First, a quick recap of the markets in July: Stocks were strong, with the Dow up 3% and the S&P500 up 1.76%. The Nasdaq continued a sharp ascent, climbing 6.92%. Small cap stocks were not far behind up over 6%. The trend of investors taking on more risk and investing in more speculative areas like biotech and internet stocks has not waned. 

The more noteworthy action, though, was in bonds. Bond prices have collapsed in recent weeks as yields have sharply risen. In July alone the Lehman Brothers long term treasury bond index was down an astounding 9.2% - one of the worst months on record (and proof that you can lose quite a bit of money in bonds). 

Over the trailing year ending July 31, our model portfolios were up anywhere from 10.17% for our safety portfolio to 26.28% for our aggressive growth portfolio. Over the same time frame the S&P500 was up 10.6% and the Lehman long term treasury bond index was up 5.33%. How did all our model portfolios beat bond and stock indexes when our portfolios are a blend of bonds and stocks and, unlike the indexes, the funds in the portfolios have fees?

We did it by investing in areas that we felt had the most opportunity, and shifting into stocks when stocks were weak. We intend to maintain this out performance going forward. 

At the end of July we made some changes to the model portfolios. We mentioned this was coming in our last newsletter, and alerted subscribers to the actual changes when we made them. 

Long-time MAXadvisor subscribers know (as does anyone who reads the archived portfolio commentary and changes sections) that we have not made many alterations to the model portfolios since we started them back in April 2002. While some of the moves we did make were to increase our allocations to certain areas, most were the result of funds closing or becoming load funds. These types of changes did not change our overall stock/bond/cash mix, and often did not even change the categories of funds in which we were invested.

What did we do and why did we do it?

For the specific moves we made in each portfolio, view the model portfolio changes and commentary pages (reachable from each model portfolio page). 

Our recent changes were subtle and keep with our overriding goals to keep portfolio turnover low (generally below 25% a year on average, except for the daredevil portfolio). The moves accomplished two things:

1) Reducing our equity exposure, particularly to areas that have been strong

2) Lowering our bond maturities and raising the credit quality of our bonds. 

Both moves should lower the overall risk profile of each affected model portfolio.

These changes were really undoing other moves we made last year. Some subscribers may recall that we decreased our cash positions and bought more bonds and stocks in many of our portfolios. At the time we felt stocks were cheap, especially given the paltry yield on money market type investments. The bond and stock market has been strong since last October, and we feel it’s time to make the portfolios a little more conservative.

Instead of moving back into cash, we are going into the Vanguard Short-Term Corporate fund (VFSTX) largely because cash is still such a poor investment and there is no sign the Federal Reserve will allow shorter term rates to climb. 

Shorter term, investment grade bonds are a safe investment, but they are not as safe as cash. When rates climb, as they did last month, investors can still lose some money, unlike with a money market fund. Last month this particular fund fell just under 1%. This is still a far shot from the near 10% investors lost in longer term government bonds. Shorter-term bond funds pay around 3% now, quite a bit more than money market funds and a risk generally worth taking.

Areas of the market we are lightening up on include real estate, micro cap and tech stocks as well as junk (high-yield), convertible, and foreign (including emerging market) bonds – all areas we have overweighed over the last year. Besides having valuations that are becoming a bit “stretched”, many of these areas have also seen inflows by individual fund investors.

Fund flows are one of the signals we use to warn us that an area of the market is getting ahead of its self. Too much money ruins a good thing, and the fact that fund investors are usually late to the party when investing.

Many of these areas are becoming less attractive because interest rates are moving higher. A few months back in this newsletter (October 15th to be exact) we wrote about how investing is often a relative game. Treasury bonds were yielding so little, as low as some stock dividend yields, that stocks represented a pretty good place to be. 

That analysis is shifting now that stocks are 25% higher in price across the board, and the treasury bond yield for a 10 year government bond is now paying about 4.5%, up from lows of 3.2%. Suddenly, a safe 4.5% is a pretty good yield. This can be particularly hard on investments that are considered bond substitutes because of the yield: categories such as real estate funds (which invest in high dividend REITs) and utilities funds. 

The whole rising rate scenario is particularly bad for real estate, as much of the gains made in real estate prices have been because of falling rates and the effect that has had on mortgage borrowing costs. Suddenly everyone can afford “more” home, which has done nothing but raise prices. At this point the only thing real estate has going for it is it tends to be a good inflation hedge, and inflation is something we may have more trouble with in the future than the general consensus feels right now.

Categories we have not lighted up on yet include Japanese and certain foreign stocks, which we think have some room for expansion.

One note about municipal bonds: we don’t use them in the model portfolios (we do use them in private accounts that we manage) because we have no idea what each subscribers individual tax situation is, or if subscribers have their money in taxable accounts or not. This does not mean we don’t like municipal bond funds. Investors who are in higher tax brackets should consider some Vanguard municipal bond funds if they don’t already own some. 

Municipal bond funds can be used as substitutes for regular short-term bond funds. Good examples include the Vanguard Short Term Tax Exempt fund (VWSTX), which yields 1.25% tax free. Higher risk investors can consider the Vanguard High Yield Tax Exempt fund, which yields 4.35% tax free (VWAHX). Municipal bonds are no panacea against rising rates, but the above average premium over treasury bonds offers some insulation. With municipal bond funds investors must go with low fee choices, otherwise you are paying the fund company's fees with your low tax income.

All this talk is not to alarm. We are not bailing out on stocks and bonds. These are just subtle shifts we make every so often to make sure we are properly diversified and not over-allocated in areas of the market that have been hot and have waning fundamentals.