New Model Portfolios Beginning July, 2017

By Tom Madell

The recommendations contained in these latest Portfolios are based on my up-to-date analysis of stock and bond fund prospects. Note, however, when subsequently calculating returns on how these Portfolios have performed, I will use a July 1, 2017 starting date.

Overall Allocations to Stocks, Bonds, and Cash

As of early June, the overall U.S. stock market remains perched at a level I define as clearly overvalued. While there is no absolute warning flag that "waves" overvaluation (and even if there were, stocks can stay overvalued for months or even years), this does not appear to be a time for shrewd investors to add significantly to their stock positions.

The increases to overall stock allocations that you will see below mainly reflect the growth that has likely occurred in investors' portfolios since the publication of our April 2017 Portfolio, which likely has been about 3%. For example, Vanguard Total Stock Mkt Idx (VTSMX) has gone from a 3/31/17 price of 59.04 to 60.96 as of June 8th. And many International stock funds have gone up by about double that amount.

Of course, one might, as always, wonder why my stock allocations for Moderate Risk Investors aren't even higher. After all, it should be quite apparent that stocks are almost always highly likely to beat bonds or cash when held for the long run. Therefore, if you are relatively young enough (say under 65 or so), and totally sure you will not buckle under and shift your investments away from stocks if a bear market hits causing you to possibly sell inordinately at much reduced prices, then and only then should such investors think about going far higher than I recommend into stocks.

Yes, stocks have almost always been far better places to be than bonds or cash. But most investors likely won't achieve such top notch rewards because, when the time comes, the fear of losing too much will outweigh the ideal of getting the absolute best returns. Of course, the older you are, the less time you will likely have to recover from bear market losses, unlike the situation when you are younger.

As I have asked myself many times, why will many investors continue to be seduced by the allure of great returns, such as we have seen for quite a while now, into throwing more and more money into stocks? Instead, I believe that such investors should remember the now trite, but still true, mantra of some of the world's greatest investors: "Buy low, sell high."

If one is buying now, other than perhaps just continuing a constant allocation flow into a 401(k), it is unlikely you are buying low. Such out of the ordinary additional purchases might be considered more a "momentum" play by an investor who figures to hitch a ride on a shooting star. Such an approach, to work successfully, might be more appropriate for "traders," and might necessitate a finger constantly perched on the sell button as soon as momentum swings the other way.

Thus, while many of us might not want to sell much, if anything, whenever stock prices get this high such as now, it could certainly make more sense to sell a little than to buy much now. On the other hand, having a somewhat substantial position in either bonds or cash, provides the opportunity for moving some of these assets into stocks at the point when stock prices do come down and are potentially more attractive; hence the opportunity to "buy low."

Model Stock Portfolio

I am introducing several changes to both the Stock and Bond Portfolios. In each case, I will discuss the reasoning behind these changes. The five most highly recommended stock and bond funds are shown in bold type; this makes it easier to pick funds when, as in most cases, you can't invest in all my recommendations.

Funds that have been removed are shown with text that appears as striken through; an explanation is given in the discussion below the table.

Notes:

1. A stock or bond fund shown with (C), (M), or (A) indicates it has characteristics that may make it most suited for Conservative, Moderate, or Aggressive investors, respectively.
2. Vanguard ETFs (exchange traded funds) are often practically identical to similarly named Vanguard "Investor" index funds with even lower expense ratios and without the higher minimums required for the "Admiral" funds. Therefore, these ETFs can be substituted for any Vanguard stock or bond index fund shown in tables. E.g. Vanguard FTSE Pacific ETF (VPL) can be substituted for VPACX; Admiral funds can also be substituted when available, e.g. VPADX.

Discussion of Stock Fund Recommendations

Small and mid-cap stocks are, like most US stocks, near "nosebleed" territory. However, since this is true of most domestic categories, you still need to put your stock investments somewhere. Our 8% position in Vanguard Small Cap Value Index is the highest allocation we recommend to a single domestic fund right now (but not to a broad fund category). It should be noted that the Small Cap Value category has gotten off to a very poor start so far this year, but is slightly less near overvaluation than most other domestic categories.

International funds, on the other hand as already noted, are far outstripping US funds, with our most highly recommended fund for Moderate Risk Investors, Vanguard International Growth (VWIGX), a managed fund, vastly outperforming an index benchmark, such as the Vanguard Developed Markets Index (VDMIX), 25.9 vs. 14.8%, and even more so a domestic benchmark, Vanguard Total Stock Mkt Idx Inv (VTSMX) which is returning 9.2% (data thru 6-8). VWIGX should now be considered an Aggressive fund because it currently has a 22% position in emerging markets and its overweight positions in several aggressive sectors such as technology and consumer cyclical stocks.

In light of the fact that international funds have considerably more reasonable valuations than domestic funds, especially for Emerging Market funds (which we still rate as a "Buy"), we are raising our allocation to the international category as a whole to 45% of your stock portfolio. We are also replacing DFA Internat Small Cap Val I (DISVX), still a good fund but a little overvalued, with Vanguard Europe Index (VEURX).

I have made some big changes to the recommendations for the Large Blend funds. Two of our prior recommendations have been removed: 1) Vang. Dividend Growth (VDIGX), while still a good fund, is closed to new investors, a condition we prefer not to feature in our Portfolios since why recommend something that isn't currently available. 2) When we first recommended AMG Yacktman Fund Service Class (YACKX), it had a reasonable minimum investment allowing most investors access to it. Now the minimum investment is sky high, preventing perhaps 99% of ordinary investors from starting a position.

In their place, I have substituted: 1) T. Rowe Price Dividend Growth (PRDGX) which is pretty much on a par with VDIGX and with an excellent long-term manager. 2) Oakmark Investor (OAKMX). Another great long-term manager (co-manager, actually), although this fund is riskier than YACKX so investors might want to wait for a pullback before opening up this fund.

We continue our somewhat overall relatively low commitment to the Large Growth category. While we wish we had had a larger commitment over the last several years, the category continues to be the most overvalued of the major categories. Additionally, our recommended inclusion of the Vanguard 500 Index Fund, also has a sizeable position in large cap growth stocks. In fact, the correlation between VFINX and VIGRX over the last few years at .98 shows that their ups and downs are nearly identical since the maximum correlation would be 1.00 Same is true between VFINX and FCNTX although the overall returns for FCNTX have proven a little better than the either VFINX or VIGRX.

In considering the Large Value category, we have been gradually reducing our allocation since the beginning of this year. While the category put in an impressive performance in 2016, especially after the election of Donald Trump, it has faded considerably as compared to Large Growth so far this year. In order to understand a possible reason why, readers should refer back to the Jan. 2017 Newsletter.

At the start of the Trump presidency, investors appeared confident that growth and inflation would accelerate as a result of his campaign promises, including rebuilding the infrastructure. But as the Jan. Newsletter points out, contrary to what one might expect, higher growth and inflation actually favor Value funds more than Growth funds. Two of the biggest components of many Value funds are typically financial stocks as well as so-called industrials. Thus far this year, both of these sectors are lagging in performance. This may be a reflection that investors are no longer so sure that the Trump administration will be able to deliver on these promises, or at least, not as quickly as originally expected.

While none of our three Large Value funds are off to a particularly good start this year, we expect Large Value will eventually make a decent comeback, with Vanguard Equity Income our favorite.

As far as Energy stocks are concerned, we are a little less optimistic than before in a recovery in oil prices, along with their stock performance. However, oil prices have recovered significantly since their Feb. 2016 lows below $27 a barrel and are now about $46, a significant increase. Our recommended fund, Vanguard Energy (VGENX), a managed fund, is in the top 10% of comparable funds according to Morningstar.com, and doing considerably better than the alternative Vanguard Energy ETF (VDE).

Model Bond Portfolio

Notes:

1. When possible, select PTTRX, although the minimum initial investment is quite high; HABDX is nearly identical if you want a lower minimum.
2. The two funds are the same but have different minimums; select DBLTX if possible because of lower expense ratio.
3. Muni bonds are only suitable for taxable accounts. Invest in a fund with bonds specific to your own state, if available, for the greatest tax savings.
4. When possible, select PRRIX, although the minimum initial investment is quite high; HARRX is nearly identical if you want a lower minimum.

Discussion of Bond Fund Recommendations

The changes to our Model Bond Portfolio from April 2017's Portfolio are relatively modest although we have introduced three additional funds.

We have always liked the PIMCO Total Return Instit Fund because of the depth of the PIMCO bond team. The fund has undergone some difficult times since the departure of its well-known founding manager, Bill Gross, leading to a huge loss of assets under management. But now close to 3 years later, the fund appears to have regained its footing and is performing excellently again. Additionally, its ETF counterpart, PIMCO Active Bond Exchange-Traded Fund (BOND), as well as its lower minimum initial investment near-look-alike fund, Harbor Bond Fund (HABDX), each with the same trio of managers, are also doing well.

Given the ability of my first three recommended funds to go practically anywhere, likely important in today's somewhat unappealing bond market, I am significantly raising our allocation here. I call the category for these funds "Diversified" because these included funds tend to invest across the spectrum of the bond market.

I have moved Dodge & Cox Income (DODIX) into the Intermediate Term maturity category; previously I assigned it to the "Diversified" category. I have also raised this fund's allocation based on its strong management team and long-term ability to outperform our benchmark, the Bloomberg Barclays US Aggregate Bond index.

Municipal bonds continue to present somewhat of an enigma at this juncture. I can see two reasons why: 1) Munis are a type of government- related bond, only at the state level. Comparable US treasury bonds are not expected to do particularly well in light of generally expected rising interest rates, so the same may be said to apply to munis. 2) While munis offer tax-exemption, the value of that tax exemption will likely drop if individual tax rates get lowered as a result of possible tax reform legislation. So, for these two reasons, I am lowering our allocation to the category, although it still remains one of our highest allocation bond categories within a taxable account.

Surprisingly, thought, munis have started out the year quite well, doing significantly better than the above mentioned bond benchmark, along with the tax-exemption to boot. Apparently, relatively well-to-do investors continue to like one of few places they can get a tax break. But longer term, we expect the category may yield only mediocre results. We'll have to wait and see.

I have not made much change to either our Short-Term Corporate bond fund or Intermediate-Term Govt. recommendations, in each case lowering the allocation a little. Once again, returns are expected to be on the paltry side with rather small dividends offered to investors.

As time passes this year and next, we expect inflation measures to gradually drift upwards in spite of some investors now taking a contrary view suggesting that inflation is going to be stuck at 2% or even below. Given our forecast, we are raising our allocation to the Inflation Protected category since these funds should do better than those without the protection. We have also added a fund we have recommended before, namely the PIMCO Real Return Instl (PRRIX), or its lower minimum look-alike fund, Harbor Real Return Instl (HARRX); both of these funds currently have had a somewhat better return experience than our other recommended fund, Vanguard Inflation-Protected Secs (VIPSX), the latter which appears to currently have more vulnerability as interest rates rise than the former two.

Our final two Model Bond Portfolio funds continue to be among our strongest single fund recommendations.

Vanguard High Yield Corporate Fund has both a high dividend plus a relatively low sensitivity to rising interest rates, a combination that is hard to find elsewhere. Of course, high yield bonds may be approaching overvaluation as they are positively correlated with stocks. But it is hard to see that a big slowdown in the economy, a major pitfall for these bonds, is anywhere near on the horizon, at least in the next year or so.

International Bonds continue to be on a somewhat different playing field than US bonds. Why? Because rising interest rates, an anathema to most bond funds (except maybe High Yield), are not as likely to happen overseas throughout 2017 and somewhat beyond, as they are in the US. While returns for our favorite such bond fund, PIMCO Foreign Bond (USD-Hedged) Adm (PFRAX), are unlikely to be as high as they have been for the last few years, there still appears to be a good chance they can do better than similar maturity US bonds. (It should be noted that while the morningstar.com website says that the minimum investment to open this fund is $1 million, it can be purchased through the Vanguard brokerage, and perhaps some others, for as little as $5,000.)

Finally, also in the International Bond category, we have added a small position in Vanguard Emerging Mkt Bond Fund (VGOVX). Since emerging market stocks have been doing well lately, and there is a moderate correlation between such performance and the performance of emerging market bonds, we think that the latter category has a good chance of being one of the better (or even best) performing categories. (There has been no such positive correlation between US stocks and US bonds lately, in fact, the correlation has actually been somewhat negative.) But given the overall riskiness of emerging market bonds, we are starting out by only recommending a relatively small allocation.

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The next Newsletter is now scheduled to be published around Aug 1st. Any possible changes to this date will be announced on my main web page.

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