Stocks and Bonds, Not Cash, Are Still the Wisest Choice

Many, if not most, fund investors tend to just hold on to their investments, especially after long periods of good returns. If they can continue to just hold on even when a possibly serious downturn hits, they will probably still make out OK because eventually the markets will come back and well surpass the recorded lows. But we all know that a fair share of investors become too nervous when stocks start to seriously slide and wind up selling off at various relatively low levels. This type of response usually causes them to get subpar returns, if not outright losses.

Perhaps a safer and wiser way to deal with the ups and down of your investments to prevent the possibility of diminished returns is to follow a very different strategy. One of the best ways to help ensure good returns in stocks is to merely observe when stocks may have gotten too high and sell some of your position. Additionally, when they appear to have gotten too low, you could add to your stock portfolio.

Unfortunately, no one can define for sure what "too high" or "too low" are at any one point in time. But it is clear that stocks tend to bounce around a lot. An added fact is that throughout history, stocks rise more than they fall, with long periods of gains typically followed by shorter periods of falls.

With this in mind, in our Aug. 2013 Newsletter, I suggested investors might want to follow a strategy whereby they reduced their overall stock allocation whenever stocks rose 25% from a prior 10% drop. And if they then rose another 25% from that original low without a new 10% drop, they might want to sell some more.

Following this strategy, as described in more detail in the above link, would have led to a decision to sell some stocks when an index such as the S&P 500 crossed 1900 in May of last year, as we called to our readers attention in the June '14 Newsletter.

Now, approximately 16 months later, stocks have not really budged at all from that level. As of today (Sept. 30th), the S&P 500 is at 1920. And the average stock fund is likely to have dropped over the period.

In August, if you hadn't noticed, there was a 10% drop in the S&P 500 index. In the above mentioned Aug. 2013 Newsletter, I suggested that investors might want to add to their stock position after such a drop. Usually, that would be a smart thing for a long-term investor to do. But below, I will give you my opinion as to whether under current circumstances, this would indeed be the best thing to do as opposed to waiting for even a further drop before taking such action.

New Model Portfolios Beginning Oct. 2015

As time goes by, even seasoned investors can incorporate new approaches from their prior experiences. As a result, I have decided to make some potentially consequential changes to my Model Portfolios, especially for bond funds. These changes, and the rationales for making them, are outlined below.

For Moderate Risk Investors

For Aggressive Risk Investors

For Conservative Investors

Rationale for the Current Overall Stock vs. Bond vs. Cash Allocations

As you can see, the allocations I previously recommended for stocks in July remain the same. However, for each of our hypothetical 3 types of investors above, we are recommending a 10% increase in the allocation to bonds, and a corresponding 10% reduction in the allocation to cash.

At first, this might seem somewhat foolhardy: Stocks have been falling and might fall further. And many people expect bonds to do somewhat more poorly as the Fed starts raising interest rates which I believe is now a near certainty in Oct. or Dec. Likewise, returns on cash might start to rise very gradually away from near zero as money held in money market accounts or CDs starts to earn a little more as well. So why am I recommending a steady allocation to stocks as well as an increased allocation to bonds as opposed to cash?

Our overall allocations are not lowered as a reflection of a "fear factor" of being more fully invested in stocks, or, for that matter, bonds. In fact, I almost always expect that over long periods, both stocks and bonds will do better than cash. Thus, a higher allocation to both stocks and bonds as opposed to cash will almost always be better than a lower allocation with this important stipulation: To typically get these better returns, one must be willing and able to hold these high allocations even as the overall asset class dips, sometimes (but very infrequently) for up to several years at a time.

Given this, the question might be raised as to why in the recent past we allocated such a large percentage of our recommended portfolios to cash.

It all had to do with our view of expected returns of each asset class over the next several years. Starting with our Oct. 2013 Model Portfolio and continuing up to the present, we began recommending relatively high cash positions (that is, 20%-25%) for Moderate Risk investors. This reflected our concern that stocks were appearing overvalued, and even bonds no longer seemed to be a relatively sure thing to show better returns than cash. (Remember too we have long acknowledged that in the now long-standing environment of low interest rates, returns on cash were likely to be just about zero.)

So while our Moderate Risk stock position at 50%-55% over the last 2 years has remained about double our bond position at 25%-27.5% and 25%-35% above our cash position, one might still ask if the cash position was too high.

In case you hadn't noticed, over the last 12 mos., most bond funds, and even cash, are currently showing better returns than stocks. The comparable figures show the S&P 500 index at about -1%, the bond benchmark (AGG) approaching about +3%, and cash remaining at about zero. This means that our cash position along with our, on average, somewhat higher than normal combined cash/bond position totaling around 50% would have been a better place for your investments during this one year period. If, however, one goes back two years, one would have certainly been way better off in either stocks or bonds than cash. So, perhaps we were on the right track with our relatively high cash position but about a year too early. (We did advise about two years ago that the poorer stock returns we expected might take approximately a year or so to manifest themselves in the Sept. '13 Newsletter.)

Of course, another reason we have frequently given for having a high cash position was not that we expected to outperform in cash, but rather, to have the resources available to invest back into stocks (and perhaps even into bonds) once these asset prices become more reasonable. Have such opportunities generally arisen in stocks during the last two years? They may be getting closer, but for us, we have not yet seen the best opportunities for the following reason:

Stocks, while a little more favorably priced now that we have had a 10% correction, still seem vulnerable to further losses. We appear to have hit one of those inevitable periods mentioned above when stocks downtrend for perhaps many, many months, or at best stay flat, after years of almost constant rises.

Bonds still appear to me to be more attractive than almost no return at all in cash but will need to be able to adequately get through the upcoming period of rising interest rates. But such rates are likely to rise at a slow enough pace so as not to drag longer-held returns on bonds lower than what you can expect to earn in cash.

In fact, the adroit investor does not always need a stash of cash to increase investments in stocks. With an adequate supply of bond fund money available in one's portfolio, one can always use relatively non-volatile bond fund investments for the same purpose.

The bottom line, then, is this: holding cash for periods of as long as, say, three years, will likely hurt your return potential. Since our recommendations are designed for at least moderately long-term investing, we have re-evaluated our relatively high cash position and are now recommending holding somewhat less.

Of course, if you believe in market timing, maybe a high cash position is justified until you think we have "gotten over the hump." But I prefer to focus our efforts on, as I said earlier, maximizing expected returns. It's going to be hard to do this by holding cash for lengthy periods. However, we still recommend a reasonable amount of cash for "insurance" in case returns in both stocks and bonds do suffer through a protracted period of negativity, an outcome, while possible, particularly for stocks, is not likely to go on for a particularly long stretch of time given the relatively healthy state of the economy.

October 2015 Model Stock Fund Portfolio

Notes:
1. Stock or bond funds with (C) are particularly recommended for Conservative investors; likewise, (M) for Moderate; (A) for Aggressive.
2. Highly similar ETFs (exchange traded funds) of the same category can often be substituted for any index mutual fund shown in this table; e.g. Vanguard FTSE Europe ETF (VGK) can be substituted for Vanguard Europe (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. Thus, HEDJ has outperformed VEURX over the last 3 yrs. by approx. 5% per year, while DXJ outperformed VPACX by about 17% per year (21% annualized vs about 4% ann. as of 9-28). If you believe, as I do, that rising US interest rates vs. stagnant European and Japanese rates will continue to favor a further strengthening of the dollar, you may want to allocate at least some of your European and Japanese investments into these two ETFs.

Our Analysis of Current Stock Market Conditions and Rationale for Investment Choices

As mentioned above, stocks recently suffered a 10%+ drop after over 3 years without one. The last such drop was in June, 2012 on an intraday basis. At the low point of 1867 on August 24, the S&P 500 index was down 12.5% from its all-time high of 2135 on May 20th. As of the end of Sept, the index has come back somewhat from that low.

Regular readers of this Newsletter will undoubtedly be aware that I have been cautioning against too high an allocation to stocks for the last two years in just such an expectation. Of course, such a drop may prove to be only short-lived; long-term investors may take comfort that such drops are not highly unusual and are usually "wiped away" as time goes by.

But several questions remain. Will the drop go no further than what we have already seen, or might the drop extend to close to 20% or more? And even beyond that, how well will stocks stand up over the next several years even if they don't drop significantly more from where they are now?

Obviously, it is impossible to know for sure the answers to these questions. And many or most investors will likely "sit tight" even though volatility seems to have returned to the markets. For truly long-term investors, sitting tight may well prove as good a response as any. However, having long argued that most categories of stocks are overvalued, the 10% correction appears to me to have only eliminated some, but not all of the overvaluation. On the other hand, in spite of what can appear to be how overpriced some categories of stocks become, there are almost always some other categories that are less so, or even highly undervalued.

Is this the right time, then, to possibly take advantage of the 10% correction, or even to pursue these relatively "bargain" categories? Especially in the latter case, it may depend on your willingness to hold some of these current sometimes rather severe underperformers for perhaps at least 3 years, if not more. Often, the types of funds it seems logical to avoid today are the very ones that will make the best investments further out. But loads of waiting time may be required to actually see these gains.

Incidentally, I believe that the Fed is making a mistake by putting off interest rate increases and perhaps the stock market agrees with me. Since the Fed's Sept. 17th decision to keep the rates it controls near zero, stocks have lost some ground, not gained as you might expect when interest rates are kept low. Why? One might say it has to do with the fostered perception of "slow growth," but US growth lately has been quite decent. Investors would like to see confirmation of this growth rather than the argument that the Fed is so unsure that they still have to keep interest rates near zero for seven straight years. Clearly, I think, an increase will demonstrate we are no longer in crisis as we were when zero rates started, and instill more confidence than trepidation among investors. And lo and behold, on Thurs. Sept. 24, Fed Chairperson Janet Yellen appeared to indicating that a rate increase was indeed highly likely at either the Oct. or Dec. Fed meeting and stocks temporarily responded highly positively the next day.

But apprehension over the state of the economy, domestic and international, appears to me to be only one source of the current sideways to tilted down direction of stocks at the current time. As long as stocks remain overvalued, a further drop to perhaps somewhere in the 15% to 20% level from the May high seems like a distinct possibility. At such a point, I would have more confidence that the downward draft might be coming to an end.

Returning to our specific investment choices as reflected in our current Model Stock Portfolio, let's look at the reasons for the changes we are recommending.

It should be remembered that our recommendations are made with a target of achieving relatively better results than standard indices when judged at least 3 years from now. It would be great if our recommendations did better even sooner than that but our experience has shown that stock prices aren't very predictable over the short-term but are much more predictable over longer periods. This is in fact highly similar to the conclusions reached by recent Nobel Prize winning economists Robert Shiller and others (see my article on this in the Nov/Dec 2013 Newsletter).

Given this fact, it must be pointed out, in all honesty, that our stock recommendations from one year ago haven't done very well at all. However, our generally outperforming recommendations from 3 years ago more aptly demonstrate why it is important to view our portfolios within this longer-term framework.

Our current Model Stock Portfolio bears many resemblances to the one from a year ago since I still believe that several of its basic premises remain valid. These are

-International stocks remain the category with the most forward-looking promise.
-Value stocks are likely to be a better place to be than Growth Stocks.
-Sector funds, if chosen at all, should represent the most undervalued sectors available.

With these considerations in mind,

-We have increased our allocation to Fidelity Low-Priced Stock (FLPSX) to 12.5% as we consider it an almost all-weather, value-oriented fund.

-We have also increased our allocation to International funds, specifically to the Vanguard Emerging Markets Idx (VEIEX). This choice is a perfect example of why one often has to fly in the face of currently poor returns to potentially set oneself up for future gains. While the immediate prospects for emerging markets might look grim, the longer term prospects look quite good to us. But investors will need to be prepared to wait it out.

-We have lowered our allocation to Fidelity Large Cap Stock (FLCSX). This is mainly because we see better opportunities in the funds where we have raised the allocation. Additionally, the fund's performance over the last year has badly trailed market averages and suggests a bearish tinge.

-Finally, we have decreased our allocation to Vanguard Financials ETF (VFH). Financial stocks are already well represented in our other choices.

October 2015 Model Bond Fund Portfolio

Note: Select a fund, if available, that has your own state's bonds for double-tax exemption, such as, for example, the California Intermediate-Term Tax-Exempt Fund (VCAIX) if you live in California.

Rationale for Current Bond Market Choices

We have dropped two funds from our July Model Bond Portfolio: the PIMCO Real Return Fund (PRRIX) and Loomis Sayles Retail (LSBRX). (Harbor Real Return (HARRX), an almost mirror image of PRRIX, has also been eliminated.)

Inflation, one of the main ingredients necessary for good performance of "real return" funds, is unlikely to be at a significant enough level over perhaps the next year or two to make this category of bonds an outperformer. In fact, over at least the last several years, PRRIX's performance has been on a steady downtrend and badly trailed the performance of our bond benchmark, the iShares Core US Aggregate Bond (AGG).

LSBRX is an excellent bond fund. However, its performance can often key off that of the stock market. Lately, as stocks have shown sub-par performance, it too has slacked off badly. It tends to invest in lower-quality corporate bonds that tend to suffer when stocks do. Our investment in Vanguard High Yield (VWEHX) remains as our main commitment to these types of bonds which are often referred to as junk bonds.

We are adding to our position in PIMCO Foreign Bond (USD-Hedged) Adm (PFRAX). While 25% of a bond portfolio in international bonds may seem like a high percentage, we think that these bonds are much better positioned to do well: As US interest rates slowly rise, those in most developed countries are highly likely either stay stable or even go down a bit. Rising rates tend to hurt bond prices while falling ones tend to enhance returns. Also, as mentioned previously, US dollar hedging should continue to be advantageous to funds that do this.

We have been tempted to add DoubleLine Total Return Bond N (DLTNX) to our portfolio before but liked our other bond fund choices better. After a careful review of this fund's track record, as well as the current managers' performance at TCW Total Return Bond Fund for the prior many years before that, we think that the expertise shown does justify a move into this fund.

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We hope to publish a mid-October update which shows in detail how our Model Portfolios recommended 1, 3, and 5 years have been doing. Please check back on our site around the 2nd week in Oct. to see that update.