July 2, 2007

You probably already know that we did a bit of trading at the end of June. The giant red trade alerts on every model portfolio page (and our recent email alerts) were probably a dead giveaway. In fact, that set of transactions represented one of our most comprehensive block trades ever.

The MAXadvisor Powerfund Portfolios are not active trading or timing services. We buy high-quality funds in out-of-favor categories, and then we hold onto them until better opportunities become available. This cycle tends to last at least a year, and often two or three for each fund that we buy. In fact, we still own some of the funds that we first bought in early 2002. That said, we expect to make a few small changes (out of a fund or category) approximately twice a year, with more structural moves (out of stocks, into bonds or cash) occurring every year or so.

Our goals for these latest trades were as follows:<ol type="a">

<li>Lower our overall stock allocations

<li>Decrease our exposure to international stock funds

<li>Escape from some of the hot sectors that we bought into at much lower prices last year

<li>Move into longer-duration, higher-quality bond funds </ol>

Some could make a case for sticking with our current stock fund allocations. Sure, the market has rallied significantly since 2002's bear market lows, but today's prices are not that much higher than the 2000 peak, and earnings have roughly doubled. One flaw in this logic lies in the fact that the 2000 market was an absolute bubble peak. Making such a comparison is about as ridiculous as claiming that stocks are really, really expensive today, because in the early 80's, most had single digit P/E ratios and dividend rates that were equivalent to two or three times the amount of today’s paltry yields. 

Now that ten-year government bond rates have surpassed the 5% mark (actually weighing in at 5.3% just a few days before we sent out our mid-June trade alert,) current stock prices are such that we anticipate only marginally better performance from stocks than bonds over the next few years.

Most of the new money being invested is going into international (foreign) funds – those mutual funds and ETFs that invest exclusively outside of the U.S. Historically, we’ve had greater international fund exposure in our model portfolios than most investors, because they were underexposed to these types of funds. But as they become more and more popular, we expect future returns to dwindle, hence our return to U.S. stock funds – a move that we’ve been making slowly for a few years now (and perhaps too early, in hindsight). We always underestimate the enthusiasm of the American fund investor.

We like to allocate some of our funds into whatever sector funds are out of favor. If those categories happen to be fairly low-risk – think utilities, real estate, or certain telecom funds - we’ll include them in our lower-risk portfolios. Otherwise, categories like technology wind up in our higher-risk portfolios. As these down-and-forgotten categories come back into vogue, we may cut them back in our more conservative portfolios first.

Our newest sector, added back in February 2006, was telecom, via the Vanguard Telecom Services ETF (VOX – formerly known as Vanguard Telecom VIPER.) During the time that we owned it, the fund climbed about 43% (more than double the S&P 500's return over the same period.) This sort of overperformance was similar to what we've witnessed from utilities funds in recent years. We're now using this strength as a selling opportunity for all of our remaining portfolios (we already sold this fund late last year in our more conservative portfolios.) 

In our opinion, this fund had way more upside than downside last year. Assets were below $100 million (now listed at around a quarter billion, but still pretty low compared to international ETFs,) and investors remained anxious after the great telecom crash-and-burn, (which was arguably the most over-hyped and over-invested area of the bubble market.) 

Other indications that solid returns were on the horizon? Zingers like this one from Morningstar analysts: “Vanguard Telecom Services ETF is one of the few Vanguard offerings we don't recommend.” What?? There are hundreds of Vanguard funds, and they're ALL worth recommending  - except this one? Funny how VOX has been Vanguard's top performer over the last year. This reminds us that Morningstar couldn’t find ONE Japan fund to recommend when the Nikkei was around 8,000 a few years ago (now it's about 18,000.)

Perhaps telecom, like utilities, will continue to rise after we sell it. If it does, as they say on Wall Street, it can do so without our money. We’re moving on.

We’ve been investing mostly in short-term bonds in recent years, since we just didn’t forecast rates going much lower, and we were waiting for a rate uptick. We also held some foreign bonds and high-yield (junk) bonds. In general, if longer-term rates are about what you can get in short-term bonds, as they have been for the majority of the past few years, there's no point remaining in longer-term bonds, unless you think that rates will go even lower (in say, another recession.) There was just too much economic stimulus a few years ago for a recession to appear. 

Moreover, if a recession isn’t in the cards, why <i>not</i> own higher-risk/higher-return bonds? Defaults aren’t likely, and an extra 2-4% over safe bonds would provide a nice boost. The word is now officially out on the brilliance of junk bonds, and they're paying minimal rewards in comparison to safer bonds. We’ll probably have to wait until investors get scared about defaults in order to heavily allocate into a fund like Vanguard High-Yield Corporate.

Today, longer-term rates are slightly higher than shorter-term rates, and a recession is more likely to occur within the next few years. While a move to 6% on the ten-year government bond is still possible, such a move wouldn't hurt the longer-duration bond funds that we're moving into. It's possible that we’ll experience another recession. Rates will drop (bond funds with longer-term bonds will climb,) and stocks will fall. We'll sell down the bond funds and increase our stock allocations if that happens.

All this begs the question - how much more will we slash our stock funds if the market continues onward and upward at such a strong clip? We envision potentially chopping another 10% off our stock allocations across the board, pending another 15% jump in stocks. But only if it happens fast and interest rates are attractive. It’s hard to predict, because we just don’t know how fund investors will react down the road. We expect them to get burned a bit in foreign markets, and subsequently move toward the relative calm of investment-grade bonds and U.S. stocks.