2013 Tom Madell, Ph.D.




June 2013

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Comments From the Publisher on the State of the Markets

It is not too often that investors are faced with what might appear to be a "good" dilemma. What is a good dilemma? Many times in investing, as in all areas of life, the choices we face are between several unpleasant alternatives. Today, however, we might seem to have the option of picking between at least two potentially favorable outcomes.

The problem at hand, along with the backdrop, is this: If you have had at least some money invested in the stock market for a while now, should you

  1. stay the course under the positive scenario that stocks will continue rising in price if not now, gradually as the future unfolds; or
  2. feel content, assuming you likely have done quite well, and therefore consider taking at least some your profits by cashing in before things possibly aren't so favorable?

In either case, unless you tend to dwell on the small imperfections in life, you should be a lot happier than if the choices were either to hold on during a falling market when you have already lost money, or, deciding to sell at a loss.

Of course, there is a third option, c), as well. You might complicate the dilemma by considering whether to, in light of the strong positive direction observed in the market thus far, add to your stock
position(s). In this case, while the intended favorable outcome has not yet arrived, you may feel good enough about future prospects to consider this option along with a) and b).

continued on page 4

When Will It Be Time to Pull Back From These Markets?

By Tom Madell

Maintaining a high exposure to the stock market has been a winning strategy pretty much since March 2009 when the market reached its low following the financial crisis. But how much longer is it wise for the average investor to assume allocations at high levels will continue to pay off?

Of course, a parallel question relates to the bond market. In this regard, a high allocation to bonds when considered on a 5 year or even longer-term basis, has proven to be a lower risk, and in some cases, a better performing strategy than investing in many categories of stock funds. And compared to merely investing in CDs or money market funds, bond funds would have proven an elixir, even for conservative investors. But is it now too late to expect further gains, and should bond fund investors instead seriously consider reducing their exposure?

This article will attempt to answer these questions, always bearing in mind that people (even experts) who try to divine these answers are often on the wrong track to begin with. Why? Because how the markets will perform, especially based on short-term considerations, are typically irrelevant for long-term investors and often take your eye off the bigger question: Will you be better off in a year or two (or even more so in 5 or more years) if you simply stick with a strategy of keeping most of your money invested in a diversified portfolio, typically consisting of mainly stocks, a modicum of bonds, and very little cash, than when you are prone to make wholesale moves altering this formula too much.

Stocks

According to a recent article on bloomberg.com (see here), during the last 50+ months post the March 9, 2009 low, stocks have gained about the same amount as during the huge tech bubble that ran from early 1996 to March '00, that is, in excess of 25% annualized. Of course, that streak ended badly when the bubble subsequently popped. While the article goes on to state that the same may not happen this time since the current market doesn't appear to be overvalued as the prior period proved to be, the outsized gains should be viewed in historical perspective to see just how far we have come.

continued below

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June 2013

(When Will It Be Time to Pull Back From These Markets?, continued from page 1)

Subsequent to its closing low, the return including dividends on the S&P 500 index over the period has been a staggering 165%. (Data cited in this article is through May 25th.) It turns out that such a gain without the onset of a 20% drop signifying a bear market is among the biggest since 1929, surpassed only by the long-term performance of the late '87 to 2000 market, as well as two periods in the 40's and 50's, and the 5 years that preceded the '87 crash. (see here for additional data; note that this link's data are from several months ago and show returns without adding in dividends).

For those who have been readers of my Newsletter going back as far as the beginning of 2009 and who followed my quarterly recommended percentage allocations to stocks ever since, they would have profited extremely well from having done so. While in Jan. '09, prior to the start of the current bull market, my suggested allocation to stocks was only 37.5% for Moderate Risk investors (and 50% for Aggressive investors), by Apr. '09 we had already raised these percentages to 45 and 65%, respectively. Since then, I have continuously raised allocations to stocks or at least held them steady, leading to our current 67.5 (and 85% allocations) for these groups, percentages that we reached back in April, 2012. Since that date about 14 months ago, the total return of the S&P 500 index has been approximately 18%.

There was one exception to our upward march in stock allocations. From July '11 through year end 2011, I dropped the stock allocation from 65 to 60% (Moderate Risk) and from 85% to 75% (Aggressive Risk). At the time, I enumerated some concerns about the stock market but did not urge readers to sell anything but rather pointed out several real buying opportunities. During the period, the index did actually decline approximately 19% before making a partial comeback by the end of 2011. I also suggested I would be using any 5-10% correction(s) as an opportunity to bolster stock holdings by a few percent.

While our new Model Portfolios and allocations will not appear until next month, the question that should currently be on many investors minds is: Given the huge gains described above, is it now the time to suggest that investors should seriously consider cutting back stock allocations that we have continued to recommend at these high levels, including the current 45% allocation we have suggested even for conservative investors?

Our research suggests, in agreement with the Bloomberg article above, that most categories of stock funds are not currently near being overvalued, at least not yet. Further, the strong momentum apparently caused by investors now adding to their stock positions tends to create a virtuous cycle. But at a certain point, stocks will start to become overvalued and it may be crucial for investors to recognize when this overvaluation stage is reached.

According to our empirical data, that point might arrive some time this fall, whether stocks continue rising at their current pace or even if they remain near their late-May levels until then. While we will not make a specific prediction that stocks are likely to fall at that time since stocks can stay overvalued for an indefinite amount of time, we will continue to monitor the situation and alert readers if and when any SELL signals are issued.

Of course, our SELL signals, just like our prior BUY signals (which have been plentiful stretching back to Feb. 2009), are geared for long-term investors. They can't pinpoint exactly when an impending drop will occur, but indicate an expectation, based on my proprietary long-term research, that stocks are unlikely to do particularly well in the forthcoming years ahead. (Note: You may want to review the tables shown in our Aug 2008 Newsletter to get a better idea of what one might expect in terms of returns for stocks if our prior research continues to be as useful as it has already proven to be and can be further generalized to how things may unfold going forward.) In the meantime, we continue to feel that remaining constant with a stock portfolio allocated similarly to our most recent suggestions made in April is the best course of action.

Bonds

Here's a fact that might qualify for Ripley's Believe It or Not: The Barclays U.S. Aggregate Bond Index, consisting of a broad mix of bonds, and which serves as the benchmark for many fund companies bond index funds such as Vanguard Total Bond Market Fund and the iShares Barclays Aggregate Bond Fund, has had only two years in which the annual total returns were negative going back to 1976! Those were in 1994 and 1999. That amounts to just 2 years out of the 37 year period (see here for additional information). Over that period, the index has had an average annual return of over 7.5%. No wonder investors have come to assume that investing in many types of bond funds and bond ETFs are close to a guarantee of success.



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June 2013


But during this year's first quarter, the Index actually declined by a small amount. And over the last 12 mos., the 2.0% total return has been much lower than the 7.5% historical average. While the 2.0% figure is still better than returns for those who remained in money markets or CDs, the question looking ahead is whether returns might wind up negative over the course of the full year, or even over longer periods. This would most likely occur if and when interest rates start rising, either because investors start switching out of their bonds to join the stock bandwagon, or the Fed starts sending clearer indications it is about to halt bond purchases (or is closer to the point of actually beginning to raise interest rates).

A Simple Test of Your Bond Fund's Prospects

Down through the years, I have come to put a lot of faith in a simple test of whether bonds look like a good investment ahead because it seems to work more often than not. Here it is: Look at how your bond fund has performed over the last one year on a website such as morningstar.com. Then look at how it did over the last 3 and 5 years to see if there is a trend over these three figures in one direction or another. A 2 to 4% (or bigger) negative change in the most recent year can be regarded as likely important and suggests the fund may be running out of gas and that you may want to lighten up on it or exit it altogether.

For example, the Vanguard Total Bond Market Fund (VBMFX) 1, 3, and 5 year past performance results currently show the following total return numbers: 2.0, 4.5, and 5.3%. The trend is clearly for smaller and smaller returns, with the 1 year return substantially below that of the much longer 5 year return, which incidentally incorporates the 1 year return within its calculation. This indicates that over a now fairly well-established period of time, investors are getting less and less. In such cases, the odds would appear to favor a continuation of these low returns and also suggest that returns could even be less than 2.0 over the next 12 months if the downward trend continues. Of course, if some now unseen event happens that causes interest rates to drop precipitously such as a major U.S. or even world calamity, or we enter what appears to be a serious period of deflation, investors might rush back to the safety of bonds, perhaps causing returns to rise more than expected.

Contrast these results with the same data for one of our Model Bond Portfolio funds, Loomis Sayles Bond Retail (LSBRX), namely 15.0, 10.8, and 8.1%. Not only are the absolute levels higher than for VBMFX, but the current 1 year performance is doing better than its own longer-term results. The fact that the fund is showing an improving trend suggests that the investment is enjoying a relative "sweet spot." The odds would seem to favor a continuation of good performance under such conditions. Of course, at some point, this fund may appear to be on the verge of being overvalued, but I would guess not just yet in light of the fact that its 5 year performance is not even as great as is the case of long-term treasury bonds, in spite of LSBRX being a considerably riskier type of investment than treasuries.

This Simple Test Can Also Be Used With Stock Funds/ETFs

Applying the above method may also be used to judge a stock fund's prospects. For example, to estimate the prospects for a S&P 500 index itself, or a fund or ETF that mirrors it, look at the current 1, 3, and 5 year returns. These are 27.8, 17.9, and 6.0% respectively.

In spite of the big recent run-up, the numbers would appear to reflect a favorable trend that could continue, assuming that the 5 year figure still suggests that the index is not overheated when considered on a longer-term basis. In using this test with stock ETFs/funds, an approximate positive 15% (or more) discrepancy between the 1 and 5 year return, as seen here, can be used to argue for highly favorable prospects, while an equal sized (or more) negative discrepancy argues for highly unfavorable prospects. If, however, at some point any fund's/ETF's long-term performance equals or exceeds an annualized 15% or more a year over a 5 year period, it has highly likely become overvalued; chances are that within the next 12 months, it will begin to fall off its perch.

This is exactly what happened by the start of Oct., 2007; overvaluation of almost all categories of stock funds was followed by one of the worst bear markets since the Great Depression. But, to recap, we are not yet in such an over-extended position at present. However, alert investors should keep an eye out for this 15% per year for 5 years demarcation line which my research shows is when the market, a fund category, or any particular fund/ETF showing those performance numbers, enters a truly dangerous stage.






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June 2013

(Comments From the Publisher on the State of the Markets, continued from page 1)

While there is no one obvious way to resolve what should be a positive dilemma (especially if you are willing to leave the uncertainties of choice c) aside), we should stop before doing anything and be reassured: No matter what we decide, either a) or b) are essentially wins. If we can think about the choice in this way, we can savor what we have accomplished, at least for now; things in life do not always go this well.

Our main article, starting to the right on page 1, will hopefully give you some new ideas on resolving this dilemma, excluding option c). (Of course, option c may be particularly apropos for investors who are starting from a very low, or even zero base, of stock ownership.) And, while perhaps not quite so recognizable, nearly the same dilemma and options now certainly apply to the bond market too.

Everyone may not agree with the ideas that I will express as they may be so different from mainstream thinking to raise some doubts. However, the ideas presented, which are based on many years of my own research as to how the markets seem to typically behave (which really means how the majority of individual investors behave), have helped me personally far more than most of the ideas I come across in my continual search for the best ways to recommend how to come out ahead in one's investing, thus far at least.

Tom Madell

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