Time To Buy! But What? And Why?

July 2, 2008

In our commentary last month we noted how, over the last year, fund investors have been getting out of stock funds after the market slipped, then buying in after the market rose – the classic buy high/sell low cycle. A successful fund portfolio does not this behavior make, and doing the opposite is pretty much what the Powerfund Portfolios are all about. We are going to use June’s sharp pullback in stocks to increase our stock allocations and risk levels across the board.

In May fund investors put $15.91 billion into stock funds – the most in at least a year. This was on top of inflows of about $12.2 billion in April. Unfortunately, the market promptly fell in June more than any June in some seventy years. While it is too early to tell, we expect to see outflows of over $10 billion in July.

Net outflows from funds are fairly rare, and usually signal good news for the market going forward. Some of the biggest outflows in recent memory were in 2002 – the very bottom of the bear market. For those investing with us in 2002, you remember we increased our stock allocations in some portfolios during these down months – and were rewarded with solid returns over the next few years off the bottom – beating the S&P 500 in 2002, 2003, 2004, and 2005 in our Growth, Aggressive Growth, and Daredevil portfolios. 

If the market drops further and/or we see more outflows by fund investors, we intend to increase risk (and potential upside) even more, but for now, the trades we just made at the end of June will suffice. We believe that the more stocks fall, the lower risk they become for longer term investors. So those who might normally want a 50% stock allocation could jump to 60% on a 20% drop in stocks.

How much further will stocks fall? We don’t know. But if interest rates stay relatively low and the real estate bubble pop heard ‘round the world doesn’t cause a deep recession, then not much. The market is not that expensive relative to alternatives like real estate, cash, and bonds. We’d be very surprised if the market fell more than 20% from these levels.

The increase in stock allocations in general is because fund investors are now more fearful of stocks than they have been in recent years. We cut back on stocks in past trades for the opposite reason, so this is the natural course of events for us. 

In our Safety portfolio, we are cutting back on Vanguard Intermediate Bond Index (VBIIX) as interest rates are low relative to dividend yields on stocks, and there are better opportunities (with increased risk) in higher yield bonds. We are adding junk bond fund Metropolitan West High Yield Bond (MWHYX) with a 10% stake. We have had junk bonds in many of our portfolios in the past, but other investors bid up junk bond prices such that there was hardly any reward for their extra risk. Now with the economy sinking and risk aversion in credit markets becoming common sentiment, we think it’s time to get back in. This is a contrarian play of course, as was our decision to add junk bonds when many companies were failing during the last downturn.

We’re also increasing our stake in relatively safe Gateway (GATEX). This fund uses options to decrease volatility – a decent strategy when you can’t earn much in cash or bonds. One issue here of note is this long-term holding recently converted to load classes – though current investors can add to their stake load-free. This was the result of an acquisition of the fund company in February. New investors should consider an alternative (we list some alternatives in the drop down windows on the portfolio pages under the fund name). Otherwise, try to get into the Y class (GTEYX) open through some brokers or a very similar closed-end fund run by the same advisor called Nuveen Equity Premium Opportunity Fund (JSN).

In our Conservative portfolio we’re cutting back on bonds and adding Vanguard Telecom Service ETF (VOX), an ETF we owned a few years ago and which we sold for a nice 40% gain. This fund is about back to where we first bought it. We’re also adding some junk bonds to this portfolio as well.

In our Moderate portfolio we’re cutting back on investment-grade bonds, adding junk bonds, and Vanguard Pacific Stock ETF (VPL). Japan is about the only foreign market we think will match or beat the U.S. market over the next few years, largely because of lackluster performance and so-so fund investor interest in Japan in recent years. You’ll recall we owned Japan funds a few years back when they were not popular. This opportunity is not quite as good as it was in 2002, but then stocks in general were a better deal back then.

In our Growth portfolio we’re cutting back on bonds, getting rid of a mid-cap fund, increasing a larger-cap growth fund, and adding a new holding -- Dodge & Cox Global Stock (DODWX). We are still not crazy about foreign stocks even though foreign markets have fallen harder than U.S markets recently. Still, global funds tend to have their largest allocation to U.S stocks and this small, new fund should benefit from its small size for the time being. This portfolio has hardly any foreign exposure as it is.

In our Aggressive Growth portfolio we’re cutting back on bonds and increasing our tech ETF stake because of the drop in the Nasdaq. We’re adding an ETF that is speculative, slightly overpriced at 0.95% a year, and in general bad idea for long-term investors: DB Commodity Double Short ETN (DEE). We’re going to try to profit from the soon-to-deflate commodity bubble, much like we did last year with our inverse short real estate fund in our Daredevil portfolio. We’re still smarting from not having the courage to short China in our Daredevil portfolio when we <a href="http://maxadvisor.com/newsletter/farchives/000667.php">wrote about the China bubble</a>. That market is down by about half since late last year.

Fund investors are very enamored with all things energy- or commodity-related these days – sort of like how anything tech tickled their fancy back in 1999. The logic behind the commodity short is that the only way stocks are going to take another big hit – say 20% or more – is if the economy really takes a nose dive. In such a case we can’t see commodities going ever higher with falling demand, but this is just a hypothesis, anything can happen in commodity markets. 

Daredevil is becoming even more daredevil-ish with the above-mentioned commodity short fund, as well as UltraShort MSCI Emerging Markets ProShares (EEV). These funds are double inverse, which makes them extra risky but open for big gains if we’re right. We cut down on relatively conservative stock funds Wasatch Heritage Growth (WAHGX), which frankly has been underwhelming, and ultra-cheap Bridgeway Blue Chip 35 (BRLIX) to get some cash for these speculative shorter-term bets. 

We’re increasing our tech ETF stake as well. With our current shorts on some real estate, longs on real estate debt, our biotech ETF, bank ETF, and U.S. dollar fund, this portfolio is now officially really, really aggressive and could diverge from the S&P 500 by a very wide margin – up or down. Check your gut before buying this portfolio. It’s even riskier new than it used to be.

It may be hard to stomach, but we need to buy when others are selling.