocks.

Both Technology and Consumer Cyclical have done quite well over the last 10 years, Utilities, Energy, and especially Financials, have not. As you probably are aware, Energy stocks have done particularly poorly over the last two years, while Financials took a particularly severe beating during the 2007-08 financial crisis and have been much slower to recover strongly since then compared to stocks as a whole.

I have been overweighing Large Value over Large Growth for several years now which, up to now, hasn't paid off. While both categories have done well, the average Large Growth fund has beaten the average Large Value fund by about 4% annually over the last 3 years.

But, according to my proprietary research (see article in left column on page 1), while both categories should do adequately in the years ahead, Large Growth still comes out a little better on my list of most recommended US stock categories.

The biggest question mark for value funds appears to be whether financial stocks, often their biggest component, can bounce off a relatively underperforming 2015, not to mention whether energy and utility stocks held in lesser amounts, can get back to anywhere near positive returns. In light of the continuing somewhat iffy prospects for Large Value funds, I am dropping my recommended allocation to 17.5% from 20%. Instead, I recommend putting the freed-up money into Fidelity Contra Fund (FCNTX).

I am also dropping my allocation to Vanguard Financials since our Large Value holdings already cover this sector.

Page 5

Jan. 2016

International Stock Funds

Given the stronger prospects for most international funds as described in the companion article (page 1) as compared to U.S. stocks, I suggest a bumped up allocation to the former.

U.S. stock funds, on average, have performed considerably better than international ones going back as far as 10 years. So, it might appear that I am running the risk of acting "prematurely" by going to an even higher international recommendation than before.

This is always the chance one takes when one starts to favor underperforming categories under the assumption that they are "due" to turn things around. But my research suggests that more frequently than not, it is usually more important to recognize potential undervaluation in a category than to always wait for strong positive momentum trends before investing. Thus, while emerging market stocks currently have strong negative momentum, my research suggests that they offer among the best prospects for longer-term investors (along with some badly beaten up sector funds), but both mainly for Aggressive investors.

It is interesting to note that stock markets in the Eurozone had a much better year than US stock markets with a main index of European stocks up about 8%. However, for US investors, the increase in the value of the dollar vs. the Euro resulted in much of those gains being wiped away, unless you were invested in a European fund that hedges its currency exposure, such as the HEDJ ETF mentioned below.

Our Specific Fund and Allocation
Recommendations Now (vs Last Qtr.)

Fund
Category

 Recommended Category
Weighting
Now (vs Last Qtr.)
-Fidelity Low Priced Stock (FLPSX)  10% (12.5%)

   Mid-Cap/
   Small Cap


    10% (12.5%)


-Fidelity Overseas (FOSFX) 5 (0) (A) (New!)
-Vanguard Europe Index (VEURX) 5 (10) (M)
-Vanguard Pacific Index (VPACX) 10 (10) (A)
-Tweedy Brown Global Val (TBGVX) 5 (5) (C & M)
-Vang. Emerging Markets Idx (VEIEX) 10 (7.5) (A)
-DFA Internat Small Cap Val I (DISVX) 5 (2.5) (A)
   (See Notes 1, 2 and 3.)

 International 


    40 (35)


-Fidelity Large Cap Stock (FLCSX) 7.5 (7.5)
-Vanguard 500 Index (VFINX) 7.5 (7.5)

  Large Blend 


    15 (15)


-Vanguard Growth  Index (VIGRX) 7.5 (7.5)
-Fidelity Contra (FCNTX) 7.5 (5)
 Large Growth
    15 (12.5)


-T Rowe Price Value (TRVLX) 5 (7.5) (M)
-Vanguard Equity Inc (VEIPX) 7.5 (0) (M) (New!)
-Vanguard US Value (VUVLX) 5 (5) (A)

    Large
    Value


    17.5 (20)

-Vanguard Energy (VGENX) 2.5 (2.5) (A)

    Sector


    2.5 (5)

Notes:
  1. Any stock or bond funds shown with (C), (M), or (A) are most suited for Conservative, Moderate, or Aggressive investors, respectively.
  2. ETFs (exchange traded funds) of the same category can be substituted for any of the above Vanguard index funds; e.g. Vanguard FTSE Europe ETF (VGK) can be substituted for VEURX.
  3. Although not included in the Model Portfolio, you may want to consider two other (or additional) international ETFs: WisdomTree Europe Hedged Equity ETF (HEDJ) and WisdomTree Japan Hedged Equity ETF (DXJ). These ETFs, unlike the Vanguard Europe and Pacific funds, tend to do better when the US dollar is strong, as it has been since roughly mid-2011.
Page 6

Jan. 2016

January 2016 Model Bond Fund Portfolio

Comments on Our Updated Bond Recommendations

Our bond fund recommendations remain highly similar to last quarter's recommendations.

We are increasing our allocation to the Vanguard Intermediate-Term Tax-Exempt Fund as muni bonds seem to be one of the best options for both safe and decent after-tax yields. Since gradually rising interest rates could potentially hurt bond fund prices, we are sticking with short and intermediate term maturity funds. (Long-term bond funds have generally done a little worse in 2015 than short and intermediate term funds.)

We are dropping Metropolitan West Total Return Bond Fund because its performance has not exceeded that of the major bond benchmark, the Barclays US Aggregate Bond Index (AGG).

Our Specific Fund
and Allocation
Recommendations
Now (vs Last Qtr.)

Fund
Category

 Recommended Category
Weighting
Now (vs Last Qtr.)

-PIMCO Total Return Instit (PTTRX) 25% (25%)
-Harbor Bond Fund (HABDX) 0 (0) (See Note 1.)
-PIMCO Total Return ETF (BOND) 5 (5)

   Diversified


    30% (35%)


-DoubleLine Tot Ret Bond I (DBLTX) 7.5 (7.5), or
  DoubleLine Tot Ret Bond N (DLTNX)
   (See Note 2.)

   Interm.
    Term   


    7.5 (7.5)


-Vang. Intermed.-Tm Tax-Ex (VWITX) 17.5 (15)

  Interm. Term
     Muni


    17.5 (15)


-Vanguard Sh. Term Inv. Grade (VFSTX) 10 (7.5)
  Short-Term
   Corp.

    10 (7.5)


-Vanguard High Yield (VWEHX) 10 (10)

   High Yield


    10 (10)

-PIMCO For. Bd (USD-Hdged) Adm (PFRAX) 25 (25)

   International


    25 (25)

Notes:

  1. When possible, select PTTRX; HABDX is only recommended if you cannot met PTTRX's minimum.
  2. The two funds are the same but have different minimums; select DBLTX if possible because of lower expense ratio.

---------------------------------------------------------------------------------------------------------------------

(Most Stock Markets Forecasts Hover at Only 50% Right (At Best), continued from page 1)

Let me summarize what that Sept. 2013 article said regarding Sept. 2013 forward-looking prospects:

1. Almost all categories of stock funds should be considered HOLDs; but a few categories are named BUYs or borderline BUYs.

2. Since we are soon approaching overvaluation of almost all stock fund categories, the above recommendations should be considered valid for the short-term only. (Note: this Newsletter generally considers "short term" as one year or less.)

3. Once overvaluation of a fund category is reached, likely as soon as Oct. 2013, my research suggests that returns over the next half decade or so may be underwhelming although sub-par returns may not start immediately, but more likely, within the next year or so.

Page 7

Jan. 2016

4. Investors who wish to avoid potential underperformance of stock categories, or who wish to potentially find "safer" investments, might consider re-allocating away from the most overvalued categories and into less potentially dangerous categories; however, investors who intend to hold their current fund choices for the next five years or longer should consider staying put.

Just as there are hardly ever any totally right vs. totally wrong investment moves, especially in implementing what are often multi-faceted investment strategies, as I state above no one should realistically expect there to be 100% accurate investment calls made in advance of such moves, mine included.

So how did things turn out? Here is a quick summary of what the following 2+ years brought, keeping in mind that the holding period for the investments I typically recommend is 3 years and even beyond:

1. Over the last 2+ years, US stocks, overall, have generally shown small to moderate gains; thus, anyone who held most US stock funds probably did better than anyone holding the typical bond fund or certainly holding cash. Foreign stock funds, especially emerging market funds, have performed negatively over the period, with the exception of those investing in Japan.

2. The gains over the 2+ year period were mainly the result of the performance of stocks over the following year (between Oct. 2013 and the end of Sept. 2014); for example, the average US diversified stock fund returned approximately 12% over the period while the S&P 500 returned close to 20%. However, between Oct. 2014 and the start of Oct. 2015, these results were about -1.5% and -0.6% respectively.

3. Thus, overvaluation, over the 2+ year period, while apparent as early as Oct. 2013 as described in our Alert to investors in mid-Oct 2013, did not have a negative impact of stock prices during the next year. However, it did have an apparent negative effect starting the second year.

4. Since the end of Sept. 2015, most fund categories have bounced back, although not enough to salvage what has been essentially a subpar year.

If you review the Sept. 2013 article, you will see that under the adverse valuation picture we described over two years ago, some of the fund categories we expected to do relatively best such as

-Europe
-Large Value
-and especially, Energy

have yet to be relatively good places for US investors to been invested over the period.

It is interesting to note, though, that stock markets in Europe have actually done well since we made our recommendation. However, for US investors, the increase in the value of the dollar vs. the Euro resulted in much of those gains being wiped away.

And, two of the fund categories I expected to do relatively worst, namely

-mid-cap
-real estate

didn't underperform the pack as I expected. However, small-cap stocks did underperform.

However, the main thrust of our forecasting appears to have been mostly accurate, as described above, namely,

-below par, and even some negative returns, starting as late as one year after becoming overvalued
-decent returns for Japan and within the financial sector
-outperformance, thus far, for long-term stock fund investors over bonds and/or cash, in spite of the
 overvaluation.

I still believe, with several exceptions, that as more time passes, many of the above predicted trends will play out more in line with the expectations expressed my in my Oct. 2013 Alert, referenced above.

This brings me to a more detailed look at which stock fund categories look the most and least promising right now, along with my specific new Stock and Bond Model Portfolios, which are all discussed beginning in the right hand column on page 1.

I wish everyone a Happy New Year and hope that it is a better year than 2015 when it comes to investing.

Tom Madell, Publisher

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