Contents:

-A Friendly Trend Continues to Suggest More Gains Ahead

-Our New Model Portfolios

-The Upsides of the Downside. By Steve Shefler
   (on separate page - to view, click here)

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This month we are publishing our Model Portfolios now, instead of waiting until the end of the 3rd quarter on Sept. 30th as is our custom. There is one main reason - scheduling conflicts make it impossible to publish around that date this year. But a secondary reason is that given all the volatility in the markets, I'm sure many people are wondering if recent events suggest changes to our outlook, and if so, how these changes might be reflected in our recommended Portfolios.

Note: Our next full Newsletter will be published around Oct. 31st; if, however, we have any urgent issues to inform you of, there is always the possibility of an update some time near mid-Oct.

A Friendly Trend Continues to Suggest More Gains Ahead

A Core Principle

I constantly follow the flow of information in the press and on the Web, but most importantly, in the markets themselves, to try to form my best estimate of the outlook for stocks and bonds. But beyond just an overall picture, I am also seeking clues as to which types of stock funds, as well as which type of bond funds, should be favored regardless of bull or bear markets.

I assume that as an investor, you are going to need to keep your assets some place. If so, it makes sense to be invested in those categories of funds that will give one the best chance of achieving the best positive returns, or, of keeping your assets from being hurt too much in the event that the overall stock (or bond) market is falling.

Obviously, my task is not an easy one, and many would even doubt it can be done at all. My first two sources - the press and the Web - are full of commentary suggesting all sorts of things, many contradictory, regarding the overall outlook for investments as well as specific categories of investments. One must take them all with a huge grain of salt. Why? Well, to be honest, for one thing many/most articles are written because a newspaper, or Web site, needs articles in order to have readers. Paid journalists have to churn out something, so they are happy to have something to say. But something does not necessary mean something that will turn out to add value over the longer term. (Not that everything one reads is to be distrusted, but I believe that it is only through knowledge of a particular commentator's forecasting record over a significant period of time that one can eventually begin to acquire faith in the opinions being expressed, allowing one to basically not pay much attention to the raft of others.)

Then, there are the opinions of not mere financial writers, but authorities deeply entrenched in either the financial industry, or the government itself. One would like to be able to trust them too, but care is still in order. Either deliberately or not, these authorities are not just communicating an opinion, but rather are usually attempting to influence their audience in a direction that will be favorable to their own objectives. Thus, for example, when the head honcho of a large fund enterprise gives his/her forecast, you can bet that the comments are highly likely to encourage investments in at least some of the products the enterprise offers. And, for the same reason, you will likely not get a totally objective analysis when a government official tells us that a "soft patch" appears to be temporary. Were he to say otherwise - like that hard times are likely for the foreseeable future - he would only add to consumer malaise, an outcome which runs totally opposite to the speaker's mission.

No matter how "expert" the opinion giver, most predictions of likely investment outcomes remain too unforeseeable to accurately predict. When the likes of Fed chairman Ben Bernanke's and bond king Bill Gross's predictions turn out to be off the mark as they far too often are (eg, Gross's recent miscall on treasuries, Bernanke's soft patch call mentioned above), investors must accept the fact that no one can be blindly trusted to make the right call. Therefore, the wise investor should try to sift through one's own personally relevant set of information whenever possible when making decisions.

Such considerations are the main reason we frequently rely on the markets "to speak for themselves." An underappreciated fact by most investors is that through the following straightforward observation, one can arrive at a reasonably accurate prediction (as good or better than that of most "experts") of where a given type of investment is headed: If an investment has been heading up, the odds favor it to continue heading up, and vice versa.

Obviously, though, people run into trouble when they too zealously apply this principle, which we'll get to shortly. But assuming the principle is not relied on in excess, the main problem in its implementation is this: There may be temporary dips or blips along with way which can easily throw one's view of the correct trend off course, raising the question as to when a dip is no longer just a dip, but a genuine change of direction. Our advice: Don't be quick to jump to a conclusion; keep watching the data and you will soon learn the answer for yourself, with still enough time to profitably adjust your investments if it becomes necessary.

Be careful not to fall victim to assuming that an uptrending investment will keep going up indefinitely. At some point, the trend will reverse and the reversal will be lasting. Therefore, at some point, caution must take over. Look for investment opportunities where a positive trend is still fairly new. Don't start investing in something after many years have already gone by of positive results - such would be more a time for being leery than plunging ahead.

Likewise, don't assume that a negative trend means you should avoid making such investments. Sure, such would appear to be a rather certain recipe for inflicting losses upon yourself. But investing in mutual funds would not have survived down through the years if people weren't able to make money at it. While there is no certainty as when a falling investment will stop falling, the principle holds that for long-term investors the lower a fund category has fallen, the better time it is to invest as compared to before it started to fall. (Remember, we're talking about investing in funds, not individual stocks; an individual stock can indeed fall to zero, but a fund category can't, unless of course the whole country goes bankrupt.)

Applying This Principle to Where We Are Now

So where is the best place for investors to put their money now? Our overall and specific category asset allocations, below, spell out our choices.

One of the first things to realize is there is no one answer to this question, as no single solution makes much sense. For example, too much in stocks could presumably (although unlikely) spell disaster. Too much in bonds while not likely ever a disaster, could cause one to drastically underperform and perhaps miss out on a significant rebound in stocks in the years ahead. Therefore, since no one knows the one best course, it makes sense to allocate a significant proportion of your assets to each broad category. Likewise for specific types of stock and bond funds: Don't make huge bets, for example, on Treasuries, technology stocks, emerging markets, etc., or, for that matter, on any one type of investment.

But before getting to our Model Portfolios, let's apply what we've said above to looking for what we would consider the best overall place to be, that is, stocks vs. bonds.

What Does the Performance of Stocks Appear to Be Suggesting?

By applying the above core principle, one thing you will immediately accomplish is that you will be steered away from using your own subjective interpretation that stocks seem to be either "good" or "bad" right now. Instead, you will be "forced" to rely on actual data when making this call. Such data is best provided by an actual chart of recent investment performance.

How far back should the chart go? We recommend over the last year, or certainly over the last 6 months at a minimum. We feel that overall stock performance is far too volatile, and therefore, basically unreliable to use to try to project where the market is likely headed over longer periods.

The overall performance of stocks can easily be examined by viewing a chart of the S&P 500 Index. We prefer to use a chart of a fund that serves as a close proxy to that index, the Vanguard 500 Index Fund (VFINX), or if you prefer, the Vanguard Total Stock Market Index (VTSMX) which includes an even broader view. This link will show you the VFINX chart - it is updated daily.

As of right now (Aug. 30), stocks still appear to be in an uptrend over the last 12 mos. in spite of the recent downdraft. (Note that the chart does not allow you to see distributed dividends; as a result, the performance is actually about 2% better than shown.) It is our best estimate that so long as performance does not drop below where it was a year ago, we are inclined to believe that the market will continue its longer-term uptrend rather than to believe that it has started a long-lasting downtrend as a result of the drop-off in performance in the end of April.

In fact, had one used this straightforward approach to suggest the overall stock market's likely degree of satisfactory gains over the following year each July since 2001, one would have been correct 8 out of 10 times. The table below summarizes these findings.

Positive vs. Negative Trend as Registered Each July and Successful Prediction of S&P 500 Returns
Date	Trend	Tot. Ret. 1 Yr Later	Forecasting Success?
2001	Negative	-18.0%	Yes
2002	Negative	0.3	Yes
2003	Positive	19.1	Yes
2004	Positive	6.3	Yes
2005	Positive	8.6	Yes
2006	Positive	20.6	Yes
2007	Positive	-13.1	No
2008	Negative	-26.2	Yes
2009	Negative	14.4	No
2010	Positive	30.7	Yes
2011	Positive	???	???

Of course, 2007 and 2009 were years when prior trends completely reversed. As a result, investors who assumed the prior year's trend would hold for the following year turned out to be wrong. But such longer-term trend reversals are much more the exception than the rule. Since the trend remains positive (both as of this July and right now), the odds remain favorable for stock returns to continue to be satisfactory over the next year as well.

What Does the Performance of Bonds Appear to Be Suggesting?

One can use the chart of the Vanguard Total Bond Market Index, in the same way, to get a sense of where the overall bond market might be heading, based on the notion that established trends are considerably more likely to persist than to be "broken." (Use the following link to view this chart.)

While this chart may be a little difficult to interpret in that the price of this fund as shown is almost identical to its starting point a year ago, it too is clearly showing an uptrend. Why? Because it too does not show dividends. Since dividends have been in the range of around 3% or so over the last year, bonds have clearly performed moderately positively when the dividends are taken into account. Therefore, our best prediction is that, in general, bonds will continue to be a satisfactory holding for some time longer. Of course, eventually, things may change if the trend changes but unless that happens, we are reasonably confident of our commitment to bonds.

An even closer look at the overall performance of bonds, such as by glimpsing at the performance table here reveals that although the performance trend remains positive over the last year, there is some cause for concern. The table shows that bonds are not doing as well over this period as they have done over the last 3, 5, or even 10 years. This strongly suggests that bonds, although still moderately attractive, have already seen their best days performance-wise. This sharply contrasts to the performance of stocks whose one year performance is head-over-heels higher than over the same longer-term periods. Thus right now, given the choice between stocks vs. bonds, we would greatly favor the former over the latter.

Our New Model Portfolios

Overall Portfolio Allocations to Stocks, Bonds, and Cash

While stocks may indeed be a riskier proposition than they have been as recently as a few months ago, we believe that the remaining investment categories of bonds and certainly cash do not offer the prospect of particularly noteworthy longer-term returns as a alternative to stocks. (In many respects, we do subscribe to the "new normal" view that possibly, for the next few years, investment returns in all categories may fall short of their long-term norms.)

Our drop in percentage allocation to stocks since July, and the rise in allocation to bonds, does not mean that we advocate selling some stocks and buying some bonds unless one is seriously over-allocated to the former and/or under-allocated to the latter. The changes are entirely accountable as a result of the drop in stock prices and rise in bond prices that occurred since our last Model Portfolios. Thus, for investors who held funds similar to our recommendations in July and made no changes over the last several months, their stock/bond percentages would now closely resemble our new allocations.

For Moderate Risk Investors

For Aggressive Risk Investors

For Conservative Investors

Specific Fund Category Allocations

Stocks

Bonds

Comments Regarding Our BUY Recommendations

As regular readers realize, we base our Portfolio investment decisions on the two main factors above: 1) our Model Portfolio overall allocations to stocks vs. bonds vs. cash, and 2) our specific fund category allocations within the stock and bond fund universes. Factor 1) sets a limit on how much of our overall Portfolio we are willing to invest in stocks; factor 2) helps to determine how to manage those overall Portfolios given that not all types of stocks or bonds are equally attractive at a given time. We personally will not exceed our overall quarterly Portfolio allocation to stocks no matter how favorable the investing environment might appear, nor will we likely go below it if a sudden downdraft hits.

Our BUY recommendations, within this context, are for long-term investors who are looking for which stock categories to add to their portfolio IF their stock allocations are currently lower than desired. If one's stock allocations are ALREADY at our recommended level, they would best be used only for tactical (or rebalancing) purposes. Specifically, this means an already fully invested investor who buys a recommended category of stock as a result of our BUY recommendation would, by necessity, need to accomplish this by exchanging out of another, and presumely less desirable category stock fund. As a result of such an exchange, then, one's overall allocation to stocks would remain the same.

In this latter instance, a BUY signal would not mean adding to one's stock position, just reallocating to a more favorable category. The same would apply if a SELL signal were issued as we would only recommend actually reducing one's overall stock allocation IF already above our recommended percentage allocation. (It should be noted that no SELL signal will be issued by our empirical tool as far as the eye can see.)

Due to the recent correction in stock prices, it might currently look as if our recently generated BUY signals were ill-timed, but only time will tell, as the signals were not intended to suggest what might happen on a short-term basis. Rather, they are designed to suggest investments that may be expected to do well over the course of at least a year. Since our signals have nothing to do with trying to anticipate what economic, political, or other world events might happen which could either throw stock markets into a tumble or send them upward, obviously when such events happen, it may have the immediate effect of throwing our recommendations off course.

Since our signals reflect both momentum and under-valuation, they will change as these factors undergo changes. Since the BUY signals were sent out on July 20th, the market's momentum has fallen while under-valuation has increased to a small extent. The result is that a few categories of stock investments have now become HOLDs. Whether a category is classified as BUY or HOLD, we still expect favorable outcomes since both BUY and HOLD recommendations are projected to lead to constructive outcomes as discussed in our Aug. '11 Newsletter).

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Continue on to The Upsides of the Downside by Steve Shefler

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