How Low Do You Go?

August 2, 2004

With the recent market weakness some Powerfund Portfolio users may be wondering if we are planning trades in our model portfolios.

As the market moved higher over the last year we made changes, selling some of our hotter stock and bond funds and then moving the proceeds to more conservative funds. Longer-term subscribers will remember that in late 2002, while the market was falling, we moved out of cash and into more aggressive funds.

There is a pattern here – buy low, sell high (although it often isn’t quite so cut in dry in practice). So when is the next buy low move?

The recent drops in the market are quite tame in the grand scheme of the market – 2002 was far worse. While certain formerly hot stocks have gotten slammed in recent months, most mutual funds have not fallen sharply, unlike 2002.

We are not active traders – in fact it should not surprise subscribers if we do not make any changes for months to come.

When we do make changes to our portfolios we do so because of a profound market move. In other words, if the Dow fell by 2,500 next week (perish the thought!), we’ll make some trades. If the market stays put, it’s quite possible we may not make trades for six months or more.

While the decision to make a trade is based on several factors (notably the economic situation and market valuations, but also fund investor behavior - both areas that are unpredictable far into the future) we can give subscribers some estimates on what type of market behavior would likely lead us to make changes over the next 6-12 months:

Scenarios and likely actions

Dow falls 10-20% from these levels (8,500 – 9,000 range)

Increase our stock allocations across all portfolios by 5-10% (if a portfolio was 45% stocks, it may go to 50 or even 55%) and consider more aggressive funds.

Dow rises 10-20% from these levels (Dow 11,000 – 12,000)

Sell down another 5% or so in our stock positions.

Growth stocks outperform value by more that 15%

Increase our value stakes across the portfolios (where relevant). The opposite would occur if value won out.

Small cap continues to beat larger cap by more that 15% over next 1-2 years

Sell more of our remaining smaller cap holdings.

Yield on 10 year treasury bond falls below 4%

Reduce stake in bonds, move to stocks or cash.

Yield on 10 year treasury bond climbs to above 5%

Increase stake in longer term bonds, reduce cash and short term bond holdings

Flattening out of yield curve

Hold more cash and mid term bonds

High risk bonds fall 10% (junk bonds or emerging market bonds) relative to safer, investment grade bonds

Bring back larger stakes in these funds

Some sector and more targeted strategies affecting certain portfolios:

Precious metals funds fall more than 35% from current levels

Add some natural resource funds, possibly precious metals funds to aggressive portfolios

Real estate funds fall more than 15% from current levels

Bring back real estate funds to lower risk portfolios

Telecom strength continues (up 20%)

Unwind our telecom holdings in our more aggressive portfolios, unlikely we’d add more unless very weak (down > 35%)

Oil / Energy

Assuming the global economy remains strong, we’d add energy funds to some portfolios on a 20% pullback in price. We’ve given this area (natural resources is broad category) a high category rating for the last couple of years. In hindsight we should have added more of these funds to our model portfolios.

It’s worth noting these are actions we may take if these market movements take place in the next 6-18 months. If the Dow goes to 12,500 over four years, we probably won’t sell down our stock holdings as the market should be going up a small amount (on average) over time – assuming the economy is growing.

These moves are relative – if the entire market climbs 50% and real estate funds stay flat, we may consider adding real estate to our model portfolios, even though we currently are not favoring the area.