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August 2019 Performance Review

September 7, 2019

Stocks gave back some of the gains made in August as economic and trade fears kept bubbling up. In this environment the bond market remained red hot as interest rates plunged yet again. This boosted our portfolios relative to benchmarks as we have been taking more interest rate risk (but less stock risk) than most other portfolios for quite a few years now. The stock market is still up around 18% for the year, including dividends, although it is up only about 2.8% over the last 12 months, as that includes the big slide late last year.

Our Conservative portfolio gained 1.93%. Our Aggressive portfolio gained 1.07%. Benchmark Vanguard funds for August 2019 were as follows: Vanguard 500 Index Fund (VFINX), down 1.59%; Vanguard Total Bond Market Index Fund (VBMFX), up 2.78%; Vanguard Developed Markets Index Fund (VTMGX), down 1.91%; Vanguard Emerging Markets Stock Index (VEIEX), down 3.76%; and Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 0.56%.

The 30-year U.S. government bond recently yielded less than 2%. This is a record low but is still quite a bit higher than foreign government bonds, many of which have negative yields. This partly explains the sudden attraction to the bond market here, though this phenomenon has been in place for quite some time — years, actually. Foreign investors aren't the only ones buying bonds; fund investors here have added tens of billions of dollars to bond funds, as fears circulate that the next recession will probably lead to another 50% drop in stocks, like the last two did — fool me thrice, shame on me. The problem with this strategy is that during the last two recessions, interest rates started high and you made money in higher-grade bonds as stocks and yields declined. We're at recession level interest rates but with boom time stock prices.

This bond market action led to some wild gains in our longer-term bond funds last month, notably with the ultra-rate-sensitive zero coupon bond ETF Vanguard Extended Duration Treasury (EDV) up 15.47% and Vanguard Long-Term Bond Index ETF (BLV) up 8.24%. These are the sorts of gains we'd expect in the next recession and big bear market, not during a time of low unemployment and near record levels in stocks.

Small caps, oil, and biotech were weak last month, leading to gains in most of our short positions as well, but not in our short gold ETN, which slid nearly 14%. Gold investors seem to think this is all going to end in inflation somewhere, or maybe now they are just trying to avoid the negative interest rates common abroad.

Looking ahead, the trouble is that we are running out of yield and upside in bonds. If stocks were very weak we'd definitely be switching from bonds to stocks. But stocks by many measures are also near historically high valuations, notably total market cap to GDP. Adding to the problems, shorter-term rates are going back down, with more drops on the way as the Fed tries to keep the economy out of recession and fight the yield curve inversion. We're also running large deficits, limiting our fiscal solutions to a future economic slowdown. Want more? Inflation isn't even that low, as it was a few years ago.

Small-cap value stocks had a surprisingly bad month with a drop of over 6%, while the S&P 500 was down just 1.6%. This has been a multi-year trend, with one of the widest performance gaps ever between large-cap growth stocks and small-cap value stocks over the last few years. As we noted years ago when we took on the inverse small-cap ETF while also owning larger cap growth funds, this was something we expected, but there was no small-cap value inverse ETF (just small cap in general) and no good way to make this bet over many years, other than merely avoid smaller cap value funds. Now it is time to consider the opposite position and shift from larger cap growth funds to smaller cap value.

It was all losses in overseas stocks, with the best of the losers being in Europe and Japan, down a mere 2%+, while emerging markets were down more in the 4—8% range. The best U.S. sectors last month were precious metals (up about 4.7%), utilities (up 2.7%), and real estate (up just over 2%). Pretty much everything else was down, especially the big 10% drop in energy, a sector that is actually looking interesting now after a terrible decade (roughly since the time everybody thought energy investing was such a great idea).

Best case: it is possible we've reached some sort of permanently high plateau in bonds and stocks, where there isn't going to be much upside in either but the economy is strong enough and inflation low enough (and the amount of money looking for investments great enough) that these markets sort of stick around these levels, but with some wild swings. Of course, in 1929, a few days before the 90% slide began, a now infamous economist said the stock market had reached what looked like a permanently high plateau, and destroyed an otherwise impressive career. Just on flows of money, which wildly favor bonds (unlike in 2000), stocks should beat bonds over the next 5—10 years. This doesn't matter much because right now everybody is concerned about the next 1—2 years.

Stock Funds1mo %
Proshares Ultrashort Russel2000 (TWM)9.20%
PowerShares DB Crude Oil Dble Short (DTO)8.02%
Vanguard Utilities (VPU)4.83%
Proshares Ultrashort NASDAQ Biotech (BIS)4.49%
iShares MSCI Italy Capped (EWI)-0.44%
[Benchmark] Vanguard 500 Index (VFINX)-1.59%
Vanguard European ETF (VGK)-1.65%
Vanguard Europe Pacific ETF (VEA)-1.88%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-1.91%
iShares Global Telecom ETF (IXP)-2.61%
Vanguard Telecom Services ETF (VOX)-2.78%
Vanguard Value (VTV)-2.97%
Homestead Value (HOVLX)-3.60%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-3.76%
iShares MSCI BRIC Index (BKF)-4.00%
Gold Short (DZZ)-13.95%
Bond Funds1mo %
Vanguard Extended Duration Treasury (EDV)15.47%
Vanguard Long-Term Bond Index ETF (BLV)8.24%
[Benchmark] Vanguard Total Bond Index (VBMFX)2.78%
SPDR Barclays Intl. Treasury (BWX)1.85%
Vanguard Mortgage-Backed Securities (VMBS)0.93%
Dodge & Cox Global Bond Fund (DODLX)-0.54%

July 2019 Performance Review

August 6, 2019

The U.S. market continued up in July and is back to record levels, erasing the losses of late 2018. With rising trade tensions as the catalyst and a backdrop of suspiciously low interest rates, August is looking to wipe out much of the recent gains with a roughly 800-point one-day drop in the Dow and interest rates plunging to levels last seen right before the last presidential election. We'll come back to the 800-point gorilla in the room after a review of last month.

In July, U.S. stocks did fine, while foreign stocks slipped. This, plus low positive returns in bonds, led to only slight gains in our more bond-heavy Conservative portfolio and slight losses in our more stock-heavy portfolio dragged down by foreign funds, more or less in line with the Vanguard STAR Fund, a global balanced portfolio, that we watch.

Our Conservative portfolio gained 0.63%. Our Aggressive portfolio declined 0.20%. Benchmark Vanguard funds for July 2019 were as follows: Vanguard 500 Index Fund (VFINX), up 1.43%; Vanguard Total Bond Market Index Fund (VBMFX), up 0.23%; Vanguard Developed Markets Index Fund (VTMGX), down 2.09%; Vanguard Emerging Markets Stock Index (VEIEX), down 1.19%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 0.52%.

Foreign markets are having a pretty good year but are lagging U.S. markets and were down in July. Healthcare was the main weak area in the United States, as constant talk of sticking it to the healthcare industry by both parties may be weighing on this industry, which has had years of above-market growth from increased subsidized health insurance and fast-rising prices for drugs and services. Our strongest areas in stocks last month were in value and telecom holdings, the latter boosted by new higher-technology stakes (which we are concerned about going forward from these levels).

Which brings us to the August situation. On the surface, this mini-slide started when the president re-upped his trade war tariff threats. Investors have seen many ups and downs in this often Twitter-based trade war with China, and frankly, the actual economic impact broadly speaking has been minimal. But then, the economy was strong and could shrug off minor issues. Now, with the bond market saying (through low long-term rates that are even lower than low short-term rates) that a global recession is coming soon, investors are getting nervous. We don't need a trade war with the number two economy in the world right now.

Adding relatively low tariffs to trade with one country was never really much of an economic drag for us. While there were certainly disruptions in specific industries, mostly commodities and agriculture, the consumer and most companies haven't felt much of a pinch.

This is partially explained by the fact that U.S. corporations are enjoying a major tax cut that exceeds by a wide margin the cost of tariffs they have to pay. Granted, some of the companies enjoying the most in tax breaks are not the ones paying the most in tariffs, but as a whole stock market, the tax cuts exceed the drag on earnings from tariffs. This doesn't mean that a trade war, if it doesn't achieve much, is a good idea, just that it shouldn't have to cause a recession.

But if you look at the history of sizable stock market slides, rarely was the trigger such a momentous economic event to warrant trillions in market value damage. In the last couple of decades, we had a crash from the Thai currency collapsing and from a default on old Soviet debt. Greece debt issues, which haven't even really gone away, once caused a major stir.

When you have jittery investors who have just seen fast gains over the previous years, you have an environment for a slide. Plus, we don't know what one relatively minor event leads to, because as Warren Buffett said, you don't know who is swimming naked until the tide goes out. For the record, Warren Buffett is sitting on a record amount of cash, probably waiting for the tide to go out so he can get some bargains.

Therefore, the real danger of a trade war with China is if we win, so to say. Most of the stuff coming in from China is really our brands anyway—we've basically set up factories or otherwise outsourced manufacturing to an efficient, low-cost, and low-regulation factory town. When was the last time you purchased an actual Chinese brand as opposed to just something made in China?

When we have a trade gap with China, it is because Apple makes phones in China and ships them here for sale. If the factory was in Texas (not going to happen, Apple just moved their last computer production from the United States to China), there would be a much smaller trade gap with China and a much higher price for phones and computers.

Through this lens, clearly we are paying the tariff. If the tariff threat ever does go up to include iPhones, either Apple is going to pay and eat the cost to keep the consumer price where it is or it is going to pass the cost on to the consumer. It could actually benefit Apple, because their leading competitor in higher-end phones, Samsung, makes their top-of-the-line phone in China. Apple has more money to subsidize tariffs. Maybe they'll have to pause their stock buyback program for a while.

How China pays is where the real economic trouble could happen. U.S. companies may cut down on demand from China. Walmart or, increasingly, Amazon may need less made-in-China items. If Apple doesn't eat the tariff and the price goes up, consumers may wait to buy a phone. All of this means that the suppliers in China temporarily lay off workers and stop buying from other suppliers. It could cause a recession—in China. Since China is a very leveraged high-growth country, this could cause unforeseen problems. Tesla is building a $2 billion factory near Shanghai. Without demand by the Chinese for these pricy cars, Tesla could default on debt.

It is worth noting that the manufacturing cost of most finished goods is a very small part of the retail price, so a 10% or even 25% increase in costs means a $100 sneaker may cost $1 more to manufacture. This isn't going to lead to much disruption to our consumers or our companies.

The latest shock to the market was when the Chinese currency declined in value, which we claim is currency manipulation, though it is exactly what you would expect if we bought less stuff in China and converted fewer dollars to Chinese currency.

On the plus side, interest rates are going so low so fast as to cause some sort of boost to an already pretty strong economy. This could all go away almost as fast as it has appeared. It really depends if people and companies go out and borrow more. Which will return us to the high-asset-price leveraged country that somehow can't handle even 2.5% short-term rates and not much higher long-term rates—which is what caused the short bear market last year in the first place.

Stock Funds1mo %
Proshares Ultrashort NASDAQ Biotech (BIS)6.59%
Vanguard Telecom Services ETF (VOX)3.43%
iShares Global Telecom ETF (IXP)2.50%
Homestead Value (HOVLX)2.17%
Vanguard Value (VTV)1.46%
[Benchmark] Vanguard 500 Index (VFINX)1.43%
PowerShares DB Crude Oil Dble Short (DTO)0.64%
Vanguard Utilities (VPU)-0.21%
Proshares Ultrashort Russel2000 (TWM)-0.79%
Gold Short (DZZ)-0.80%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-1.19%
iShares MSCI BRIC Index (BKF)-1.74%
iShares MSCI Italy Capped (EWI)-1.89%
Vanguard Europe Pacific ETF (VEA)-2.04%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-2.09%
Vanguard European ETF (VGK)-2.60%
Bond Funds1mo %
Dodge & Cox Global Bond Fund (DODLX)1.09%
Vanguard Long-Term Bond Index ETF (BLV)0.51%
Vanguard Mortgage-Backed Securities (VMBS)0.44%
Vanguard Extended Duration Treasury (EDV)0.44%
[Benchmark] Vanguard Total Bond Index (VBMFX)0.23%
SPDR Barclays Intl. Treasury (BWX)-1.29%

June 2019 Performance Review

July 4, 2019

The stock market continues to rebound from all the traumatic events of the past year or so. Strangely, this is not due to particularly strong expectations for growth globally; it appears to be mostly related to interest rates declining in anticipation of an economic slowdown. The rate decline pushed up bond prices again, keeping us more or less in the ballpark of more stock-heavy (and risky) portfolios.

Our Conservative portfolio gained 3.17%. Our Aggressive portfolio gained 3.49%. The results for benchmark Vanguard funds for June 2019 were as follows: Vanguard 500 Index Fund (VFINX), up 7.03%; Vanguard Total Bond Market Index Fund (VBMFX), up 1.15%; Vanguard Developed Markets Index Fund (VTMGX), up 5.93%; Vanguard Emerging Markets Stock Index (VEIEX), up 5.42%; and Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 5.07%.

While there are continued fears over the trade war leading to gyrations in stock prices, the real risk is whether we get a global economic slowdown — which, if it happens, probably won't be because of a relatively small trade war of a few billion dollars a year in taxes, a sum eclipsed by the tax cuts we have already received.

The stock market doesn't seem to think a real economic slowdown is in the cards as it makes record highs, but the bond market says a recession is likely — it is like two different economies.

Stock market investors are hoping that the low interest rates caused by fear of a global slowdown will lead to the economy avoiding a recession from the boosting of low rates. In addition, the expectation is now that the Federal Reserve will lower rates soon to fight the slowdown, and it will work maybe a little too well. Basically, investors are hoping the economy looks worse than it actually is and that low rates will juice the economy, just like the tax cuts and increased spending did last year. This may not be as crazy as it sounds, given we're even considering cutting rates to boost an economy with a 3.6% unemployment rate — and the short-term rates the Fed controls directly never broke 2.5% on the way up, which is less than half the level of before the 2008 recession.

None of this addresses how we will buy ourselves out of a serious recession, if one appears. We have government power split dysfunction again, and have already lowered taxes and increased spending — a de facto stimulus plan. All the Fed can do is lower short-term rates by a couple of percentage points, after which we have little available in turbo boost except more money creation to buy our own debt.

We will probably need to create money to buy our debt because our yearly deficit will quickly skyrocket above $1 trillion. It is already going to be around $900 billion for this fiscal year, and that's in good times. In 2009 the deficit about tripled to $1.4T from the previous year. Next time around we may have to raise taxes in a recession to keep the deficit under $2T. Or try Modern Monetary Theory, or MMT, the hipster central bank strategy of just printing money to pay for stuff. Apparently that is a question for another day, because record stock market closes continue…

Our only S&P-beating stock fund performer in June was iShares MSCI Italy Capped (EWI), up 9.72% as a rising euro and receding fears of politically oriented economic problems boosted prices. Yield-oriented funds such as Vanguard Telecom Services ETF (VOX), Vanguard Utilities (VPU), and iShares Global Telecom ETF (IXP) were our weakest non-short funds, with gains between roughly 3% and 4%. This was a month when the S&P 500 beat almost all fund categories, except in a few strong areas such as Latin America and Precious Metals. Our longer-term and foreign bonds did well compared to the bond index with a 3.43% return for SPDR Barclays Intl. Treasury (BWX), a 2.79% return for Dodge & Cox Global Bond Fund (DODLX) and a 2.69% return for Vanguard Long-Term Bond Index ETF (BLV).

Stock Funds1mo %
iShares MSCI Italy Capped (EWI)9.72%
[Benchmark] Vanguard 500 Index (VFINX)7.03%
Vanguard Value (VTV)6.44%
Vanguard European ETF (VGK)6.31%
iShares MSCI BRIC Index (BKF)6.03%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)5.93%
Vanguard Europe Pacific ETF (VEA)5.83%
Homestead Value (HOVLX)5.59%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)5.42%
iShares Global Telecom ETF (IXP)4.07%
Vanguard Telecom Services ETF (VOX)3.94%
Vanguard Utilities (VPU)3.35%
Proshares Ultrashort Russel2000 (TWM)-12.98%
Gold Short (DZZ)-15.04%
PowerShares DB Crude Oil Dble Short (DTO)-17.01%
Proshares Ultrashort NASDAQ Biotech (BIS)-17.04%
Bond Funds1mo %
SPDR Barclays Intl. Treasury (BWX)3.43%
Dodge & Cox Global Bond Fund (DODLX)2.79%
Vanguard Long-Term Bond Index ETF (BLV)2.69%
[Benchmark] Vanguard Total Bond Index (VBMFX)1.15%
Vanguard Extended Duration Treasury (EDV)0.75%
Vanguard Mortgage-Backed Securities (VMBS)0.68%

May 2019 Performance Review

June 5, 2019

The sharp rebound in stocks in early 2019 ended just as rapidly in May, with a 6.36% drop in the Vanguard 500 index fund including dividends. In late April, just days after the U.S. stock market broke through the old highs from September 2018 and gained back all the losses from late last year, stocks started falling. At one point in early June, the Nasdaq was back down around 10% from the recent highs—a percentage drop considered a correction (a bear market is 20%).

Last month's stock market weakness was pretty much across the globe, with no area showing positive returns. Bonds, however, continued to do well as interest rates plunged to the lowest levels since 2017. This interest rate action helped our portfolios fall much less than the market or the Vanguard balanced fund we use as a portfolio benchmark.

Our Conservative portfolio declined 0.50%. Our Aggressive portfolio declined 1.82%. Benchmark Vanguard funds for May 2019 were as follows: Vanguard 500 Index Fund (VFINX), down 6.36%; Vanguard Total Bond Market Index Fund (VBMFX), up 1.83%; Vanguard Developed Markets Index Fund (VTMGX), down 5.26%; Vanguard Emerging Markets Stock Index (VEIEX), down 6.45%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 3.90%.

What makes this behavior interesting is how it related to interest rates. Last year, the stock slide started because interest rates were going up somewhat sharply. The Federal Reserve was raising shorter-term rates and longer-term rates were creeping up as well. Then panic set in that rising rates might cause another recession, as the global economy seemed to be wobbling and trade war fears seemed menacing. After a few weeks of dropping late last year, the stock market was down around 20% from earlier highs or the level that is considered a bear market. The Federal Reserve calmed everyone down and noted they will not keep raising rates, but by then falling longer-term rates had already started declining.

After the holidays, the stock market turned around and the global economy looked a little better. Investors regained confidence that with lower rates and resulting lower mortgage rates, the economy should stay strong. Good jobs and GDP numbers this year helped with this narrative. Then a funny/not funny thing happened: rates kept going down, actually plunging in recent days, at one point down to around just 2.08% on the 10-year government bond. This equates to a sub 4% thirty-year mortgage. Rates were more than one full percentage point higher last November, at just over 3.2% for comparison. The fear now in stocks is that surely a recession is coming or why would interest rates be so low? Unlike past bouts of low rates, short-term rates are not about as high as longer-term rates, thanks to the Fed raising rates. This sort of spread further scares investors that we are heading into recession.

Where we go from here is either we're going to get a recession in the next year or so and the market will probably fall another 20% or more early in that trajectory of economic slowdown, or we start getting even hotter economic numbers boosted from the now lower interest rates, and then rates will climb back up with stocks and maybe inflation, hurting bonds.

With all that interest rate action trying to forecast our economic future, we have a parallel problem on the growth side of the stock market in technology. Some recent troubles at Tesla, Uber, and the like seem to point to no end in profitless growth for some hot tech names, while the hot tech names that actually mint money, like Google, Apple, and Facebook may be near the end of high margins and growth resulting more and more from their monopoly status.

In our portfolios, our own losses in stock funds were largely offset by gains in our short funds (except gold), which were all up double digits, and big gains in longer-term bonds with Vanguard Extended Duration Treasury (EDV) up 9.74% and Vanguard Long-Term Bond Index ETF (BLV) up 4.16%. Higher-risk bonds moved down with stocks, which is why Dodge & Cox Global Bond Fund (DODLX) was down 0.46%—our only negative bond fund last month.

The trouble going forward is we are losing our upside potential from our long-term bonds the lower rates go, though it is worth noting that rates are much lower in other major economies. At some point we're either going to have to move to stocks or short-term bonds. The trouble with short-term bonds is that although you are protected somewhat from rates going back up, you are not protected from rates going down even more. In all likelihood the Federal Reserve is going to be lowering rates later this year if the economy trips. This is going to send a 2% yield on shorter-term bond funds down towards 1% again. It might make more sense to just keep the longer-term bonds and slightly increase stocks, so you have more offsetting gains should rates go back up, hurting longer-term bonds.

Looking at fund investor behavior over the last six months of this wild stock and bond market has shown what not to do. First, back in October, investors started pulling money out of bond funds right as rates peaked and after some weak returns in bond funds, and bonds started to do well again. Then fund investors started taking money out of stocks more aggressively in December (with near $60 billion out that month alone) and January around the bottom in stocks. The money hasn't come back in much in stocks during the recovery earlier this year, but, broadly speaking, between bonds and stocks, stocks are less in favor with fund flows and probably are the better choice going forward if you can stomach the risk of being in stocks going into a recession.

Apparently the slide scared the Federal Reserve because on June 4th the market turned back up sharply on the near guarantee of lower rates and easy monetary policy from the Fed.

Stock Funds1mo %
PowerShares DB Crude Oil Dble Short (DTO)32.16%
Proshares Ultrashort Russel2000 (TWM)16.66%
Proshares Ultrashort NASDAQ Biotech (BIS)12.18%
Vanguard Utilities (VPU)-0.87%
Gold Short (DZZ)-2.95%
Vanguard Europe Pacific ETF (VEA)-5.21%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-5.26%
iShares Global Telecom ETF (IXP)-5.64%
Vanguard Telecom Services ETF (VOX)-5.66%
Vanguard European ETF (VGK)-5.67%
Homestead Value (HOVLX)-6.15%
Vanguard Value (VTV)-6.33%
[Benchmark] Vanguard 500 Index (VFINX)-6.36%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-6.45%
iShares MSCI BRIC Index (BKF)-7.70%
iShares MSCI Italy Capped (EWI)-8.31%
Bond Funds1mo %
Vanguard Extended Duration Treasury (EDV)9.74%
Vanguard Long-Term Bond Index ETF (BLV)4.16%
[Benchmark] Vanguard Total Bond Index (VBMFX)1.83%
SPDR Barclays Intl. Treasury (BWX)1.14%
Vanguard Mortgage-Backed Securities (VMBS)1.11%
Dodge & Cox Global Bond Fund (DODLX)-0.46%

April 2019 Performance Review

May 3, 2019

The stock market has recovered all of the losses since the previous peak in late September 2018. This quick reversal was largely because interest rates are now lower than last year, and the Federal Reserve will not spark the next recession by raising rates, as inflation is mild at best.

The U.S. economy, and now much of the world, seems not to be sliding into an economic slowdown. These are good reasons for the market not to drop by more than the 20% it fell late last year, but not really good enough reasons for new record highs.

Our Conservative portfolio gained 1.24% in April. Our Aggressive portfolio rose 1.31%. Benchmark Vanguard funds for April 2019 performed as follows: Vanguard 500 Index Fund (VFINX), up 4.04%; Vanguard Total Bond Market Index Fund (VBMFX), up 0.04%; Vanguard Developed Markets Index Fund (VTMGX), up 2.90%; Vanguard Emerging Markets Stock Index (VEIEX), up 2.08%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 2.61%.

With bonds weak in April and with a relatively low stock exposure, we had a hard time keeping pace with benchmarks. While stocks worldwide have been strong this year, foreign markets (unlike the U.S. market) are still below their peaks of early 2018 and are actually not far from their pre-crash 2007 levels. The U.S market, if we include dividends, has more than doubled from its pre-crash 2007 highs.

Much of this lackluster decade-plus return abroad has been due to a rising U.S. dollar, but better U.S. economic growth and more dynamic growth companies — and now a corporate tax cut — play a big part in the U.S. market's relative strength, as well as the strong dollar. Our interest rates are also significantly higher than those in foreign markets, which attracts capital, which boosts our currency. In 2008, one euro was worth about $1.60. Lately it has been kicking around $1.12, which is around a 30% decline.

Given the current low valuations abroad and the potential for the dollar to slowly slide over the next decade, returns from abroad should be higher. The problem with this forecast is that it is fairly popular, and there is still more money going into foreign funds than into domestic stock funds, though much of this is from rebalancing into the underperforming stock category. The euro can go lower too; it was worth only $0.80 back in 2002, before the big run up in foreign stocks.

Investors' money hasn't returned to stocks even though prices have rebounded. Stock buybacks from companies are probably a bigger driver than mutual funds and ETFs now. Money flows to stock funds in 2018, U.S. and foreign combined, were negative by about $50 billion — and turned negative for the year only in December 2018, right before the market took off.

Flows this year are still flat to slightly negative; investors aren't buying into it, and that is probably the best single sign for stocks at these elevated levels. Investors put in much more in early 2018, at the start of a rocky year. The actual investor return in the market has been worse than the market because of poorly timed investments, as is often the case.

In funds in April the telecom sector was hot, largely because of technology shares that have been infiltrating the holdings of these formerly conservative dividend-oriented funds. Facebook and its ilk have recovered nicely this year, boosting these funds. As a reference to how much these funds have changed, our holding Vanguard Telecom Services ETF (VOX), up 6.06% last month, now yields just over 1% compared to the Vanguard 500's roughly 1.9% yield. Traditionally, telecom funds have had higher yields than the market. AT&T has a roughly 6% dividend yield, and Verizon yields over 4%. Our newer global telecom fund, iShares Global Telecom ETF (IXP), up 5.17% last month, has seen the dividend yield drop by half as well, thanks to Facebook and Google pushing Verizon and AT&T to new lower allocations in the portfolio. We expect to exit these funds soon.

In bonds, all our holdings were down except our relatively new holding Dodge & Cox Global Bond Fund (DODLX), up 0.93%, as riskier bonds and some foreign bonds had a decent month relative to safer longer-term bond funds that take less credit risk.

The bottom line is that we may have dodged an economic bullet. Our current tax cuts and low interest rates may have coincided with an economic slowdown and essentially acted as a stimulus to avoid a slowdown, if not a full recession. This doesn't guarantee no more big slides in stocks or much higher highs, and most bear markets start well before recessions start anyway. Avoiding a recession and starting a new bull market are two different things.

We still have an epic boom in technology that will have to cool down at some point. It might make sense to hide in foreign value stocks, far away from the domestic craziness in growth stocks. On the plus side, investors are not that enthusiastic about U.S. stocks, and that usually means the market will be fine.

Stock Funds1mo %
Proshares Ultrashort NASDAQ Biotech (BIS)9.71%
Vanguard Telecom Services ETF (VOX)6.06%
iShares Global Telecom ETF (IXP)5.17%
Vanguard Value (VTV)4.06%
[Benchmark] Vanguard 500 Index (VFINX)4.04%
Vanguard European ETF (VGK)3.92%
Vanguard Europe Pacific ETF (VEA)3.27%
Homestead Value (HOVLX)2.99%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)2.90%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)2.08%
Gold Short (DZZ)1.98%
iShares MSCI Italy Capped (EWI)1.80%
iShares MSCI BRIC Index (BKF)1.16%
Vanguard Utilities (VPU)0.86%
Proshares Ultrashort Russel2000 (TWM)-6.26%
PowerShares DB Crude Oil Dble Short (DTO)-11.54%
Bond Funds1mo %
Dodge & Cox Global Bond Fund (DODLX)0.93%
[Benchmark] Vanguard Total Bond Index (VBMFX)0.04%
Vanguard Mortgage-Backed Securities (VMBS)-0.10%
SPDR Barclays Intl. Treasury (BWX)-0.55%
Vanguard Long-Term Bond Index ETF (BLV)-0.60%
Vanguard Extended Duration Treasury (EDV)-3.00%

March 2019 Performance Update

April 5, 2019

With the Federal Reserve now more worried about the global economy than inflation, investors continued to jump back into stocks — causing U.S. markets to almost completely erase the sharp slide late last year.

With our long-term bond funds performing well, many of our stock funds beating the S&P 500, and even most of our shorts doing well (except for oil), we actually outpaced the S&P 500 in both portfolios and beat our balanced fund benchmark by a fairly wide margin in March — all at a lower risk profile.

Our Conservative portfolio gained 2.41%. Our Aggressive portfolio gained 1.97%. Benchmark Vanguard funds for March 2019 were as follows: Vanguard 500 Index Fund (VFINX) up 1.94%; Vanguard Total Bond Market Index Fund (VBMFX) up 1.96%; Vanguard Developed Markets Index Fund (VTMGX) up 0.42%; Vanguard Emerging Markets Stock Index (VEIEX) up 1.90%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 1.17%.

Long-term interest rates have plunged, as the Federal Reserve said they will dial back the money furnace that was essentially removing about $50 billion a month from the economy — a very slow rate of burn to the near $4 trillion in quantitative easing or "QE" money minted during the financial crisis. The recent action means more of the interest payments coming into the Fed on the bonds they bought with fabricated money will get recycled back into new bonds — essentially creating demand in the bond market and pushing down rates. This means mortgages get cheaper and we've seen a 30-year mortgage rate go from around 5% to around 4% in the last few months. Just the talk of this balance sheet reduction slowdown led investors to pile into long-term bonds.

But unless the Fed is now totally wrong about the economy and the economy is hotter than it looks globally, being more "accommodative" isn't going to kick off new boom times. At best, we may just avoid a recession. Bottom line, it's great that the Fed didn't cause a recession by fighting inflation too aggressively, but that won't create a boom either. It might create inflation (unlikely), but even that can be good for stocks and real estate. This is why investors like a Fed that errs on the side of too much inflation.

Normally, when the market is strong our shorts are weak, but last month, small cap, biotech, and gold were down while the market as a whole was up, boosting our shorts. Oil did continue this year's rally, hurting our oil short as the oil slide from last year reversed on optimism about lower interest rates and some oil production cuts.

The large cap growth vs small cap value performance gap was one of the worst over what has been a fairly wide performance gap over time, resulting from small cap value being overvalued about a decade ago relative to larger cap growth stocks. Large cap growth funds were up just over 2% for the month, while small cap value funds were down just over 3%.

Utilities were our strongest regular stock fund holding, with Vanguard Utilities (VPU) up 2.83% followed by some foreign markets that are rebounding well this year, driving iShares MSCI BRIC Index (BKF) up 2.72%, iShares Global Telecom ETF (IXP) up 2.51%, and iShares MSCI Italy Capped (EWI) up 2.36%. In general, higher yield stocks do well when rates go down, as the dividend yield becomes more attractive. As long-term bonds had a great month, we saw a 7.47% jump in Vanguard Extended Duration Treasury (EDV) and a 4.87% rise in Vanguard Long-Term Bond Index ETF (BLV). Our strong U.S. dollar limited the gains of SPDR Barclays Intl. Treasury (BWX) at 0.89% and Dodge & Cox Global Bond Fund (DODLX) at 1.23%.

Stocks in China seem to be benefiting from what looks like an improvement in the trade war, with funds in this area up almost 4% for the month (bested only by a near 10% rise in stocks in India). Latin American stocks were the only really weak area abroad, with a just over 3% slide for the month. Latin America has been the worst area over the last 5 years. Like small cap value, Latin American stocks got way too popular in the early 2000s. Financial sector funds were the worst sector, down 3.6%, as investors think the flat-to-negative yield curve is going to be bad for earnings.

Stock Funds1mo %
Proshares Ultrashort Russel2000 (TWM)3.85%
Gold Short (DZZ)3.75%
Vanguard Utilities (VPU)2.83%
iShares MSCI BRIC Index (BKF)2.72%
iShares Global Telecom ETF (IXP)2.51%
iShares MSCI Italy Capped (EWI)2.36%
[Benchmark] Vanguard 500 Index (VFINX)1.94%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)1.90%
Vanguard Telecom Services ETF (VOX)1.80%
Homestead Value (HOVLX)0.91%
Vanguard European ETF (VGK)0.76%
Proshares Ultrashort NASDAQ Biotech (BIS)0.73%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)0.42%
Vanguard Europe Pacific ETF (VEA)0.17%
Vanguard Value (VTV)-0.12%
PowerShares DB Crude Oil Dble Short (DTO)-8.89%
Bond Funds1mo %
Vanguard Extended Duration Treasury (EDV)7.47%
Vanguard Long-Term Bond Index ETF (BLV)4.87%
[Benchmark] Vanguard Total Bond Index (VBMFX)1.96%
Vanguard Mortgage-Backed Securities (VMBS)1.41%
Dodge & Cox Global Bond Fund (DODLX)1.23%
SPDR Barclays Intl. Treasury (BWX)0.89%

Febuary 2019 Performance Review

March 7, 2019

The market continued to recover quickly from the slide late last year. This year, the leaders are mostly the areas that fell the hardest during the mini-bear market of 2018. With foreign markets, value stocks, and lower credit risk bonds weak in February and our relatively low allocation to the hotter areas of the market (like tech and small cap), our model portfolios lagged the U.S. market.

Our Conservative portfolio gained 0.93%. Our Aggressive portfolio gained 0.73%. Benchmark Vanguard funds for February 2019 were as follows: Vanguard 500 Index Fund (VFINX), up 3.20%; Vanguard Total Bond Market Index Fund (VBMFX), down 0.06%; Vanguard Developed Markets Index Fund (VTMGX), up 2.18%; Vanguard Emerging Markets Stock Index (VEIEX), up 0.65%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 2.31%.

Our best performers were Homestead Value (HOVLX) and Vanguard Utilities (VPU), with 4.73% and 3.88% returns in February. This was a relatively weak month for value- and dividend-oriented stocks, so these were, to a certain extent, outliers. Telecom stocks were weak globally, with Vanguard Telecom Services ETF (VOX) and iShares Global Telecom ETF (IXP) barely up at all. Other than a 1.63% return shorting gold with Gold Short (DZZ), our weakest areas, as you would imagine, were short funds as global stocks and oil rose.

In bonds, all our funds fell except for a relatively new holding Dodge & Cox Global Bond Fund (DODLX), which is actively managed (not an index fund) and takes a little more credit risk than our other holdings that were held down by slightly rising interest rates.

The hottest areas last month included U.S. small-cap growth funds, up just over 6% in February, almost double the S&P 500. Stocks in China were hot, as their economy and stock market probably have more to gain if this trade war winds down because they have seen more of a drag to both.

Emerging markets in general performed about as well as the U.S. market last month. Investors were comfortable with risk again as higher credit risk bonds did well, even as safer, longer-term bonds were down. Technology stocks continued a sharp rebound, though energy stocks didn't rise with oil prices.

Much of this rebound is driven by relief that the Federal Reserve is no longer on inflation watch, risking causing our next recession to fight it. In addition to not raising shorter term rates more, the Federal Reserve is likely going to slow—if not stop—the already slow unwinding of the so-called "balance sheet".

In brief, this is the roughly $4 trillion in new money the Fed created during the financial meltdown and its aftermath to counter the money destruction and deflationary forces in a crashing economy. The Fed essentially created money out of thin air, bought bonds mostly from the U.S. Government, then sat on those bonds, collecting interest. This put new money into the system and lowered longer-term interest rates including, importantly, mortgage rates. They called this process "Quantitative Easing", or QE, rather than "New Money Maker" or something that might frighten investors.

The unwinding means the Fed essentially burns the interest payments they were receiving monthly—to the tune of around $55 billion a month—in a digital furnace. This is the opposite of what they were doing when they created money in the crash aftermath years. Investors started getting scared this printing press in reverse was going to cause a recession, so the Fed is now considering collecting the interest payments and just buying more debt with them (as opposed to destroying the payments and making the money pool shrink). This means in the next recession we'll probably just start creating even more money out of thin air to buy bonds again because, even in a good economy, we can barely destroy some of the new money created in the last recession without a mini-meltdown.

While this all seems quite scary, it is still one step away from actually creating money to buy government debt and then saying "Forget it. You don't owe us anything, U.S. Government. Keep the new money." That is called monetizing the debt and, officially, we are not there yet. Even monetizing the debt is still a step away from just printing money and paying bills, like they apparently have been doing in Venezuela.

The important distinction between us and Venezuela is we can still reverse engines if inflation picks up. In fact, we have more power to stop inflation than perhaps at any time in history because we can just sell our $4 trillion in bonds and destroy the proceeds. Imagine selling a bond you own, getting cash out from the bank, and burning it in the backyard—that money is gone from the system. You are shrinking the money supply and doing the opposite of leaving that money in the bank, where it would become available to make new loans.

But the danger here is not inflation, even though it seems the obvious risk attached to creating money to fix problems. The danger is deflation and recessions that can't be fixed, even by unorthodox monetary policy. Since our government is now growing the yearly deficit again significantly—just recently, we started moving close to a gap of $1 trillion a year between what we collect in tax revenues and what we spend—our ability to fight the next recession with more tax cuts and interest rate cuts is diminishing. Nobody wants to shore up the budget, and investors freak out when interest rates go up. We're trapped.

This situation could increase the severity of our next recession and the next bear market

Stock Funds1mo %
Homestead Value (HOVLX)4.73%
Vanguard Utilities (VPU)3.88%
iShares MSCI Italy Capped (EWI)3.74%
[Benchmark] Vanguard 500 Index (VFINX)3.20%
Vanguard European ETF (VGK)3.16%
Vanguard Value (VTV)2.86%
Vanguard Europe Pacific ETF (VEA)2.33%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)2.18%
Gold Short (DZZ)1.63%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)0.65%
Vanguard Telecom Services ETF (VOX)0.37%
iShares Global Telecom ETF (IXP)0.31%
iShares MSCI BRIC Index (BKF)0.26%
Proshares Ultrashort NASDAQ Biotech (BIS)-5.78%
Proshares Ultrashort Russel2000 (TWM)-9.50%
PowerShares DB Crude Oil Dble Short (DTO)-10.01%
Bond Funds1mo %
Dodge & Cox Global Bond Fund (DODLX)0.86%
[Benchmark] Vanguard Total Bond Index (VBMFX)-0.06%
Vanguard Mortgage-Backed Securities (VMBS)-0.07%
Vanguard Long-Term Bond Index ETF (BLV)-0.79%
SPDR Barclays Intl. Treasury (BWX)-1.08%
Vanguard Extended Duration Treasury (EDV)-1.77%

January 2019 Performance Review

February 6, 2019

What December took away January gave back. With the sharp rebound that started right after Christmas, the stock market has recovered a little over half the losses from the 20%+ drop that started in late September. The primary support has been low interest rates (which have also helped bond prices). Earnings have been good enough to beat reduced expectations. The fund categories that have lagged the most over the last 5+ years were leaders in January, the main exception being technology-oriented funds that have been top performers over the last five years and in January, bouncing back from a sharp decline in late 2018.

Our Conservative portfolio gained 3.34%. Our Aggressive portfolio gained 3.15%. Benchmark Vanguard funds for January 2019 were as follows: Vanguard 500 Index Fund (VFINX), up 8.00%; Vanguard Total Bond Market Index Fund (VBMFX), up 1.01%; Vanguard Developed Markets Index Fund (VTMGX), up 7.36%; Vanguard Emerging Markets Stock Index (VEIEX), up 8.52%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 5.90%.

These don't seem to be the most impressive figures for our model portfolios relative to the S&P 500 until you consider the recent downside as well. In December, the Vanguard 500 fund was down 9.04% and the Vanguard STAR fund was down 4.73%, as opposed to only a fractional decline in our Conservative portfolio and a 1.66% decline in our Aggressive portfolio. Our upside in January was significantly higher than the inverse of our downside, unlike these benchmarks. That said, much of this was the benefit of long-term interest rate exposure and, with rates now fairly low again, this upside potential and downside protection will diminish, which means we will have to take on more stock market risk to maintain significant upside which will increase downside as well.

It's looking like we missed a brief opportunity to increase our risk level and capture more upside, but the bottom in this 20% decline didn't last very long. Without a global recession, the stock market likely won't drop 20% to 50%. This is basically what happened in 2011 when problems in Europe led to a 20% slide in U.S. stocks, which then recovered— things just didn't get bad enough for it to drop more. There is just too much money piling in on dips (including companies buying back their own stock in big numbers), especially when the alternatives—bonds—are now yielding significantly less than in late 2018. That said, investors are on edge waiting for the bull market and economic expansion to end, so the selloff could be even more significant.

This recovery is also likely not the beginning of higher records for stocks. The rest of the world isn't doing that well, and the possibility of the U.S. having problems buying its way out of the next recession (as we already have tax cuts and increased spending) could start to be a concern. We need this economy to remain strong to get us financially stable for the next trouble zone.

Our top performer was iShares MSCI BRIC Index (BKF), up 11.6% as emerging markets rebounded and the U.S. dollar weakened slightly. Latin American stocks were the primary driver, up over 15% for the month. China has been a drag during the trade-war scuffle but recently turned around by having the second-best larger international market performance of the month.

Stocks from India were actually down but have been the hottest foreign market over the last five years.

Now that the index providers have turned telecom stocks into information-technology stocks, essentially by adding Facebook and the like, it is no surprise that Vanguard Telecom Services ETF (VOX) is now one of our most volatile holdings. This worked in our favor in January with a 10.56% return, followed by the recently added iShares Global Telecom ETF (IXP), up 9.07%.

Dodge & Cox Global Bond Fund (DODLX) was up 2.54% as this newish holding for us benefited from a slightly weak dollar and falling interest rates. We no longer own it, but higher-risk bonds did well in January, with high-yield (junk) bonds delivering about 4%, recovering much of their sharp losses of late 2018.

The last will be first as many of the worst places to be over the last 5+ years led the returns in January. Smaller cap value funds in general where tops—up over 11% after the worst five-year showing relative to other U.S.-style categories. The gap was significant even with this turn, as small cap value delivered annual returns of just under 5% over the last five years and larger cap growth gained just over 10%.

The hottest sector was energy-related funds, up around 14% for the month but also the worst- performing five-year sector.

Stock Funds1mo %
iShares MSCI BRIC Index (BKF)11.60%
Vanguard Telecom Services ETF (VOX)10.56%
iShares Global Telecom ETF (IXP)9.07%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)8.52%
iShares MSCI Italy Capped (EWI)8.10%
[Benchmark] Vanguard 500 Index (VFINX)8.00%
Vanguard Europe Pacific ETF (VEA)7.47%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)7.36%
Vanguard Value (VTV)6.95%
Vanguard European ETF (VGK)6.68%
Homestead Value (HOVLX)5.98%
Vanguard Utilities (VPU)3.72%
Gold Short (DZZ)-5.00%
Proshares Ultrashort Russel2000 (TWM)-19.60%
Proshares Ultrashort NASDAQ Biotech (BIS)-23.35%
PowerShares DB Crude Oil Dble Short (DTO)-34.61%
Bond Funds1mo %
Dodge & Cox Global Bond Fund (DODLX)2.54%
Vanguard Long-Term Bond Index ETF (BLV)1.86%
SPDR Barclays Intl. Treasury (BWX)1.41%
[Benchmark] Vanguard Total Bond Index (VBMFX)1.01%
Vanguard Mortgage-Backed Securities (VMBS)0.83%
Vanguard Extended Duration Treasury (EDV)0.18%

December 2018 Performance Review

January 10, 2019

On Christmas Eve in this very rocky December, the stock market, as measured by the S&P 500, was down 20% from its October peak. Technically, this wasn't officially a bear market as the price slide from the peak closing value in the S&P 500 to the bottom in late December was just shy of 20%. Officially, the market needs to be down 20% from a market close to market close. Unofficially, this is a silly concept, and any 20% drop from a high in the market should qualify as something bigger than a "correction" (itself an overly positive term), which is a 10% drop. Whatever you want to call it, we haven't had many of these drops since the 2009 bottom, which is one reason investors are skittish—the good times have to end eventually, right?

Any way you slice it, December was the sort of month where the benefit of not taking on too much risk and avoiding popular strategies worked, basically the opposite tack from the previous months.

Our Conservative portfolio declined 0.35% in December. Our Aggressive portfolio fell 1.66%. Benchmark Vanguard funds for December 2018 were as follows: Vanguard 500 Index Fund (VFINX) down 9.04%; Vanguard Total Bond Market Index Fund (VBMFX) up 1.80%; Vanguard Developed Markets Index Fund (VTMGX) down 5.37%; Vanguard Emerging Markets Stock Index (VEIEX) down 2.97%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 4.73%.

December was among our best performances relative to the S&P 500 since these model portfolios started in early 2002. It's way too early to brag, and we were lagging during the last months of this bull market such that our returns relative to the stock market are still so-so. Still, if you like sleep-at-night downside risk, it was a good near-bear market for us.

For 2018 as a whole, our performance was underwhelming but acceptable. Our Aggressive portfolio was down 5.24% compared to the negative 4.52% showing for the Vanguard 500 fund in 2018 (with dividends). Our Conservative portfolio dipped just 2.81%. The Vanguard Star fund, our globally balanced benchmark, was down 5.34% for the year. What was most interesting about 2018 was how lousy "diversified" portfolios did, even ones that are balanced with bonds and stocks. Vanguard Star Vanguard Star Fund (VGSTX) is 60% stocks and 40% bonds, and it fell more than the S&P 500 and our portfolios.

2018 was the worst year for a globally balanced portfolio since 2008. This was largely because bonds were down significantly in 2018, especially longer-term and higher-credit-risk bonds, and foreign markets were down sharply. Just looking at market gyrations up and down, we're taking less risk than the market and less even than most balanced funds. According to one hedge fund tracker, the average hedge fund fell over 4% in 2018 as the highest-paid experts in minimizing downside had trouble doing just that.

The few positive return areas in December (if not the year) included longer-term and investment-grade bond funds like those we own in the portfolios. All bond funds except short-term bond funds with limited interest rates and credit exposure (including our holdings) were actually down for the year. Still, the rebound in bond funds in December was a key reason our portfolios didn't fall much during this rough month.

Higher-yield, higher-credit-risk bonds performed poorly for the year and month as these areas tend to have near-stock-market downside during market corrections and less upside than stocks during rebounds. Selling our position in Artisan High Income Fund (ARTFX), a higher-credit-risk bond fund, in June proved timely as this fund, which was up solidly in 2016 and 2017 and early 2018, slid 5.27% in the last three months of 2018 year.

The only fund sector in positive territory in 2018 was utilities. Our own Vanguard Utilities (VPU) holding was down 4.12% in December but still delivered a positive 4.37% for the year. After technology, utilities have shown the highest returns over the last five years in sector mutual funds, sort of amazing in this growth-oriented market. Considering the lower down side, the risk/reward has been very good.

Unfortunately, our inverse MLP (Master Limited Partnerships) fund was shut down for lack of investor interest in 2018 right before shorting energy-related investments started working very well. This could have helped our Conservative portfolio score even better numbers in 2018. MLPs fell as much as 20% in the last three months of 2018 and were down double-digits for the year. Our oil short PowerShares DB Crude Oil Dble Short (DTO) was up 18.59% after a 45%+ gain the previous month, yet only delivered a 13.77% return for the year. The smart move would have been doubling up on this holding when the short MLP fund was closed.

Shorting in general obviously worked well in December, except for shorting gold. Proshares Ultrashort Russel2000 (TWM) was up 26.35% for the month for a 19.19% year, while Proshares Ultrashort NASDAQ Biotech (BIS) gained 24.40% but was only up 5.18% for the year.

Conceptually, our call to favor large cap and short small cap in recent years was right in the sense that large cap funds were up 6.6% on average per year over the last five years, while small cap funds were only up 3.2%. The gap was even bigger between large cap growth and small cap value—the latter up just 1.86% per year over the last five years. But, as we noted, there were no ETFs with which to do that other than shorting small cap value ETFs directly. Our short positions in inverse ETFs dwindled during the booming market (because they are flawed products) such that the offsetting gains where limited here.

So, is this a dip to buy or the start of a 50% slide?

When the market broke down in 2007 and 2008, we saw similar relative performance benefits in our portfolios compared to falling benchmarks. We also increased the risk level on the way down in that bear market by increasing our stock allocation. This worked when the eventual recovery hit. We have no way of knowing if this market slide will continue or rebound quickly (as it did after the 2011 slide and appears to be happening in January so far). Either way, a 20% decline is an opportunity for any portfolio that isn't on a fixed-risk level (say, 60% stocks, 40% bonds permanently) to start increasing risk. If the market goes down 50%, we aim to be as aggressive as we were in early 2009, meaning our downside risk can start increasing on the way down in order to boost our upside.

Stock Funds1mo %
Proshares Ultrashort Russel2000 (TWM)26.35%
Proshares Ultrashort NASDAQ Biotech (BIS)23.40%
PowerShares DB Crude Oil Dble Short (DTO)18.59%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-2.97%
iShares MSCI Italy Capped (EWI)-3.36%
Vanguard Utilities (VPU)-4.12%
Vanguard European ETF (VGK)-4.86%
iShares MSCI BRIC Index (BKF)-5.18%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-5.37%
Vanguard Europe Pacific ETF (VEA)-5.70%
iShares Global Telecom ETF (IXP)-6.45%
Homestead Value (HOVLX)-7.94%
Vanguard Telecom Services ETF (VOX)-8.27%
[Benchmark] Vanguard 500 Index (VFINX)-9.04%
Gold Short (DZZ)-9.08%
Vanguard Value (VTV)-9.16%
Bond Funds1mo %
Vanguard Extended Duration Treasury (EDV)8.06%
Vanguard Long-Term Bond Index ETF (BLV)4.36%
SPDR Barclays Intl. Treasury (BWX)2.09%
[Benchmark] Vanguard Total Bond Index (VBMFX)1.80%
Vanguard Mortgage-Backed Securities (VMBS)1.66%
Dodge & Cox Global Bond Fund (DODLX)0.89%

November 2018 Performance Review

December 6, 2018

November was a rocky month for stocks and bonds, but it ultimately ended on a positive note. Our portfolios did well compared to the Vanguard STAR fund, which has recently had more downside than our portfolios and potentially less upside as investors shift their portfolio strategies.

Our Conservative portfolio gained 1.04% in November, and our Aggressive portfolio gained 2.15%. Benchmark Vanguard funds for November 2018 were as follows: Vanguard 500 Index Fund (VFINX) up 2.03%; Vanguard Total Bond Market Index Fund (VBMFX) up 0.53%; Vanguard Developed Markets Index Fund (VTMGX) up 0.39%; Vanguard Emerging Markets Stock Index (VEIEX) up 4.45%; and Vanguard Star Fund (VGSTX), a total global balanced portfolio, up 1.30%.

Just a few weeks ago, fast-rising interest rates risked dragging the housing market (and possibly the entire economy) into a mild recession. Now falling interest rates are indicating a possible recession on the horizon. There seems to be a very small band of acceptable interest rates.

The initial take by professional investors when rates went up was that they were going up for the right reasons, which means the economy is booming, demand to borrow is high, and inflation is picking up. This narrative quickly changed when stocks started to drop, and a prevailing view emerged that significantly higher rates would cause a recession for a variety of reasons, including a too-strong dollar, real estate market issues, and the great unknown of trillions in corporate debt.

When interest rates drifted back down, things improved for stocks. In recent weeks, the benchmark 10-year government bond rate drifted up towards 3.25% on several days, which equates to roughly a 5% 30-year fixed rate mortgage; each time this happened, stocks slipped hard and then recovered as rates drifted back down.

Now we are facing a more disturbing situation since the benchmark rate has sunk below 3%: rates are going down for the wrong reasons, which means a recession could be coming, and low inflation and demand for safe investments will push rates right back down to the levels we saw a year or more ago.

This drop in rates has been good for bonds and yield-oriented investments and helped our portfolios—we are effectively recession-ready relative to other portfolios. Our top three stock funds were all value- and yield-oriented, and they beat the S&P 500: Homestead Value (HOVLX), Vanguard Utilities (VPU), and Vanguard Value (VTV) went up 4.42%, 3.92%, and 3.27%, respectively. These three were only bested by our short on oil PowerShares DB Crude Oil Dble Short (DTO) and iShares MSCI BRIC Index (BKF) riding a reversal in emerging markets in general and stocks in India in particular, for a 6.48% gain.

Larger-cap value funds were the best performers in U.S. stock funds last month. Emerging market stocks and bonds had a nice run after a terrible year. These areas could see a move up if investors start to look somewhere else for risk besides U.S. tech.

The rising economic fear has also been bad for oil, which slid more in recent weeks than even after the 2008 commodity bubble burst. The trigger may have been increased output by Saudi Arabia and Russia in anticipation of Iran sanctions that never came in earnest. Fears of a recession and leveraged gamblers in the oil market unwinding their positions didn't help either. We saw a 45% gain in November shorting oil with 2x leverage in PowerShares DB Crude Oil Dble Short (DTO) after an 18% gain in October. Don't be too excited since the fund is still down slightly for the year because oil rose substantially during the economic optimism of recent months, setting up shorting oil as a good hedge against a recession. Shorting small-cap stocks and biotech stocks lost money in November as riskier stocks recovered after the slide in October.

Stock Funds1mo %
PowerShares DB Crude Oil Dble Short (DTO)45.61%
iShares MSCI BRIC Index (BKF)6.48%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)4.45%
Homestead Value (HOVLX)4.42%
Vanguard Utilities (VPU)3.92%
Vanguard Value (VTV)3.27%
[Benchmark] Vanguard 500 Index (VFINX)2.03%
iShares MSCI Italy Capped (EWI)1.36%
iShares Global Telecom ETF (IXP)1.22%
Vanguard Europe Pacific ETF (VEA)0.51%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)0.39%
Gold Short (DZZ)-0.33%
Vanguard European ETF (VGK)-0.68%
Vanguard Telecom Services ETF (VOX)-0.74%
Proshares Ultrashort Russel2000 (TWM)-3.77%
Proshares Ultrashort NASDAQ Biotech (BIS)-10.13%
Bond Funds1mo %
Vanguard Extended Duration Treasury (EDV)2.18%
Vanguard Mortgage-Backed Securities (VMBS)0.90%
SPDR Barclays Intl. Treasury (BWX)0.85%
[Benchmark] Vanguard Total Bond Index (VBMFX)0.53%
Vanguard Long-Term Bond Index ETF (BLV)0.40%
Dodge & Cox Global Bond Fund (DODLX)0.19%

October 2018 Performance Review

November 4, 2018

Ouch. The good times ended in October and rather suddenly at that. There are many straws out there, and it's impossible to know which one broke the market's back but break it did.

The best explanation, which is one part voodoo and one part real economics, was that the market has been up for so long that investors were looking for signs that the music was going to stop. The sign was rising interest rates leading to fears that the global economy and real estate market couldn't handle higher rates. This in turn led to worry that tech stocks have risen so far so fast that the downside is exceeding the upside.

In October, our Conservative portfolio declined 3.52%. Our Aggressive portfolio declined 3.11%. Benchmark Vanguard funds for October 2018 were as follows: Vanguard 500 Index Fund (VFINX) down 6.85%; Vanguard Total Bond Market Index Fund (VBMFX) down 0.73%; Vanguard Developed Markets Index Fund (VTMGX) down 8.49%; Vanguard Emerging Markets Stock Index (VEIEX) down 7.58%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 5.71%.

Even with our interest-rate-sensitive portfolios with significant foreign exposure (a performance drag), we fell significantly less than the S&P 500. More notable is that the global total portfolio benchmark that we also aim to beat over time, the Vanguard STAR fund, was down 5.71%, almost as much as the S&P 500 and quite a bit for a diversified global portfolio that is only 60% stocks. We're trying to deliver a better risk/reward tradeoff than this balanced fund (not an easy task given this is a great low-fee total portfolio fund, but we aim high) but have been lagging it recently on the way up. As you can see, such upside performance often comes at a price—Vanguard STAR was taking quite a bit more downside risk than we were.

One reason balanced portfolios fell in October is that all categories fell. That has become the new problem with building portfolios: there is nowhere to hide when the drops come but low-return cash. Diversification doesn't really work anymore.

The best-performing fund categories in October were precious metals, utilities, and Latin America. Not coincidently, precious metals funds and Latin American funds have some of our highest category ratings on MAXfunds: 91 and 97, respectively. We're still short gold because we don't believe it has any long-term investment merit, and our limited stake in Latin American stocks in our iShares MSCI BRIC Index (BKF) fund was offset by losses in the RIC part—Russia, China, India—of BRIC (though the fund fell less than emerging markets in general).

Other areas of relative strength include value stocks in general, an area we are focusing more on after the big run in growth and tech this past decade or so. But our only traditional stock fund that posted a gain was Vanguard Utilities (VPU), up 1.17%—even Vanguard Value (VTV) was down 4.35%.

Homestead Value (HOVLX) dropped 9.03% despite being a value fund because it's somewhat of a tech value fund now. The fund's holdings are probably more economically sensitive than many other value funds, and the fears of rates hurting the economy hit this fund hard.

All our bond funds where down, but long-term bonds fell the hardest with Vanguard Extended Duration Treasury (EDV) down the most at 4.61%. Long-term rates shouldn't go up much from here (at least not quickly without risking much more downside to stocks). You'd rather be in long-term bonds with the moderate loss you will take than the stock alternatives if rates climb quickly.

The shining stars of October were our three short funds, all up high double digits: PowerShares DB Crude Oil Dble Short (DTO) up 18.6%, Proshares Ultrashort Russel2000 (TWM) up 24.56% and Proshares Ultrashort NASDAQ Biotech (BIS) up 33.42%. These funds, which can slowly go to nothing over time as markets long term go up, can be useful in a crash scenario. We should have rebalanced into a short tech fund because our short stake was so small after dwindling in value in the portfolio from losses in the bull market as to have minimal upside performance impact. That said, we did beat the balanced portfolios out there and these funds are a good part of the reason our "riskier' aggressive portfolio actually fell by less than our short-fund-free conservative portfolio.

Stock Funds1mo %
Proshares Ultrashort NASDAQ Biotech (BIS)33.42%
Proshares Ultrashort Russel2000 (TWM)24.56%
PowerShares DB Crude Oil Dble Short (DTO)18.60%
Vanguard Utilities (VPU)1.17%
Gold Short (DZZ)-3.47%
Vanguard Value (VTV)-4.35%
Vanguard Telecom Services ETF (VOX)-6.20%
iShares MSCI BRIC Index (BKF)-6.32%
iShares Global Telecom ETF (IXP)-6.79%
[Benchmark] Vanguard 500 Index (VFINX)-6.85%
Vanguard European ETF (VGK)-7.53%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-7.58%
Vanguard Europe Pacific ETF (VEA)-8.26%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)-8.49%
Homestead Value (HOVLX)-9.03%
iShares MSCI Italy Capped (EWI)-9.44%
Bond Funds1mo %
Vanguard Mortgage-Backed Securities (VMBS)-0.57%
[Benchmark] Vanguard Total Bond Index (VBMFX)-0.73%
SPDR Barclays Intl. Treasury (BWX)-1.65%
Dodge & Cox Global Bond Fund (DODLX)-1.77%
Vanguard Long-Term Bond Index ETF (BLV)-3.22%
Vanguard Extended Duration Treasury (EDV)-4.61%

September 2018 Performance Review

October 7, 2018

In early October the unemployment rate dropped to its lowest level since 1969. This is sending interest rates back up to 'normal' levels. The difference this time is the stock market is now sinking along with bonds.

In September, larger market value stocks crept up slightly in the U.S. while smaller-cap stocks fell. Abroad was a similar story — big companies in major economies were up marginally while riskier emerging market stocks continued to sink.

Bonds where weak across the board with bigger drops in longer-term interest rate sensitive bonds as rates continued to move up on good economic news and general optimism. The backdrop of a strong economy helped junk bonds and higher risk debt score fractional gains as defaults seemed less likely. All in, our benchmark global balanced fund by Vanguard was down fractionally, as was our Aggressive model portfolio. The recent changes to our Conservative model portfolio helped it eke out a positive month.

Our Conservative portfolio gained 0.18% in September. Our Aggressive portfolio declined 0.37%. Benchmark Vanguard funds for September 2018 were as follows: Vanguard 500 Index Fund (VFINX) up 0.55%; Vanguard Total Bond Market Index Fund (VBMFX) down 0.54%; Vanguard Developed Markets Index Fund (VTMGX) up 0.73%; Vanguard Emerging Markets Stock Index (VEIEX) down 1.31%; Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 0.18%.

The strong economy is pushing interest rates up, which so far has been good for U.S. stocks and higher risk bonds. Foreign stocks and bonds have been weak as the brunt of the trade war seems to be hitting markets that export to us.

But there also could be another reason that rates are going up that is not just the backdrop of a growing economy with rising inflation. In fact, inflation isn't rising that fast — nor are wages, which would warrant higher interest rates across the board. No, what we may be seeing is just too much borrowing.

Our government is now increasing borrowing in a strong economy that normally would lead to a slowly shrinking yearly deficit (as was the case in recent years and is the case with most foreign governments). Corporations are borrowing more too. While a handful of tech companies are swimming in trillions in cash, most are still borrowing, and a good chunk have credit ratings that are either junk grade or just marginally investment grade — they're basically subprime borrowers. Lucky for them bond fund managers and increasingly index funds keep loading up on borderline junk debt just like investors did with low grade mortgage debt in the mid 2000s.

These companies seem to be using the increased cash flow from tax cuts to buy back more stock and not pay off debt, which is good for stock prices, but not bonds. In fact, the tax cuts make debt less valuable in financial engineering because the tax deduction of interest rates becomes less valuable. The problem is twofold — CEOs are compensated (highly) when stock prices rise. Paying off debt doesn't increase the value of their stock options like buying back stock does.

In the movie Scarface a young climber up the criminal ladder played by Al Pacino is given sage advice by a more conservative successful drug dealer: Don't get high of your own supply. Today many companies are high off of their own supplies of bonds. Buying other companies, buying back stock etc.

Low interest rates and debt-hungry investors make it all work, at least for now. But many of these marginal businesses are in no position to handle higher interest rates. They need to stop buying stock at high prices and start paying down debt because refinancing at 2-3 percentage points higher isn't going to work — companies that need to leverage are already having problems. GE's stock price is not far off from the 2009 levels when the world economy was in perhaps the worst debt crisis in history.

Stocks may look reasonably valued compared to past bubbles when you look at the dividend yield (1.96% on the S&P 500) but when you consider that some of these companies need to cut back on the dividend sooner rather than later and start paying off debt, and that payout ratios (how much of earnings are going out as dividends) are already higher than in 2000, and that earnings are somewhat juiced by low interest rate borrowing — a spread that can quickly decline with rising borrowing costs — the market is almost as expensive as the biggest valuation bubble in history, early 2000.

The days of rising rates hurting bonds while stocks go up with the economy and earnings likely ended in early October as the market blew through 3% on the 10-year government bond. Nobody knows how real estate is going to do with 6% or even 7% thirty-year mortgages, but we're already seeing indicators that the 5% level just hit this week is causing issues. Nobody knows what happens to Ford when customers can't finance a new truck at low rates. It is completely possible 1/3 of the S&P 500's earnings could away at a 5% 10-year bond rate a level.

More disturbing is how our government is going to finance the $20+ trillion in debt at 5% — or $1 trillion a year in interest costs alone. We currently shelling out $500 billion a year in interest costs. As recently as 2012 that number was $360 billion. We're now paying 2.5% on the debt pile, which (lucky for us) is barely above inflation. Yes, it takes quite some time to change this rate given the vast portfolio of maturities and debt type, but it is going up.

Best case: if interests keep rising (and they may not because the demand to borrow at higher rates could plunge) we'll have to raise taxes and cut spending rapidly (like Greece) and some leveraged companies (like GE) will go bankrupt. You don't want to know the worst case.

The longer corporations and our Government use excess debt to drive GDP growth and stock prices during these good times, the harder the next fall is going to be. The President — no stranger to debt problems — knows this which is why he, according to inside the White House stories, wanted to raise the top income bracket to help pay for the corporate tax cut. Republicans talked him down because Republicans don't do that. If interest rates continue to climb somebody is going to be paying more taxes soon. Maybe that's the real reason we're adding tariffs to imports.

Stock Funds1mo %
Proshares Ultrashort Russel2000 (TWM)4.68%
iShares Global Telecom ETF (IXP)3.51%
iShares MSCI Italy Capped (EWI)2.07%
Gold Short (DZZ)1.69%
Homestead Value (HOVLX)1.14%
[Benchmark] Vanguard Tax-Managed Intl Adm (VTMGX)0.73%
[Benchmark] Vanguard 500 Index (VFINX)0.55%
Vanguard Telecom Services ETF (VOX)0.52%
Vanguard Europe Pacific ETF (VEA)0.35%
Proshares Ultrashort NASDAQ Biotech (BIS)0.19%
Vanguard Value (VTV)-0.04%
Vanguard European ETF (VGK)-0.32%
Vanguard Utilities (VPU)-0.38%
[Benchmark] Vanguard Emerging Mkts Stock Idx (VEIEX)-1.31%
iShares MSCI BRIC Index (BKF)-1.32%
PowerShares DB Crude Oil Dble Short (DTO)-8.31%
Bond Funds1mo %
Dodge & Cox Global Bond Fund (DODLX)0.75%
[Benchmark] Vanguard Total Bond Index (VBMFX)-0.54%
Vanguard Mortgage-Backed Securities (VMBS)-0.60%
SPDR Barclays Intl. Treasury (BWX)-0.74%
Vanguard Long-Term Bond Index ETF (BLV)-1.27%
Vanguard Extended Duration Treasury (EDV)-4.11%