How Should We Then Invest?

Last week we began a series on developing a philosophy of investing. This week we will continue with part 2 as we focus on what types of investments should do well after the economy turns around. Then we look at specific funds you can go into now.

Next week, we will return to surveying the economic landscape. It is not pretty, as country after country is slipping into recession. World trade is slowing at an alarming rate. I know many of you are worried about inflation, as the Fed is pumping the money supply and the government goes back into deficit spending. How, you ask me, can this not produce rampant inflation? Next week, I will attempt to answer. Like Charles Schwab, I will tell you to stay calm. I will use the words "pushing on a string" and similar technical economic terms to your delight and amazement.

But for today, let's focus on what we will do when the economy turns around, as it will. As a reminder and a jumping off point, let's review a few key points:

Broad stock market indexes over long periods of time do not grow faster than the economy. Therefore, if they have grown substantially in the recent past, either they will fall in value until they revert to the average growth trend, or they will go sideways for long periods until growth catches up with them. Either way, investors will be frustrated.

The prices of stocks are driven by earnings. We reviewed an important study last week that shows earnings of corporations as a whole do not rise faster than the general economy, or about 3% per year plus inflation and dividends. There are exceptions, of course, but index fund investing does not find them.

Other studies show that stock markets always revert to trend in terms of P/E values, and right now we are at the all-time high for P/E values for the S&P 500. In an article in today's NY Times, we read that "The P/E ratio of the Standard & Poor's 500-stock index reached its highest level ever yesterday, at 35.99. That figure, based on reported profits over the last 12 months, exceeded the record of 35.82 set on April 12, 1999." That is because earnings have dropped faster than stock prices. History says there is still some room for stocks to drop. Potentially, there is a lot of room.

Repeat: There has never been a time in History when investors have been rewarded over a ten year period for investing in stocks at these values. Buying and holding, like Modern Portfolio Theory says, is going to give you the long term average of the market. That is, if you stick with it and don't leave after you are down 40%. Or if you don't concentrate your investments in one area like tech where you get power growth and then power losses. Especially not if you wait until 1998 to enter the tech market.

History says the long term average is not going up over the next ten years. I am saying that buying index funds or stocks with high valuations today and holding is going to be a low percentage play for the next ten years. It will be a game for losers.

How Should We Then Invest?

First, we stop playing the Modern Portfolio Theory Game that says all that matters is relative value over the long term. The next time a portfolio manager tells you he did a good job because he only lost 20% but his benchmark lost 25%, hang up. The next time a broker says that you HAVE to stay in the market 100% of the time and suffer losses because that is the only way to grow your portfolio, hang up. For the next ten years, when someone says the word "momentum", be on your guard. There are some very good momentum investors and funds, but there are not many. They are probably not on the other end of your phone. (One day, I promise, I will write about some managers who are good momentum players and how they do it.)

Momentum investing in a bull market makes geniuses out of ordinary investors. It's an investment aphrodisiac. It's like going to the carnival midway and hearing the barker scream, "Everyone's a winner!"

But when bear markets come, or markets like we will probably see over the next decade, reality hits. Genius is forgotten. Momentum giveth, and momentum taketh away.

What I think investors should be looking for over the next decade are absolute returns and investments where the trend and History is on your side. It will be quite possible to make 10-15% per year once again. Just not now. We must be patient.

In August of 2000, we saw a negative yield curve. As I wrote, we always have had recessions one year after negative yield curves, and stock markets go down in recessions. While it looked for a while like Greenspan was going to beat my man History, it now seems that History has won once again.

I hope that no reader ever again tries to stay long the stock market after the appearance of a negative yield curve. No matter how many rate cuts and "this time it's different" stories you read, when the yield curve goes negative, get out of the market.

When our Three Amigos give us an all-clear signal, we can get back in the stock market. But we will not buy S&P 500 index funds. John Bogle of Vanguard is going to have a rough decade trying to sell his index funds bytelling people the only way to invest is to buy and hold. He has looked brilliant in a bull market. He will again look brilliant after 2010. This next decade is going to be tough on genius.

This is going to be the decade of VALUE. Index funds are not value. Growth funds are not value. Specifically, we will be buying small-cap and mid-cap value funds and stocks. The more aggressive will be buying micro-cap value funds and stocks.

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Dividends will be king. We will look for solid companies which have a track record of growing dividends with low P/E ratios. There are not many, but there are enough.

Research will be important. Simply buying a company because its stock is going up will not work. If you are going to invest in a company, you need to research that company just as if you wanted to buy the whole company. And when you do buy it, you want to stay on top of it. There are services that will send you every mention about a company in the news and on the internet.

If you can't do that research, then use a mutual fund whose manager does. When the time comes, I will recommend a dozen or so of the better ones. And yes, there will be ups and downs in those funds, but we will live with it comfortably. That may seem inconsistent with what I have written above, but it is not.

Here is why. No one truly knows when the economy will turn around. We all try and guess. But one thing I am confident of is that it will turn around at some point. Companies and their earnings will start to grow again.

Companies whose P/E ratios are sky-high will have a lot of growing to do to catch up to trend, or their stocks will fall a lot to come back to trend.

But companies who are already below trend and are in growing markets will rise to trend. By and large, those are going to be smaller companies with good values, (with a few large exceptions).

This is not the Warren Buffet school of investing. Buffet buys companies that he wants to own 50 years from now. He buys value and then holds it. When Coke stock rises to where it is over-priced, he doesn't sell. When Coke stock drops 50%, he doesn't care. He simply wants to own Coke.

That works for Warren. Most investors will be better served by buying Coke when it is below trend and selling it when it is above. I am not marrying a company. I am just taking it out on a date. When the party is over, we will go our separate ways, with fond memories.

Slow. Steady. Patient. Steady Eddy will win over the next decade. We will buy value and hold value until the yield curve goes negative. 10-15% per year average gains over time are quite feasible, in my opinion, with this style.

Sidebar: There will be opportunities for larger short-term gains over the decade. There are managers who have good track records at tactical allocation investing or other forms of momentum investing, although they are not doing well now. When the economy turns, there will again be opportunities for these managers. I will bring them to your attention when our Tree Amigos let us get back in the water

Cleaning Out the Garage

In July of 1991, the default rate on junk bonds peaked at 13.1%. The default rate is about 9% today. Some junk bond funds are yielding over 15% (such as the Strong High Yield Bond fund (STHYX). If you are expecting 9% of your portfolio to go sour, the outlook is not good.

The quotes Jeffrey Koch, portfolio manager of the Strong High Yield Bond fund. He says his analysis shows that high yields have never been cheaper when compared with corporate bonds and to Treasuries. Looking at corporates, for example, Koch takes the ratio of the yield on the high-yield index vs. the Lehman Brothers Aggregate Bond Index. The ratio is a record 2.7. The previous high was 1.95 set in 1990. "You can see that by valuation measures alone, absent any fundamental factors, it looks attractive," says Koch. Koch also points out that the risky, low-quality telecom sector has diminished in importance to the overall market's performance. Of the total high-yield index, telecom now represents just 12%, nearly cut in half from its peak weighting of 22%. "And over half of that [12%] is wireless, where there isn't as much of a problem," says Koch.

High Yield Bond funds are cleaning out the junk in their portfolios. When this economy turns around, these funds are going to be the big winners. In the near term, as we see interest rates go down, the difference Koch talks about above could get even wider. The wider it gets, the more profits we will see in junk bond funds. Following the 1991 recession, some funds returned over 70% in three years.

Is it time to get in? I track high yield bond funds as part of a management program for clients. They are now at the lowest point I have seen in years. But a month ago they were at the lowest point I had seen in years. Many of these funds are down 25% or more in the last two years.

Just because something is at its lowest point does not mean it cannot go lower. We are at the beginning of a recession. Default rates are likely to go higher.

At some point, the trends in these bonds will reverse. They will start to produce steady returns, and for a few years will probably rival even the best stock funds for total return. We will want to have some of these in our portfolios.

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That being said, if you want to gamble a little, I could not argue too much with putting some of the money you will eventually put into junk bonds to work today in a good fund like the Strong Fund (above) or the Federated High Yield fund (FHIIX). At a 15% yield, you will not be risking too much. I am personally waiting, for the record. We will do well enough in junk bonds when the economy turns that reaching for the potential extra 3-5% just doesn't feel right.

Hedging Your Bets

The steadiest returns I know of today, and expect to see in the future, are in certain types and styles of hedge funds. Unfortunately, these are not available to the public at large. In November, I will be starting my book on hedge funds. There are beginning to be some ways for investors to find out about these funds and to access them, but the minimums are still high and the information on the individual funds is hard to come by.

I think that is going to change over the next decade. I can point out dozens of funds which average 10% or more a year, with 90% or more positive months, and have done so for many years. But the minimums are high, only high net worth investors can even get in them and that is if they can find the funds. The government regulations are such that small investors cannot get into these funds, which in my opinion would be far more appropriate for small investors than most of the equity mutual funds they are in.

And yet, in contrast, any investor can invest in cattle futures, internet stocks, options, the Janus 20 Fund or any number of wild and crazy markets.

The rules governing hedge funds were appropriate once, but times have changed. I think Congress will see that as well. I think that within a few years small investors will be able to access these funds now only available to wealthier investors. There have already been some changes, and more will come. When this happens, steady performing hedge funds will also be a place for some of your portfolio.

By the way, it is not the SEC which makes the rules. They just enforce the rules. It is Congress who makes them. The next time you see your Congressman or Senator, tell him you don't like the private placement rules which so outrageously favor the rich over the poor.

Example: there are many hedge fund that invest in Ginnie Mae bonds. They buy these bonds, hedge out the interest rate directional risk (and some even hedge out the repayment risk), leverage up and then return steady 10-12% returns per year, with very few losing months. Why shouldn't smaller investors be allowed to have access to this type of fund? It is far less risky than investing in a Ginnie Mae mutual fund, which has interest rate risk and other exposures, and typically they return double that of the better Ginnie Mae mutual funds.

In 1999 the American Century Ginnie Mae fund only returned 1%, while lots of hedge funds in the same market did 10% or more.

I should point out that not all hedge funds are steady or safe. Many are just as risky (or more so) as cattle futures or options trading. Just as with any investment, you have to look under the hood and preferably take apart the engine before you invest.

What Do We Do Now?

One of my favorite movie scenes is from a sci-fi picture. The bad guy alien ship had just been hit with a rocket, and they were falling slowly into the moon. The alien commander turned to the ship Captain and screamed, "What do we do now?" The Captain said simply in a steady, rolling, drawn out, gravelly James Earl Jones type voice, "We die."

Guess you had to be there.

We aren't going to die, but right now, I just don't see a lot of good options without a lot of risk. Have we seen the bottom in stocks? That is a possibility, but History says no. It seems to me the potential risk is higher than the potential reward. There are some stocks of good companies which are paying 4% plus dividends like TRW or ConAgra, but if the market resumes it downward trend even high dividends will not keep these stocks from going lower.

As I said above, I think it is too soon to go into junk bonds. There will be some great buys in real estate after the recession. There will be some great businesses to buy out of bankruptcy. There will be lots of opportunities.

Right now, for most investors, it is time to keep our powder dry. It is time for patience. But money market funds aren't paying anything, so let's look for some alternatives.

Consider inflation-adjusted treasuries notes. These pay a guaranteed 3% plus whatever the inflation rate is, adjusted every six months. The government adds the inflation amount to the value of the bond. Currently the total yield is 5.71% but will be going lower in November. Individuals are limited to $30,000 of these bonds, but you can put more in a mutual fund that invests in these bonds. Mutual fund guru Tony Sagami tells me the Vanguard Inflation-Protected Securities fund (VIPSX) is the best because of their low fees.

Of course, if we actually saw outright deflation for six moths, this T-bill would subtract the deflation from your asset value, but we can watch out for this in advance..

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Another way to get a few points better than money markets is the Vanguard Fixed Income Short Maturity (VFSTX). Morningstar says, "In general, short-term bond funds aren't designed to provide big thrills, but this one loads up on investment-grade corporate bonds instead of government and other high-quality debt. Its low fees, low volatility, and solid long-term returns also make it stand out." It has yielded a total of 8% so far this year. If interest rates rise, it could lose some, but if short term interest rates are rising, then we are probably coming out of recession and would hopefully be leaving this fund anyway for greener pastures.

One interesting fund Sagami mentions is the Merger Fund, which invests in stocks of companies with announced mergers. It is a 5-star Morningstar rated fund, has never had a losing quarter and has averaged 11% over the last five years. The managers have been with the fund for over 12 years and target 10% a year. They have "only" done 3.16% this year. They don't give us much risk for a potential 10% reward. Even over the last 30 days, they are only down about 1/3 of 1%. Some years, like 1999 and 2000 saw 17% returns.

And of course, there is the American Century Target 2025 (BTTRX) fund for those of us who think long term rates are going down. Warning: this fund is NOT Steady Eddy. It is a leveraged play on interest rates, but with ample reward for being right. It can be punishing if rates go up, and has been very volatile as of late.

Afghanistan Update

My friends are leaving for Afghanistan Sunday. They were hoping to be able to use helicopters to go into Afghanistan from Tajikistan, but all helicopters have been grounded, which means they will have to do truck convoys to get food and medicines into the Northern Afghanistan area. This will not be a fun trip over freeways. It will be arduous and dangerous. Many of you wanted to know what the overhead expense is. There is none. They take no salaries and have no office. Everyone is a volunteer on their own nickel. These are truly the good guys. Pray for them. Not just for their safety but their backs A week in a truck in that type of country. Ouch.

They will be part of just a handful of people with experience in Afghanistan food relief over there.

You can still make donations to:

Knightsbridge International
P.O. Box 4394
West Hills, California 91308-4394

Make your checks out to Knightsbridge. Donations over $100 will get a video of the trip. I will be in contact with them and hope to get a few pictures by satellite to post on my web site. Do not be surprised if you see them pop up on the news.

Time to put out the pansies this weekend, as it gets cooler in Texas. I love this time of year. Next weekend, I leave for Bermuda to the biggest hedge fund conference of the year. I will take good notes and share the best ideas I find.

And yes, I actually broke 100 the second time I tried. My wife and I went for a day trip to Sedona. Sedona is one of the most beautiful parts of the world I have ever seen. I look forward to getting back and staying.

Have a great weekend,

Your in-Awe-of-God's-creation-analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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