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The stock funds in our model portfolio returned 6.5% for the 2nd quarter outperforming the S&P 500 which returned 5.8%. When the performance of our bond funds and small cash position is factored in, our overall return for the quarter was 3.1%. This represents a 12.4% return, if converted to an annualized basis. Additional 2nd Qtr performance information is presented below.
Here are some suggestions we think are worth considering:
At long last, many general stock funds appear to have reduced much of the extreme excesses from the last few years. Even if a true bottom has yet to have been reached (unlikely), or less painful, if stocks while having hit bottom several months ago, are still destined to meander and underperform for the foreseeable future, it is hard to imagine that they will continue to sink precipitously as they did beginning last Fall. Given the 6 month lag that usually occurs before interest rate cuts kick in, and the fact that stocks tend to rise 6 months before an economic recovery, we could now be primed for a simultaneous improvement in both the economy and stock prices since we are just 6 months past the onset of the first rate cuts and possibly 6 months or less from a true turnaround in the economy.
But in spite of the carnage, this might actually be a good time to invest abroad, especially if you haven't already done so, with the stipulation that you keep your commitment to any allocation of funds to Japan low until such time as Japan can begin to pull out of its seemingly eternal slump. Europe seems set to catch up with some interest rate cuts of its own, and again, although we cant say we're at a bottom yet, it seems unlikely that any huge amount of further damage can occur. As a result, for the patient investor, annual returns of 15 percent or more when funds are held over the next few years, seems like a distinct possibility. And for investors willing to take a chance with emerging market funds, we even think they may be worth a shot as well, although for most people, it is nearly impossible to readily track the various economic fundamentals in each of these countries that will determine whether a given country's stocks will do well or poorly.
We feel that the strength seen in bond funds during the last year is probably behind us. In fact, as noted above, during the last quarter, very few categories of bond funds actually advanced in spite of the Fed easings. This is probably due to the fact that like with stocks, sophisticated investors in bonds also look ahead about 6 months or so rather than just at present conditions. They attempt to anticipate where interest rates and inflation will be at that time. And what many of them are expecting will be an end to Fed easings and even a possible gradual rise in inflation, and even possibly higher interest rates at some not too distant point as a result of a Fed-mastered pickup in economic activity.
We tend to agree that bond investors will have a much harder time in even achieving annualized returns in excess of 5-6% for the remainder of the year and beyond. However, you should continue to be fairly safe in short-term bonds. For maximum return, we suggest corporate bonds as opposed to Treasuries. Yields on corporates are significantly higher and corporate bonds themselves will hold up better if the economy begins to improve.
One category of bond funds that we have not recommended before but think are now worthy of consideration are inflation adjusted, inflation protected bonds. Throughout this year, and even again this week, most analysts and government officials, including Alan Greenspan himself, have been assuring investors that inflation is not a big worry. If that is so, then one has to ask why inflation protected bonds have been outperforming US Treasuries, which have no inflation protection, over the last year?
In spite of Mr. Greenspan's reassurances, inflation has in fact been creeping up over the last year or so although not to the point that it is considered serious YET. However, once the economy starts to respond to the deep interest rate cuts, the threat of inflation may well return. We should also mention the fact that higher energy prices have yet to spill over into the cost of other goods, something that will eventually have to happen, unless of course energy prices are nearly completely rolled back fairly soon.
A final argument in favor of inflation protected bonds is this: by examining the current yield differential between US Treasuries and inflation protected Treasuries of the same maturity, we can observe that investors are only expecting about a 2% inflation rate for the foreseeable future. Examining inflation figures over the long term, even though inflation has recently has been about that low, over the longer term, US inflation has tended to be higher. Therefor, a 2% rate of inflation seems highly optimistic. And if inflation does actually come in higher than about 2%, anyone who buys these bonds will earn a better return than someone who buys the comparable maturity Treasuries.
Here then are our choices and allocations for the 3rd Qtr which reflect the reflect our current appraisal. If you are an experienced mutual fund investor, we hope you are aware of how extremely difficult to predict which fund categories will do well vs. not well over periods as short as 3 months without modifying choices for the entire 3 months. Our 3 month choices are mainly presented for the benefit of those of you who want to know our current thinking on which fund categories seem to make the most sense right now. However, our real focus is on long-term results and our real portfolio is more closely aligned to the one presented under "Our Long-Term Recommended Funds". It is here that you can see the true benefits of our long-term investing approach.
Our Recommended Fund | Morningstar Style | New Allo- | Previous | Updated July 2006: |
|---|---|---|---|---|
Vanguard REIT Index | Real Estate | 5% | 5% | +18.9% |
Fidelity Low Priced Stock | Small Cap Value | 10 | 10 | +14.8 |
Vanguard Index Europe | Foreign (Large Blend) | 10 | 10 | +10.4 |
Vanguard International Growth | Foreign (Large Blend) | 10 | 10 | +9.4 |
Vanguard Small Cap Index | Small Cap Blend | 10 | 10 | +9.0 |
Vanguard Extended Market Index | Mid Cap Blend | 10 | 0 | +8.9 |
Tweedy Browne Global Value | Foreign (Mid Cap Value) | 10 | 10 | +8.3 |
| Vanguard Windsor | Large Value | 20 | 20 | +5.6 |
Vanguard Growth and Income | Large Value | 10 | 10 | +2.8 |
| TIAA-CREF Growth Equity | Large Growth | 5 | 0 | - 2.4 |
5 yrs after making these above recommendations, 9 out of 10 were beating the S&P 500!
Note: The following stock funds from last Qtr's Model Portfolio, with their previous category and allocation shown in ( ), have been removed for this Qtr:
Fidelity Growth and Income (Large Blend - 10%)
T. Rowe Price Value (Mid Cap Value - 10%)
Note: Previously we included Real Estate under the category of "other". Since a REIT is really just a type of equity, we are now including under stocks. As a result, the "Previous Allocation" totals shown above are more than 100%.
Our Recommended Fund | Morningstar | New Allo- | Previous | Updated July 2006: |
|---|---|---|---|---|
Vanguard Inflation Protected Securities | Low | 30% | 0% | +6.9% |
| Vanguard High Yield | Medium | 20 | 10 | +6.3 |
| PIMCO Total Return Instit. | Medium | 25 | 45 | +5.9 |
| Vanguard Short Term Corporate | Low | 25 | 0 | +3.7 |
After 5 yrs, 3 out of 4 of our recommendations were beating their benchmark!
Note: The following bond funds from last Qtr's Model Portfolio, with their previous allocation shown in ( ), have been removed for this Qtr:
Vanguard Short Term Treasury (10%)
American Century Target Maturity 2015 (15%)
Vanguard CA Ins Long Term (10%)
American Century International Bond (10%)
Class | Current | Previous |
|---|---|---|
Stocks | 67.5% | 52.5% |
Bonds | 25 | 40 |
Cash | 7.5 | 7.5 |
Tom Madell, PhD