There Are Many Overvalued Funds. Which Are They?

By Tom Madell

Most domestic categories of stocks have again been gradually pushing toward what I consider overvalued levels. While alluring, their excellent prior performance can lead to one of the biggest enigmas faced by investors.

The magnitude of investment performance for a particular fund or fund category, including for bonds, tends to persist over relatively extended periods. Thus, in a sense, the best short to intermediate term predictor of future performance of a fund does turn out to be past performance. As a result, investors are reluctant to change course when things are going well. Of course, when a fund or fund category has been doing relatively poorly, taking action seems far easier.

So here is the dilemma: When a fund or fund category has been doing well for a long time, perhaps for years, do you stick with it even if it seems to have become overvalued? The reality is that most fund investors don't care about a hard-to-define concept such as overvaluation. They tend to stick to their winners while dropping losers, end of story.

Unfortunately, potential overvaluation may not appear to be a problem until it stealthily morphs into one. Until it actually happens, it is hard for most to embrace the notion that an overvalued fund or fund category over time will typically lead to disappointing results.

Since the value of any investment is highly subjective and, in truth, really lies the eyes of those willing to buy it at its now current price, there is no absolutely certain way to determine when overvaluation may have occurred. As a consequence, investors may have to rely mainly on their own rather subjective estimation of what a reasonable price for a fund investment might be.

Is it likely that an investment that has already increased in value by approximately 17% per year over the last seven years period is reasonably valued? This is the return for the Vanguard Total Stock Mkt Index Fund (VTSMX) which almost exactly represents the performance of the entire US stock market since Sept. 28, 2009 through Sept. 28 of this year.

Put in another way, is it reasonable to expect mid-double-digit returns on stocks over a long period when the long-term average return is in the 9 to 10% vicinity? To my way of thinking, that 9 to 10% return on stocks should be regarded as a highly rewarding outcome worth capturing. It is far better than any available to those who might invest anywhere else, assuming an equal, moderate level of risk. But holding out for a continuation of excessive returns in stocks carries more risks than potential rewards. While some may achieve such greater returns, excessive risk-taking typically creates more sub-9-to-10% outcomes than ones above it.

While by this yardstick, the overall US stock market should be considered overvalued, some types of stock investments still appear to be at reasonable levels, or even undervalued. Further, investing more heavily in fairly valued or undervalued segments of the market can lead to incrementally greater rewards than retaining investments in overvalued market performers. My own 15 year ongoing research has shown that using this approach is one way investors can often get long-term returns that are modestly ahead of the market average.

With this in mind, we are recommending a few changes to our specific fund choices from last quarter, although not to our overall stock vs. bond fund percentages.

Overall Allocations to Stocks, Bonds, and Cash

For Moderate Risk Investors

For Aggressive Risk Investors

For Conservative Risk Investors

Specific Stock Fund/ETF Recommendations

The following table shows our new Model Stock Portfolio. See below the table for an explanation of the changes from July's Portfolio.

We have marked in bold type those funds which seem to have the best prospects.

Notes:

1. A stock or bond fund shown with (C), (M), or (A) indicates it is most suited for Conservative, Moderate, or Aggressive investors, respectively.
2. We dropped Vanguard Europe (VEURX) and replaced it with Vanguard International Growth (VWIGX); the two are highly correlated but VWIGX is more diversified.
3. 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 Growth ETF (VUG) can be substituted for VIGRX.

Comments on Stock Fund Selections

Many small/mid-cap funds, including Vanguard Small Cap Value Index Fund (VISVX), are still among the most overvalued within domestic realm and have been for a quite a while. But it would be a mistake to eliminate the category all together from a portfolio. However, a lowered allocation would appear to be appropriate.

International funds appear to have better forward-looking prospects than domestic ones with the positive prospect of even lower interest rates than in the US and further support by their central banks to aid their economies. Difficult to predict currency movements, which had a negative impact for US investors in most international funds thru mid-2015, have now turned supportive.

Vanguard International Growth (VWIGX), with over a 20% allocation to emerging markets, is likely to benefit if emerging market performance continues strong as we expect.

Vanguard 500 Index (VFINX) (as well as Vanguard Total Stock Mkt Index Fund) currently overemphasizes stocks that have already done well and tend to be overvalued, and thus, might be considered backward-looking at this point. We think AMG Yacktman Fund Service Class (YACKX), unlike the S&P 500, is not overvalued.

Large Growth funds too appear overvalued and have already started to fade after at least five years of being one the best performing fund categories.

We are reinstating an old favorite, T. Rowe Price Eq. Inc (PRFDX), into the portfolio. We like what the new manager has done since November, outperforming the S&P 500 by about 3 percent and Vanguard US Value (VUVLX) by about 6% over that short span.

We now regard Vanguard Energy (VGENX) as an outright "Buy." Investors must realize, though, that this aggressive investment will likely continue to be highly volatile and the good results that we expect may take several years to materialize.

Specific Bond Fund/ETF Recommendations

The following table shows our new Model Bond Portfolio. See below the table for an explanation of the changes from July's Portfolio.

Notes:

1. When possible, select PTTRX; HABDX is only recommended if you cannot meet PTTRX's 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.

Comments on Bond Fund Selections

We continue to struggle with an appropriate allocation to our long-time favorite bond fund, PIMCO Total Return Instit (PTTRX). Unfortunately, since the departure of its legendary manager, Bill Gross, the fund, while not performing terribly, has underperformed. We continue to recommend holding the fund, but with a reduced allocation.

DoubleLine Tot Ret Bond I (DBLTX), another highly rated fund with a highly rated manager, is also trailing its index. For this reason, we are also reducing its allocation.

We continue to like muni bonds here, relative to most other choices out there. We think long-term bonds of all sorts, while better performers than shorter maturities in recent years, are still somewhat dangerous now due to the strong possibility of higher interest rates ahead which will potentially hurt the former more than the latter.

While I am lowering the allocation to Vanguard Sh. Term Inv. Grade (VFSTX), one can pretty safely invest some of the "idle" cash you would otherwise invest in a money market fund in it for the immediate future, as I pointed out a while back, since it appears highly likely to do better than cash unless the Fed becomes a lot more aggressive going forward in raising short-term rates. We currently regard this possibility as rather small.

Inflation, while still low, appears likely to pick up going forward. Therefore, a higher allocation to Vang. Inflation Prot. Sec (VIPSX) seems to be appropriate.

Vanguard High Yield (VWEHX) has been consistently outperforming its benchmark, Barclays US Aggregate Bond, for so long, that it is prudent to continue to hold a decent allocation to it, if not a slightly higher one.

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