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January 9, 2016

It was a rough-and-tumble 2015 - a year in which most funds fell. Very few total portfolios of bonds and stocks posted gains in 2015. We've made some changes to keep portfolio downside risk low for the time being, and we're taking some winnings off the table. 

Broadly speaking, we've been right about focusing on investment-grade long-term debt over higher-risk debt (though both were down last year), and especially on U.S. large-cap stocks over everything else. Our mistakes were not following our own logic and holding some smaller cap funds, allowing a long/short fund in the portfolio that didn't share our negative commodity philosophy, and jumping back abroad too soon before the money that's flooded in during recent years flooded out again.

More beneficial was our long-term strategy of shorting commodities. The negative aspect of our success shorting oil in 2015 is that we now need new ways to protect our portfolio from significant downside if we get another recession and a major market slide. The stock market isn't that bad a deal historically (if we avoid recession), and bonds and cash still yield very little; this is no late 1999 or even 2007. These new portfolios should capture a good chunk of the market's upside and protect downside. Expect to see increased stock allocations on further weakness.

We're still taking significant interest rate risk, most notably in the conservative portfolio, where we have less offsetting stock allocation in case a hot economy lifts rates and stocks. We are now adding back some credit risk here with a new pick, Artisan High Income Fund (ARTFX). This is not because we are big on junk bonds quite yet, even after the drop in recent months. In fact, our MLP short (added a little late in the game, unfortunately) should offset any losses in higher-risk debt in our new pick. This risky credit slide has more to go, but the fund is benefiting from other factors. It's also possible that this strategy is wrong and this is as good as it gets in lower junk bond prices. We're sticking with our bet on the euro recovering. If it doesn't, it should be good for Italy - a new holding that, unlike many other places, has minimal natural resource exposure.

As for new shorts, while these will not be in the portfolios for long periods of time like commodity shorts over much of the last decade, biotech stocks and small cap stocks sort of capture the over-exuberance of investors and will likely fall faster than the other funds we own in a slide. Larger-cap stocks are still a better deal than smaller cap stocks, and the popular (and wrong) bet was thinking that small cap is where you want to be into the next wave of U.S. recovery. (This morphed into another bad bet, which is that the rising U.S. dollar would not hurt smaller cap companies as much as the more internationally focused larger cap companies.)

The real risk to the economy and investors going forward is the next wave of the commodity collapse. Does oil go to $20? Or will it just stick in the $30s and $40s for the next few years? Natural resource-driven economies like Canada and most emerging markets are already in big trouble, and this could spiral into an even larger problem worldwide. Most speculative producers and miners rely on debt and could default with continued low prices. Layoffs will increase. All of the essentially related businesses will have major problems. Until very recently, it was popular to say, "Oh well, they still have to transport the commodities, even at low prices." Such logic didn't save investors in shipping companies in the last recession or business-to-business internet plays in 2000—2002. If and when these production facilities shut down, there won't be anything to pump or transport. Was this bubble as big as real estate? No, but it was bigger in raw employment and debt than the dot-com bubble of the late 1990s. If we get a recession in the U.S. and market slide, this will be why.

If our portfolios underperform in 2016, it will be because rates go up and riskier credits do well, with higher-risk U.S. stocks doing better than lower-risk stocks - all while the U.S. dollar goes up even more.

Fund-Specific Notes

Vanguard Mortgage-Backed Securities (VMBS) We're adding a riskier leveraged mortgage REIT so we don't need as high an allocation here. Expect to see this holding switched to TIPs if they continue to perform poorly.

Vanguard MegaCap Growth (MGK) Large cap growth did well, and larger cap value should do better (especially relatively speaking) in a down market.

Vanguard Telecom Services ETF (VOX) Not as attractive as recent years, but we'll keep some of it in one portfolio until something better comes along.

Wasatch Long/Short (FMLSX) Bad bets on energy are inexcusable. Maybe they have a good year next year, but we don't own funds that short to fall faster than ordinary stock funds in a down market. We are using Vanguard Market Neutral in client accounts, but the minimum is too high for the model portfolios. Watch out for the 2%/60 day short-term redemption fee.

ETRACS 1xMonthly Short Alerian MLP (MLPS) Risky small ETN that bets against MLP index prices. MLPs move energy production in a weird tax-avoiding structure. They were way over-owned and have high dividends that are going to get cut to zilch in many cases. Use limit orders - the spread is wide because of low assets and limited trading volume.

Artisan High Income Fund (ARTFX) A new junk bond fund that is avoiding energy collapse, ARTFX is also benefiting from inflows and other fund family advantages at this early stage. Risky if we get a real credit crash like 2008.

Vanguard Utilites (VPU) Utilities underperformed last year, and as we think interest rates aren't going up more, on the long end this fund should do well in a rocky market this year.

Homestead Value (HOVLX) Oldie but goody, cheap and NTF; we have owned it in client accounts for years. HOVLX should do well relative to the market if larger cap value outperforms.

iShares Mortgage REIT (REM) Speculative high-yield leveraged mortgage REIT. High yields are not from high credit risk, but rather from extreme leverage. If rates go up - especially short-term rates relative to longer-term rates - the yield could collapse, but if the fed doesn't raise rates much and long-term rates stay about the same, this fund could do quite well. Best in IRA accounts because of high taxable yield. Worst in an IRA because you won't get a tax loss if we're wrong….

SPDR Barclays Intl. Treasury (BWX) We're increasing our existing stake in BWX. It's a wager on the euro doing well. Lower fee iShares International Treasury Bond ETF (IGOV), which we also own in client accounts, is the cheaper choice if you don't benefit from BWX being NTF at TD Ameritrade or are buying large quantities (over $25k-ish).

PRIMECAP Odyssey Growth (POGRX) You've got to know when to hold 'em and know when to fold 'em, people. We've owned POGRX for a long time, but other fund experts with questionable track records like this now popular fund too much, and the heavy biotech and tech allocations will hurt when those hot areas sink. In the past, we had to do the same to Janus, Fairholme, and Royce. PRIMECAP, no hard feelings - we'll be back someday, I'm sure.

PowerShares DB Crude Oil Dble Short (DTO) Our lowest buys are up several hundred percent. This was up just shy of 100% in 2015, and while oil definitely can go lower and isn't going back to $50+ anytime soon, these leveraged funds are risky on a rebound. Remember what happened after we cut back early in 2015? Big slide. We're keeping some for now largely for lack of better ways to play the continuing commodity bubble pop.

Proshares Ultrashort NASDAQ Biotech (BIS) Risky shorter-term pick here. We've been in healthcare (even biotechs) for much of the model portfolio's history because it really is the best sector from pure demographics, rising insurance coverage, and near limitless pricing power for drug makers. But the game is over. Valuations are too high, the area is too popular, and political heat is building over high drug cost. The hard question is coming - just how much should taxpayers and insurance companies be paying for a few extra months of life? How many tens of thousands a year should insurance pay for hot new cholesterol drugs because you want to eat more donuts? This may not play out this year, but expensive growth stocks are under attack, and we need downside protection.

Proshares Ultrashort Russel2000 (TWM) Should have bought this last year, as small cap stocks have underperformed larger cap (which we own). This should continue. Keep in mind this is a risky way to profit from such a performance gap; the sensible low-risk strategy is just avoiding hot areas, as we primarily try to do, especially in lower-risk portfolios.

iShares MSCI Italy Capped (EWI) Italy has been under fire in the markets from debt problems years ago. However, it is benefiting from a weak euro and isn't going to have the problems many oil-rich countries are having (like Canada and Brazil). Likely has no more downside than U.S. stocks from here and more upside. If we get a huge fire sale from foreign stocks across the board (not just in emerging markets), this fund could fall.

Technical Info

We are not realizing any short-term capital gains in this trade, and you shouldn't have to either. Those with non-IRA portfolios be aware if you purchased after we did - you may want to hold off on realizing gains if you have no offsetting losses. Many of these trades could be put off a few months if needed for tax reasons. We have also owned these funds well beyond any short-term redemption fees, either by the fund or brokerage platform; check your own info. There is no need to realize a short-term redemption fee for any of these trades. SATMX has a 2% redemption fee for any sales made within 360 days. FMLSX has a 2% redemption fee for any sales within 60 days. Most of the larger ETF allocations we are using are NTF (no transaction fee) at TD Ameritrade if held for 30 days, which is why this is a good brokerage choice to follow our portfolios.

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We own all of these holdings in client accounts as well as personal accounts. We also own similar funds - either higher minimum, institutional access only, or load-waived - that are the same portfolio with a lower fee structure or target the same broad strategies.