Mutual Fund Research Newsletter
Copyright 2011 Tom Madell, PhD, Publisher
Nov. 2011


-Stocks vs. the Alternatives: The Fund Investor's Asset Allocation Dilemma

Our Recent Bullish Take on the Stock Market Proves Rewarding

-Has the King of Bond Funds Lost Its Way?

-1, 3, and 5 Year Performances for Our Model Stock Portfolios

-Political Wildcards Add Uncertainty to Market Prediction. By Steve Shefler
   (on separate page - to view, click here)


Stocks vs. the Alternatives: The Fund Investor's Asset Allocation Dilemma

One of the most important questions mutual fund investors face is how much of their total investable assets should they now be allocating to stocks vs. how much to bonds, cash, or any other alternatives. This article will try to shed some light on this question without, however, providing a definitive answer since only investors themselves can decide on their own appropriate asset allocation based on how they view the prospects for each of these asset categories as well as what they see as the purpose of their investments.

A Shift in Investors' Stock vs. Bond Allocations

The US stock market continues to befuddle anyone desiring to get a clear sense of where the overall market might be heading. It has see-sawed back and forth of late while having shown only minimal gains over the past 5 years. All the while, a pervasive sense of gloom has eroded stock fund investors' confidence that the foreseeable future will be turn out any rosier. Bond fund investors, on the other hand, have tended to see a fairly constant positive performance in recent years, although not overwhelmingly so.

Most investors have generally assumed that over the long term, stocks will nearly always perform better than bonds. Thus, they typically overweight them as compared to bonds in their portfolios. (Of course, some investors are exclusively interested in the "guarantees" of income they receive from bonds; therefore, many of these investors would not likely invest much or anything in stocks regardless of stock's very long-term history of superior past performance.)

It has not gone unnoticed by investors that during the last decade (2000-2010), bonds have generally showed better overall performance than stocks. But many investors have stuck to the assumption that stocks would prove to be better investments. So, given stocks recent underperformance vs. bonds, especially over the last 5 years, such die-hardedness has proven to be to these investors' detriment. (Over the past 5 years, the average stock fund has returned about 0% for those who maintained their positions, that is, buy and hold investors. Over the same 5 years, the main index for bonds, Barclays Aggregate Index (symbol: AGG), rose steadily from about 100 to over 109 while all along providing dividends. And the typical taxable intermediate-term bond fund is about 5.5% higher per year, or about a 27.5% cumulative return.)

Given such results, it should therefore come as no surprise that many investors have begun to tilt more in favor bonds, as measured by fund flows in and out of bonds vs. stocks. These investors, having seen their prior expectations shaken to the core, have gradually begun to shift their asset allocations toward a greater weighting to bonds, cash, and alternative investments and less to stocks. This process appears to have gained momentum especially over the last several years. It therefore makes sense to try to assess whether or not such a move is likely to yield better investment results than most of these investors have been receiving under their prior more stock-heavy strategy.

Will the "Real" Stock Market Please Stand Up

In spite of the poor overall returns, the past 5 years however have not been consistently bad for stock fund investors. There have been two distinct, and roughly equal in length, sub-periods of highly contrasting performance. From late 2006 to early 2009, stocks in general fell considerably, with the S&P 500 Index dropping from a high of 1382 to a low of 673. In contrast, from March 2009 thru the end of Oct. 2011, the S&P 500 rose from that same low to the current level of around 1285 (thru 10-28).

As a result of numerous disappointments over the last 10 to 11 years (two severe bear markets, periods of extremely high volatility, and now long-lasting poor economic data, to name a just few) along with the poor 5 year performance cited above, investors have become seemingly justifiably lacking in confidence in future returns for the market. Thus, in recent months, investors have been less bullish than usual on the stock market's prospects and more bearish. On the other hand, the relatively smooth and positive returns in the bond market have allured a greater number of investors into thinking that that is where they should be now be targeting more and more of their investments.

But, as we've pointed out, stocks have shown two faces over the last 5 years. In fact, since the March 9, 2009 bear market low, the S&P 500 Index is up a whopping 91%, not including dividends of about 2% per year. Thus, in spite of two near bear market corrections, one during the last 6 months and one in mid-2010, the stock market has been a highly profitable place for your money over that nearly 32 month period.

You might ask yourself which of the two stock market snapshots is the one to "believe in" when thinking about how much faith you have in the market going forward: the current 2 1/2 yr. one which has been highly profitable, or the overall 5 yr. one that has not? After all, the overall market trend can be an important predictor of future performance, at least in my opinion. (Of course, if one is a thick or thin, die-hard, buy and hold investor, this question is moot since these investors believe in maintaining their position "no matter what.")

It might seem most reasonable, and sounder logically speaking, to assume that the longer 5 year view (not to mention the 10 year view which also generally shows a stock market barely showing any profits) would be the one to carry more weight in forming your judgment. A 5 year trend would seem to be a more reliable and therefore "safer" way to decide how much risk to subject your hard-earned money to than a mere 2 1/2 yr. one.

But it seems to me that the great majority of investors who are shifting their allocations are basing their actions on the following supposition: the US economy is not at all in good shape, and neither President Obama, Congress, nor the Federal Reserve Board will be able to do much, if anything, to improve it. In fact, it is based on this assessment that Barack Obama has recently been forecast to suffer a "heavy defeat" in 2012 by the economic advisory firm IHS Global Insight. (Of course, some investors moving out of stock funds may be doing so out of necessity because they need to be sure of having cash on hand.)

If we are correct that many investors share a sense of pessimism, then fund investors are apt to continue to reduce allocations to stocks, or at least, not consider adding to their currently held stock fund positions. And while bond funds have never been investors' perennial favorites, at least some degree of positive returns certainly appear better to some than taking the risk of returns that could be considerably worse in a stagnant economy.

A Contrarian Approach

Obviously, no one can know whether a relatively high or low allocation to stocks will prove to be the better choice over the next year or two, or even longer. But from what I've already said, it appears that more and more investors will be acting cautiously with regard to their stock positions.

But time and again, the stock market usually confounds a logical analysis: Just when investors appraise the situation as particularly dire, good returns somehow appear, and vice versa. In my opinion, we are likely to be in just such a situation now.

Why are good investment returns usually illogical and contrary to expectations? Because once severe problems are recognized, as appears largely to be the case today, many of those prone to sell will have already done so. These occasions can be recognized when problems are already so severe that "worst case scenarios" are already viewed as likely. If these scenarios do in fact occur, little further selling by investors may happen because that's what people expected anyway. But if there is even a gradual amount of improvement from the dire picture, a cadre of aggressive investors who mainly invest in individual stock issues and really move the market (not fund investors) are likely to begin buying in earnest, pushing stock prices up, often at a highly rapid pace.

This is what appeared to have happened in March 2009. And we suspect it may happen again in the near future, if it hasn't already begun happening this month. In March '09, like now, conditions appeared bleak with no apparent resolutions in sight. A careful realistic analysis of various sobering issues currently seem to "logically" suggest little to give anyone confidence that either the US or the major regions of the the world (except perhaps for some emerging market countries) are on the right track, or have good prospects for resolving their numerous difficulties anytime soon.

Are we suggesting that ordinary fund investors now make big, bold bets in an attempt to reap big rewards? Perhaps only if you are a highly aggressive investor. The wisest strategy would appear to be investing across the investment spectrum in stock, bond, and alternative funds for the foreseeable future, with at least some overweight for stocks for moderate and aggressive investors.

Our Recent Bullish Take on the Stock Market Proves Rewarding

In our Sept. '11 Newsletter, we wrote that "A Friendly Trend Continues to Suggest More Gains Ahead." (This Nov. Newsletter is our first one since then due to travel commitments in Sept. and Oct.) At the start of Sept., the S&P stood at 1219. After a huge jump in Oct., we're now at 1285, or 5.4% higher. Yet stocks haven't quite caught up with the level of 1305 we were at in July when we recommended a Buy alert for almost all categories of funds. But over the last 12 mos., stocks are once again affirming our longer-term bullish position with the Index up nearly 11% on a total return basis since then (go to our Nov. 2010 Newsletter to see the reasons we were bullish exactly one year ago).

Has the King of Bond Funds Lost Its Way?

In our Newsletter published on Sept. 1, we pointed out that Bill Gross, manager of our recommended Pimco Total Return Fund, symbol PTTRX, (and Harbor Bond Fund, HABDX), had made an errant prediction on likely US Treasury bond performance. As a result, the top rated fund had slipped to near the bottom of 2011's comparable bond fund rankings. This led to him admit the mistake in a Financial Times article on 8-29, and to later issue an apology and to state that he was working harder than ever to bring the fund back.

Recently published articles have stated that he has added Treasuries to the fund and increased the fund's duration, meaning that he now expects Treasuries to continue to rally and interest rates to drop even further. If so, the fund will start to do better again, but if not, the fund will do worse than had he not made such an about face.

This seems to us to be rather strange and perhaps dangerous bet to make, given how much Treasuries have already rallied and how low rates have already fallen. It goes completely against what he forecast at a time when rates were considerably higher earlier in the year.

As of the end of Aug., the fund had a NAV of 11.01. As of the 28th of Oct., the NAV was 10.83 for a drop of over 1.6%, not including dividends. Over the same period, the AGG bond index was essentially unchanged. Obviously, whatever Gross was doing wrong before, he hasn't corrected it yet. Thus, the YTD return of PTTRX is now approximately 2.6% (10-28) vs. the return of 6.1% for the index, for a shortfall of over 3.5%.

In light of this underperformance, should investors reduce or even exchange out of any existing allocation to the fund? Perhaps to a small degree. We will watch closely to see if the fund regains its usual mojo in the months ahead. It should be remembered that the fund turns over its position more than most other bond funds. Gross seems willing to make big bets on a short-term basis, and overall, the bets have turned out well. It wouldn't be surprising to see him alter the fund's position again before long. But unless we see performance at least equalling the index soon, it will raise a red flag suggesting that perhaps this is not the fund for investors who expect at most a moderate degree of risk taking, and not any higher.

1, 3, and 5 Year Performances for Our Model Stock Portfolios

Note: All performance figures cited below are for periods ending Sept. 30, 2011.

In Oct. 2010, we were quite positive on stocks for moderate and aggressive risk investors. However for conservative investors, we recommended overweighting bonds.

Investors who tilted toward bond funds typically wound up doing better. So, the AGG bond index returned 5.3% while the Vanguard Total Bond Market Index returned 5.1% over the following 12 mos. But even for bond fund investors, there were some disappointing aspects. The average taxable bond fund only returned 2.7% and the number one bond fund in size, and our usual favorite, Pimco Total Return Inst. (PTTRX), returned a mere 1.0% (see above).

The S&P 500 Index returned a paltry +1.1% but the average diversified stock fund did considerably worse (-2.3%). Mid-cap and small cap indices were also negative, with yearly returns of -1.3 and -3.5%, respectively. But the bad news for stock fund investors was far worse for the average international or emerging markets fund. Here the 12 month returns were -11.0% and -17.7% respectively. Even mutual funds investing in gold, an investor favorite lately, returned -5.1%. (Most fund flows into stock mutual funds by investors over the past year were into international as well as emerging market funds, which suggests a large underperformance vs. the S&P 500 Index for these investors.)

It's no wonder then that our Model Portfolio trailed the S&P 500 Index by its biggest margin ever, that is, over 5%, vs. our prior 10+ yr. record of generally beating the Index after 1 yr. by over 2.5% annually. Thus, in order to have beaten the Index over the last year in stock funds, one would have to have had most of their entire portfolio in the 500 Index itself, plus in a few other Index beating stock funds.

Fortunately, our specific fund picks did somewhat better than these category averages. And had you selected our more conservative choice for your international holding, Tweedy Browne Global Value (TBGVX), your shortfall would have been reduced to about -1.5% vs the Index.

We also trailed the Index over 3 and 5 yrs, although by much smaller amounts (-0.5 and -1.0% respectively). This was also mainly due to our international investments, a category which has underperformed for quite a while. However, our specific fund picks did beat the Index over each of these periods.


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Continue on to Political Wildcards Add Uncertainty to Market Prediction by Steve Shefler