(Published 06/01/2007) What's the #1 indicator that a fund category isn't going to perform well? The number of new fund launches in it.

Fund companies launch new funds when they spot an opportunity to make money – not for fund investors, but for themselves, in the form of fees paid by new shareholders. Frequently, the most "saleable" funds are those that have performed well in recent years, enjoyed a significant buzz, and received steady, positive media coverage.

During the final stock bubble years in the late '90's, fund companies launched new tech or growth funds every few days. Back then, brand-new tech funds could bring in hundreds of millions (if not billions) right from the get-go. A classic example was Merrill Lynch Internet Strategies, which launched on March 22, 2000 (within days of the market peak). The launch arrived just in time to bring in over a billion dollars (with a sales load…) before diving nearly 80% in the first year alone.

Today, most new fund launches are ETFs (exchange-traded funds) that run the gamut from countries to currencies and tech to telecom. Many offer access to extremely specialized commodities, currencies, or investment strategies. Traditional open-end mutual funds, on the other hand, are arriving with much less variety. Since December 2006, the majority of new funds are international funds (although some are global). No less than two dozen new international funds have been launched in the wake of that category’s recent sizzling performance. Many investors focus on specific "hot" areas in international markets, like international small cap or real estate investments. There's even a renewed interest in single-country open-end funds.

Apparently, investors aren't anxious about making international investments after they experience great returns. Quite to the contrary, they look for even more focused and risky ways to make their money. We last saw this behavior during the good old tech bubble days, when general tech and growth fund launches in the 90's morphed first into focused Internet funds, then later into new and different types of Internet and telecom funds – remember "b2b" (business to business) "content," and "Internet infrastructure" funds?

Another indicator that we use is fund investor money flow, which analyzes which funds investors are buying and selling. Since fund companies launch funds in sectors where they perceive a demand, it should come as no surprise that investors have been piling into international funds at a record pace. Virtually all new fund dollars are going into foreign funds, even though the U.S. market has been plenty hot itself in recent years. We’re talking tens of billions a month – the sort of numbers that tech and growth funds saw in early 2000.

As contrarian investors, we firmly believe in doing exactly the opposite of what the investing herd does. The more popular a fund category is today, the more likely it is to under-perform tomorrow. That’s why we're downgrading international diversified funds yet again, from a (Weak) to our lowest rating, a (Least Attractive). Back in 2002, we rated international funds a (Most Attractive), and they held on until April 2004, when we cut the category down to a (Neutral). This category continued to perform well. A year later, in 2005, we downgraded international diversified funds to a (Weak), which is where their rating has remained prior to this edition. We're also now forecasting a negative return for this category - a first for us.

From best to worst in six years. Well, maybe we sold the emerging market and small cap foreign funds in our model portfolios just a bit too early. Maybe we’re still a little early - we’ll just have to wait and see. Maybe, just maybe, for the first time in fund history, the fund types that investors want the most will beat the market and the other fund categories over the next few years. But we doubt it.

Category Rating: (Least Attractive) - should underperform the market and 80% of the remaining stock fund categories over the next one to three years

Previous Rating: (last change 3/31/05): (Weak) - should underperform the market and 60% of the remaining stock fund categories

Expected 12-month return: -1% (decreased from 1% in our last Favorite Fund Report)

(Published 03/01/2007) With yet another year of large-cap growth funds underperforming basically every other fund category out there, fund investors are finally throwing in the towel.

Lipper estimates that investors yanked $3.2 billion out of large-cap growth funds in the first four weeks of the New Year. What’s unusual is that January is a month where fund investors put almost $40 billion into stock funds – almost $20 billion alone into funds that invest in international stocks.

There have been many calls for out-of-favor, large-cap growth funds to lead the market – notably by us in the summer of 2006 when we upgraded large-cap growth funds to a (Most Attractive) for the first time in our history. While the a stock market in general (large-cap growth in particular) has done fine since then, large-cap growth funds have not been where the big action has been.

Long-time MAXfunds readers remember how negative we were on the whole large-cap growth and tech craze in 2000 – with our anti-Janus articles and the like. We started our MAXadvisor fund investing service in early 2002 with a (Weak) rating on large-cap growth funds. As large-cap growth continued to underperform other categories, we slowly increased the rating.

Why hasn’t large-cap growth taken off yet? The last year large-cap growth was king of the hill was 1998, when these funds scored about a 30% return. In 1999, larger cap growth funds were up almost 40% - but since other categories were even hotter (these were the bubble years remember), 40% was only an average return.

Small cap value funds – the funds that have been topping the charts more or less ever since the glory days – were basically flat during 1998 and 1999. No wonder fund investors bailed and put money in large-cap growth funds. Nobody likes a boring party.

Herein lies the reason large-cap growth stocks have yet to take off: they had so much over-valuation to work off. If one asset group almost doubles in two years, and another remains the same, it can take years of the cheaper asset group outperforming the former leader before relative valuations are back in sync.

Moreover, fund investors never really bailed out of larger cap growth funds. Today many of the formerly hottest funds still have billions in assets – though asset growth has slowed or reversed at one time or another in recent years. Today larger cap growth stocks would represent excellent value and opportunity to double your money in a few years, if only fund investors had pulled out tens of billions each quarter for the last seven years or so.

Unfortunately for us contrarians, mildly out of favor is about as good as it is likely to get here. Your best relative value in the market is large-cap growth stocks (and money markets…) and we expect this category to be in the top tier for the next few years.

Category Rating: (Most Attractive) - should outperform the market and 80% of stock fund categories over the next 1 to 3 years

Previous Rating (6/30/06): (Interesting) - should outperform the market and 60% of stock fund categories over the next 1 to 3 years

Expected 12-month return: 8% (increased from 7% in our last favorite fund report)

(Published 12/01/06) There are two ways to invest in emerging market funds. One is to choose a small allocation and stick with it through booms and busts. As these fluctuations will sometimes occur opposite the other investments, investors may experience a lower overall risk. With a buy and hold strategy, investors should rebalance after big market moves to maintain their small – say, 5% to 10% – emerging market allocation.

The other way is to invest a bit more than this permanent allocation, but only after significant weakness in emerging markets and widespread fear of crisis by investors occurs (i.e., when prices are dirt cheap). Such an active strategy would require lightening up after a big run-up in emerging markets (such as we did in our portfolios in recent years). This means a 20% allocation after an emerging market slide, lowered to perhaps 5% after significant gains.

We’re following the second plan – invest when down, and lighten (even to 0%) when up. However, there is nothing wrong with the first method for investors who don't have the time or the expertise to be active investors.

Sadly, too many investors follow plan 9 (from outer space) – they load up on emerging markets funds after a big 3-5 year run, only to get slammed by the eventual hit these markets will take. Then they sell low. We know this happens because funds in this category often have tax loss carry forwards on the books – ghosts of bad investments by investors.

We can tell we're probably near a market peak when all the past losses on the books of old emerging market funds are gone. Today, the Vanguard Emerging Market Index fund (VEIEX) – one of the largest (started in 1994) and a favorite here – has almost no capital gains on the books, even after a 5-year average ANNUALIZED return of 23%. That's one of the best performing funds in recent years, and as a group, shareholders haven’t made a dime. That should give you an idea of how badly fund investors time their buying and selling of emerging market funds. (Not to brag, but our other fund favorites in this category have beaten even this top–performing, low-fee emerging market index fund, and the bulk of all emerging market funds since we added them as favorites).

Investor activity is a good way to gauge optimism – tracking what they’re buying and what they’re selling. This is our primary gauge of investment opportunity. Another is fund company launch dates. Check the inception date of most emerging market funds and you’ll see they were launched in the early 1990s – around the time of big run-ups in emerging markets, and right before a big slide.

Another useful indicator is relative valuations across investment categories.

If junk bonds (high yield bonds) are in favor with investors, prices generally run high relative to other bonds. This means a low quality corporate bond might pay just 2% more than an ultra safe U.S. government bond. In times of investor fear of default, junk bonds can pay 4% or more than U.S. government bonds. We had larger allocations to junk bond funds in our model portfolios in the “Enron” days a few years back when these fear premiums were more pronounced.

Emerging market stocks currently trade at a discount of roughly10-15% to the valuations of “emerged” stocks like you find in the U.S. In other words, a beverage company in Brazil may trade at 15 times earnings, while Coca-Cola (KO) trades at 17 times earnings.

Clearly, Coke is a safer investment. The company is based in the U.S. and has global operations. As far as any single stock goes, Coke is relatively low-risk. The chances of currency fluctuations, accounting shenanigans, or political risks destroying your investment in Coke are small.

The Governor of Georgia isn’t going to nationalize Coke. Their core product is safer than most products from the risk of competitors guzzling their market share, and most people that drink Coke can afford to – regardless of where the economy goes. Investors can relax…and enjoy Coke. They’ll even collect dividends along the way. Unlike bank CDs, the dividends will even likely go up over time.

By comparison, a company located in an emerging market is chock full of extra risks. How much cheaper investors expect to get emerging market stocks as a whole is a good indication of how enthusiastic they are about investing in emerging markets in general. Scared investors would expect a big discount. You want to invest where investors are scared to go without major incentives in the form of cheaper stocks.

Just a few years ago, before most emerging market stocks went up 2x, 3x, even 4x or more, emerging market stocks were trading at big discounts to U.S. stocks – 50% or more typically, or 10x earnings compared to 20x earnings in the U.S. Not anymore. Returns have been exceptional because there has been valuation expansion (now stocks trade at higher multiples of earnings) AND earnings have grown faster than safer stocks. This is the double whammy that leads to huge investor returns – it’s exactly what drove tech stocks in the late 1990s.

Rather than considering the risks in emerging markets, investors today are more focused on great opportunities. Unlike in the U.S., economic growth in many emerging markets seems boundless. The worldwide commodity boom has been particularly lucrative for many emerging markets that rely heavily on commodity exports.

But there is always a good reason why an investment can continue to go up. The investment went up largely due to these reasons in the first place. In fact, those reasons seem more sound the better the past performance – the ultimate legitimizer of investor theories (…these numbers don’t lie…).

This current optimism is why future returns will be sub-par going forward. Current optimism is not quite as wild as it was in the last emerging market craze – the early 1990s. Back then, emerging market stocks were actually trading at HIGHER valuations than U.S. stocks. From those levels investors in U.S. stocks did very well, and investors in emerging markets fared poorly. Some emerging market funds are only now getting back to those boom 1993 levels. The difference was about as extreme as it has been in the last five years, as the Dow struggled to get back to year 2000 levels and emerging markets posted double digit gains year after year.

It’s possible that the action in emerging markets will continue a little longer. We’ve already shortchanged the emerging market move and bailed out a little too early. Maybe we’ll return to early 1990s valuations and U.S. stocks will be cheaper than emerging markets. However, we don’t play the hope-for-valuation-expansion-to-save-us game.

Category Rating: (Least Attractive) - should underperform the market and 80% of stock fund categories over the next 1 to 3 years

Previous Rating (12/31/05): (Weak) – should underperform the market and 60% of stock fund categories

Expected 12-month return: -8% (lowered from -7% in our last favorite fund report)

(Published 09/01/06) The last time we upgraded technology-oriented mutual funds was in August 2002, when we raised the category from a (Weak) to a (Neutral). At the time, the Nasdaq was in the 1,300 to 1,400 range – close to the crash low and near the index levels of 1996.

Why didn’t we upgrade to a (Interesting) or even a (Most attractive) given the opportunity in tech at the lows of 2002? The main reason was, at the time, there were better opportunities in other fund categories and our rating system is relative to the market.

Recent subscribers may think of us as negative on most fund categories, but at the time of our 2002 tech upgrade we had top ratings on several fund categories: small-cap growth, telecom, natural resources, utilities, convertibles, balanced, international diversified, global, global balanced, Japan, Asia, Europe, and Latin America. Most funds in these categories have beaten tech stocks over the three years following August 2002. Today, with valuations and investor optimism where it is, we’d be more excited about tech only if the Nasdaq was at 1,300.

In 2002 our rationale for the tech upgrade was–-

“…largely because the valuations of many tech stocks today are not that far out of whack with the rest of the market, adjusting for potential future growth. We don’t see tech stocks as a class dramatically underperforming the market as we have the last couple of years. We’d be perfectly happy if it takes five years for the NASDAQ to reach 2000 because from these levels that would be a 10% return per year. “

As it turned out, the turnaround in tech came on pretty strong after it finally bottomed in late 2002. The Nasdaq broke 2,000 – almost a double from the crash low – at the beginning of 2004 but has been holding at that level ever since. We downgraded the category back to a (Weak) in June 2004 (at Nasdaq 2,000).

Such is the nature of the stock market – often it takes an advance on the future prosperity of corporate America, and then has to sit and wait for fundamentals to catch up.

The Nasdaq took a quick dip to below 1,800 in 2004 after our summer downgrade and we upgraded back to a (Neutral) in September 2004. Along the way we’ve picked up some tech funds (usually ETFs like iShares Semiconductor – IGW) in our higher-risk portfolios during moments of weakness. Some we’ve sold after the Nasdaq ran up a few hundred points to the outer reaches of reasonable valuations.

We don’t see technology stocks as a particularly great value now, just reasonable compared to everything else, hence the upgrade to a positive rating – our first for tech. We expect a 6 to 8% return annually in the coming years, with some swings that may make it possible to see 10% or more with the right entry point.

Fundamentally, technology stocks are risky and sensitive to an economic slowdown (computer budgets get slashed during hard times – at home and at work). More important to us, investors are not that interested in technology anymore – they see better upside abroad or in commodities. Mega-cap tech, the old 1990s growth favorites, like Dell (DELL), Intel (INTC), and Microsoft (MSFT), are particularly out of favor compared with just about any time in the last decade or so (the market crash bottom of 2002 being the only possible exception). Some of this is warranted as growth going forward is going to be slow and margins compressed. Without a major recession it’s unlikely these sorts of companies will fall on much harder times – or at least do no worse than most other companies. We’d have to see actual panic selling in tech and even better valuations – maybe Nasdaq 1700 or so – to upgrade to our highest rating, but funds investing in tech stocks should perform better than most going forward.

Tech ETFs are among the least favorite of the more mainstream ETFs around. Total assets in all no-load tech funds and ETFs are just under $20 billion today. For comparison, near the bubble peak just two tech funds collectively had over $20 billion in assets (T.Rowe Price Science and Technology - PRSCX and Janus Global Technology - JAGTX).

More stunning is the fact that fund investors have lost more money in tech funds in the 2000-2002 crash than currently is in tech funds. They even lost more money collectively than was made in all those hot, triple-digit return years of the late 1990s. Buy high, sell low.

It’s almost impossible to find a tech fund that isn’t sitting on tens of millions – sometimes billions – in loss carryforwards from the crash. Paper gains quickly became very real losses for millions of investors. Don’t expect any taxable dividend distributions anytime soon in this category.

It’s a good idea to invest in fund categories that other fund investors have lost gobs of money in. It’s proof you are doing the opposite of other fund investors – and doing what the other investor isn\'t is the cornerstone of the Powerfund strategy.

Category Rating: (Interesting - should outperform the market and 60% of stock fund categories over the next 1 to 3 years)

Previous Rating: (Neutral - should match the market\'s return and perform in the middle of other stock fund categories).

Expected 12-month return: 8% (raised from 6% in our last favorite fund report)

(Published 06/01/2006) Real estate mutual funds are due for a drop.

Fundamentals were strong in real estate in recent years (of course, fundamentals were strong in tech back in the 90s). Real estate funds primarily own REITs (real estate investment trusts – essentially investment companies that own and operate buildings for rent), and to a lesser extent, real estate-related stocks like homebuilders (Hovnanian (HOV) and Lennar (LEN), and others that benefit from housing booms, like Home Depot (HD).

With property prices escalating, REITs have done spectacularly well. With new homes selling as fast as they can build ‘em (and with fat profit margins over construction costs) homebuilders have been raking in cash.

Just because an asset class takes off doesn’t mean it has to stop – Powerfund investors don’t sell just because they`re up. Two key factors kill many mutual fund golden geese: 1) declining fundamentals (over-valuation), and 2) inflows of too much money from performance-chasing investors.

Real estate mutual funds fail the Powerfund test on both counts. Today we can safely say that fundamentals are eroding, particularly in REITs, and inflows are strong.

REITs can be risky. If the economy turns south, rental revenue dries up and all available income to the REIT goes to pay interest on their massive debt (that’s how they bought the properties in the first place). However, in a strong economy with high rents and climbing real estate values (leading to windfall profits when an REIT sells a building) the business is very profitable and REITs can generally payout very high dividends to shareholders (by law they have to pay out income, much like a mutual fund).

While the stocks of homebuilders like Hovnanian have already collapsed almost 50% in price on little more than fears over future home sales (despite great earnings), REITs remain hot. While the fundamentals at REITs are strong, the prices of REITs are even stronger. This means, even taking into consideration better earnings and more valuable property, REITs are expensive.

The best indication of REIT overvaluation is the dividend yield on a low-fee REIT index fund, like one of our favorites in this category, Vanguard REIT Index (VGSIX). When you adjust out for dividends paid by REITs that are not from operating income, the yield on this fund is below 4%. A few years ago an REIT index paid about 6% in dividends or more.

So what? The S&P500 doesn’t even quite pay 2% (though ordinary stock dividends are usually taxable at a lower rate than REIT dividends, which are taxable like bond interest, or as ordinary income in most cases). REITs are bought for income, sort of like utility stocks (which are also overvalued now). Sure there is potential for growth in rental income (though there is a higher likelihood of growth in stock dividends) and more appreciation of underlying real estate assets, but there is also a chance for declines.

This risk usually means investors should get more yield in an REIT than, say, a money market fund or a government bond. That is no longer the case. Why bother? Investors can get 7% in a Vanguard junk bond fund if they want a lower-risk return. There will need to be a continuing housing and economic boom to earn more in most REITs than in a low-risk bond portfolio. Like all overblown areas, investors are paying too much for the future’s likely revenue stream.

The best thing that could happen to an REIT investor at this point is a big increase in inflation – because rents to the REITs would go up, as would their property values. Any slowdown in housing or further increases in interest rates could lead to a 15-25% decline in an REIT index.

As for fund company and investor behavior, there has been a pick-up in new real estate fund launches in the last three years. The Vanguard REIT index has about as much money in it as the Vanguard Energy fund, another over-invested area. Trouble is, REIT and real estate-related stocks don’t have the combined market cap of energy stocks so this represents a fairly large fund assets-to-underlying business size ratio.

For the record, we recently sold our last real estate fund stake in a client account due to valuations issues.

Category Rating: 5
Previous Rating: 5
Expected 12-month return: -12% (lowered from -7% in our last favorite fund report)

(Published 09/01/05) One of the hottest fund categories over the last three years (ending 8/31/05) has been utilities. The three-year total return for the Dow Jones Utility index is a whopping 90% –double that of the S&P500 over the same time period. The typical mutual fund in this category scored a whopping 73% return. Our favorite in this category, the American Century Utilities fund (BULIX), which has appeared in several of our MAXadvisor Newsletter model portfolios, scored a 77.5% return over the same three-year period.

With investor excitement for utilities stocks at the highest levels since the days before the Enron debacle, we are finally downgrading utilities to a negative rating. We think utilities funds should underperform the market and 60% of stock fund categories in the next one to three years.

Utilities has been one of our favorite categories since we started the MAXadvisor Newsletter. From April 2002 through the end of January 2004 we gave the sector our highest rating (Most Attractive – should outperform the market and 80% of stock fund categories over the next 1 to 3 years). Then, for the next eight months, we maintained a positive rating (Interesting – should outperform the market and 60% of stock fund categories over the next 1 to 3 years). We then downgraded utilities to a neutral, and finally sold much of our utility stakes in our model portfolios a few months ago. But even after our downgrades, the funds in the category just kept climbing higher.

Despite the sector’s continued outperformance, we’re now more confident than ever that a utilities downturn is imminent. The only reason we’re not downgrading to our worst rating is that new utility funds are not sprouting up like mushrooms (new fund launches are one of the strongest contrarian signals of trouble ahead for a category), but existing utilities funds and ETFs are hugely oversold already. The iShares Dow Jones U.S. Utilities Sector Index Fund (IDU) has $800 million in assets. Our own favorite, Utilities SPDR (XLU), has an unbelievable $1.97 billion in assets.

For comparison, the Technology SPDR (XLK) – which is also a portfolio holding of ours – has around $1.3 billion. The only sector ETF with more money is the Energy SPDR (XLE), and we just slapped our worst rating on natural resource funds – the category energy falls under.

Can you imagine utilities funds being more popular than tech funds? Certainly not a few years ago. This is why utilities have doubled the market return in the last three years – nobody wanted anything to do with these during the dot-com bubble. Between Enron’s collapse and stories of over-leveraged, new-economy-style energy companies teetering on the edge of bankruptcy, the stocks had nowhere to go but up. The fact that a utilities index paid almost 6% in dividend yield didn’t entice anybody.

The ultimate buy sign was when Vanguard decided to convert their utility fund (one of the only good, low-fee funds around, our former top favorite and portfolio holding) into a plain-vanilla, dividend income fund. Vanguard did this in late 2002 because they couldn’t give away shares of a utility fund at the time.

But the category has now come full circle. This is not a good time to buy utilities funds. It is a good time to sell, which is what we’ve been doing all year in our newsletter and other portfolios. Performance has brought utilities stocks back to their pre-Enron levels, when utilities stocks were priced as if failure in their leveraged business models was impossible.
Worse, yields have fallen near proportionally with the rising prices (dividend increases haven’t come close to matching stock price appreciation). Today’s utility buyer is getting a dividend yield perhaps 1% over the S&P500 (3% instead of 2%) and about the same P/E ratio for owning heavily regulated businesses in one of the slowest growth and oldest economy areas around.

Sure, new home buying will lead to some growth, but come on, is your run-of-the-mill electricity utility going to grow earnings like other components in the S&P500 – like Pfizer, Wal-Mart, and Microsoft? Utilities are supposed to be cheap; they are a nice bond alternative that can perform better with inflation because dividends can go up with price increases, but that’s about it. Today’s utility fund buyer is looking at the near doubling over the last three years while ignoring the fact that utility stocks are going to have a tough enough time keeping pace with the market over the next few years (much less outperforming even more).

We’re sticking with our two lone favorites here largely because there are not too many compelling choices – at least since Vanguard made their utility fund disappear. Does Vanguard regret this move now? Maybe. They launched a couple utility index funds last year (their original utility fund was actively managed). The first was an ETF, Vanguard Utilities VIPERs (VPU), followed a few months later by one admiral class open-end fund with a $100,000 minimum, Vanguard Utilities Index Fund Admiral Shares (VUIAX). Both are fine alternatives to our picks below as well.

Most utilities funds are load funds because brokers need something to sell to widows and orphans and still land commissions since churning a stock account for those needing fixed income and low-risk could get them into trouble. What few utility funds are available without a load are fairly expensive. Since utilities should be bought primarily for yield, this is unacceptable. At the current paltry utilities yields, a 1.2% expense ratio quickly turns a utility fund dividend yield into an S&P500 index fund yield because fund fees are paid with dividends first.

We had our highest rating on down-and-out utilities back in 2002 and 2003. In 2004 the area was about the hottest this side of energy. Money keeps dumping into utilities stocks, and dividend yields are now paltry after even more big gains in stock prices in 2005 (beyond what we expected). Given the likely business growth, this is bordering on absurd. When interest rates move up this hot area is going to fall.

Category Rating: (Weak) – should underperform the market and 60% of stock fund categories

Previous Rating (08/31/05): (Neutral) - Should match the markets return and perform in the middle of other stock fund categories

Expected 12-month return:-2%

(Published 06/01/05) You can tell a lot about what’s hot and what’s not in mutual funds by just watching Vanguard.

Investors got gold fever? Vanguard closed their precious metals fund. Bond investors have no more Enron and WorldCom type fears? Vanguard closes their high yield bond fund. ETFs all the rage? Vanguard launches VIPERs. Nobody wants anything to do with utilities stocks? Vanguard re-badges their utilities fund as a plain-vanilla dividend growth fund.

We watch Vanguard closely, not just because several of their funds are in our model portfolios and on our favorites lists, but because Vanguard offers a strong signal of what smart investors should avoid or invest in.

Lack of investor interest is a good thing. Two of the hottest areas in the market over the last few years have been utilities and natural resources. Vanguard couldn’t give away their utility fund, so they gave it a strategy-altering makeover. American Century couldn’t find buyers for their global natural resource fund (an old holding in our newsletter) so they liquidated it. Both would have been up around 60% or more had they stuck by those funds as out-of-favor categories came back.

In 2003 plain old convertible bonds were on fire. Vanguard Convertible Securities (VCVSX) was up 31%. By 2004, investors were piling into Vanguard’s Convertible bond fund. In May when the fund neared a billion in assets, Vanguard simply had to shut the door. We dropped the fund as a favorite soon after, in August 2004.

From April 2002 until the end of September 2004 we had the convertible category rated 2 – Interesting. We had a convertible bond fund in our two safest model portfolios for much of this period. At the end of September 2004 we skipped 3 – Neutral and downgraded the convertible fund category to a 4 – Weak. (Too much of a good thing.)

Then a funny thing happened – convertible funds started to stink. Vanguard Convertible Securities was down 5.12% for the year to date as of May 31st, although it has recovered a bit recently.
Another funny thing happened: a half billion (about 50% of total assets) vanished from Vanguard Convertible Securities in a matter of months. In March of this year, Vanguard even opened the fund to existing investors while assets under management continued to drop (previously the fund was hard-closed, meaning essentially nobody could buy). Still, the assets fell.

On June 23rd Vanguard announced the fund was now open to new investors once again, but with a couple caveats: 1) the minimum is raised from $3,000 to $10,000, and 2) the fund will slap a 1% redemption fee anybody (who buys after September 15th 2005) selling within a year.

So now that the performance chasing investors have left the convertible bond market, we can safely upgrade the category to 3 – Neutral. We can also add Vanguard Convertible Securities back to our favorites list, it will join our other favorite pick and former portfolio-holding Northern Income Equity (NOIEX). Unlike Vanguard’s previously bloated fund, this fund has done fine over the last year, up about 11% landing it in the 10% of similar funds, although the fund underperformed when convertibles were red hot in 2003.

Category Rating: (Neutral) - Should match the markets return and perform in the middle of other stock fund categories

Previous Rating (12/31/05): (Weak) – should underperform the market and 60% of stock fund categories

Expected 12-month return: 5%

(Published 03/01/05) When we started the MAXadvisor Newsletter in early 2002, natural resources was one of only three stock fund categories that had our top rating of “Most Attractive”. We give this rating to fund categories we think will beat the U.S. stock market and 80% of fund categories over the next 1 to 3 years.

It turns out that our optimism for this category was well-founded. Natural resources funds have been near the top of stock categories over the last three years.

As we often do when an area comes into favor, we downgrade the ratings – but not until we think things are really getting overblown. We kept natural resource funds at a “Most Attractive” until May of 2004, when we downgraded the category to “Attractive” (these funds should beat the market and 60% of fund categories).

The category kept performing well, so we downgraded the category again to “Neutral” in October of 2004. The million dollar question: what should we do now?

It’s not enough for us to recommend an out-of-favor category that goes on to do well. We need to tell you when to sell, or at least cut back on your stake of categories that have done well but are heading for a downturn. This is where things get a little tricky. To be perfectly frank, we tend to get out of hot categories a little too early, as long-time subscribers to MAXadvisor (and MAXfunds readers) know. Real estate and precious metal funds come to mind.

Natural resource funds have been hot because commodities have been hot. These funds largely own mining and energy related companies. Until more resources can be explored for and produced, stocks in the category tend to do well when natural resource prices rise.

Natural resource stocks have also done well because they were cheap before but aren’t so cheap now – valuation expansion. Nobody wanted anything to do with such dull, old-fashioned businesses back in the new economy days. Today, the benefits of buying a business on the cheap are obvious, as are the negatives from paying too high a price. The five-year average annual return on the typical natural resource funds is about 18% - good enough to turn a $10,000 investment into $23,000. (The five-year average annual return on tech-nology funds? Try a negative 21% per year, enough to turn a $10,000 nest egg into a $2,700 cracked egg.)

Among the signs we look for that a category might be heading south are 1) huge inflows of fund investor money in the category, 2) new category focused mutual funds being launched, 3) increased ‘buzz’ about the category, 4) over-stretched valuations.

1) Inflows And this is where we are a bit on the fence concerning the natural resources sector. We’ve seen big flows of cash to energy funds. One of our favorite funds in this category, Vanguard Energy, just closed with $6.5 billion in assets. It had $2.5 billion in 2003 and $1.3 billion in 2001. Shareholder inflows to funds here make us negative on natural resources.

2) New Funds As for new funds, there have been a few, notably Guinness-Atkinson Global Energy (GAGEX) – a decent but expensive choice (full disclosure: Jim Atkinson of Guinness Atkinson is a former MAXfunds executive). We’d like to see more fund launches to really mark a top here. The “new fund” signal produces no clear verdict one way or the other on the future of natural resources.

3) Increased Buzz Recent trends suggest that you just can’t get away from Johnny-come-lately energy bulls. I’m not going to name names, but guys I recall touting tech stocks five years ago are now ga-ga over Exxon- Mobil. Amazing how the new economy gurus crossed over to the old economy. Too bad they didn’t change their minds earlier. They could have saved investors some money…
And of course, the experts talk a good game, and energy seems to make sense. Things look good for energy stocks, which is why they’re up a gazzilion percent, for Pete’s sake! Many natural resource funds were up 15% or more last month alone! But then, didn’t tech stocks look pretty good back in the day?

This week on CNBC one energy bull showed a chart of energy stock’s percentage of the S&P500. Unlike tech stocks, which peaked out as a bigger chunk of total market cap in the S&P500, energy stocks are a mere 10% or so. This analysis was compelling because we look at the bigger parts of the S&P for contrarian signals as well. Then he went on to show how energy stocks used to be 20% or more of the index a few decades ago. So therefore, we have got a long way to go in this new bull market in energy.

Or do we? A few decades ago we didn’t have mega cap software and computer companies with billions in earnings. By the same historical logic, buggy whip stocks should stage a comeback. What about textiles? Agriculture? Railroads? Autos? Tech bubble or no, companies like Microsoft earn billions and deserve to hog up some of the index – the economy has evolved to the point where old industries like transportation and energy will never be the percentage they once were in the stock market, or in the economy for that matter.

4) Valuations While energy earnings are very strong right now, they are tied to sky high oil prices. While there is no law that says oil prices have to fall again, they could, and drastically. With commodities, you’re always one global recession away from a 50% haircut in prices. Profits could get cut sharply at energy companies in short order. Does Microsoft have to worry about such a situation? Maybe commodity based businesses should have lower P/Es than stocks that are more in control of their own near term destiny.

Even worse, Vanguard Energy now has a LOWER dividend yield than the Vanguard 500 Index – 1.1% compared to 1.6% (only some of this is because of slightly higher fees on the former). This is troubling because energy stocks are largely owned for dividends as long term growth prospects are expected to be average at best. Stock valuations point to a below average future for energy stocks.

Three out of our four sell-warning bells are ringing; the other (new fund launches) isn’t giving us a clear indication one way or the other. Our signals are clear – natural resources stocks have peaked. We’re now downgrading the category - for the first time in MAXfunds history - to a negative rating.

We are dropping the category; going to a “Least Attractive” should under-perform the market and 80% of stock fund categories over the next 1 to 3 years.

We recommended an energy fund in our 2004 hot sheet and we own energy funds in many of our managed accounts. We are now in the process of selling at least part of the stakes and locking in these gains – something you should consider if you followed our advice with this area in recent years.

When you do sell, be wary of short term redemption fees and short term tax rates if you own these big-gain funds in taxable accounts. Vanguard Energy is up 50% over the last year- you don’t want to pay a short term tax rate on that gain if you can push it off a few weeks and trigger a long term gain.

Remember the golden rule of fund investing with MAXadvisor: The (fund) customer is (almost) always wrong!

Sell when they buy and buy what they sell and you’ll do just fine over time.

Category Rating: (Weak) – should underperform the market and 60% of stock fund categories

Previous Rating (12/31/05): (Neutral) - Should match the markets return and perform in the middle of other
stock fund categories

Expected 12-month return: 5%