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Poor Future Returns Ahead According To Ten Years Of Highly Accurate Predictions

Can any one indicator predict, with a generally high degree of accuracy, whether stocks are going to do well or poorly over the next several years? Ditto for bonds? Most people would probably think not. Therefore, if you as an investor were to come across two such indicators, you would have to assess whether their successful results were indeed valid and likely to foretell future results, or on the other hand, perhaps be attributable merely to luck or chance, and essentially non-repeatable. Part of the obvious difficulty in finding such indicators is that both overall stock and bond prices cannot be attributable or influenced a single factor alone but a great number of factors. These factors interact, sometimes as might be expected, but at other times, differently, creating outcomes that few would have predicted. Some of these factors entail how certain aspects of the economy are functioning, but others would defy a straightforward relationship with the investing universe. Rather, the latter would likely require an estimate of hard to anticipate “psychological” factors that cause investors to either “love” or “hate” stocks and bonds, often over significant periods of time. At least, this is the conclusion I, and others, such as 2013 Economics Nobel Prize winner Robert Shiller have come to. In my case, this comes after approximately three decades of studying the movements of stock and bond prices and trying to understand what influences them. Given this, “single-dimensional” predictors of stock and bond prices are unlikely to be consistently successful, whether they be interest rates, gross domestic product, P/E ratios, consumer sentiment, or you name it. Instead, I’d rather study as many of the subfactors that potentially affect investment performance and come up with my own approximate assessment of potential future performance, even as highly subjective as that might appear. Narrowing this down further to a “composite” measure which might serve to help me predict future stock as well as bond performance might appear to be a nearly impossible task. But I will now present considerable evidence to the contrary. Specifically, the two measures I have come up with, one for stocks and one for bonds, have now been shown to have an impressive record going back to 2005. Note: Similar results were reported by me a little more than a year ago and even five years ago , and since then, new data continue to support the same findings. Of course, there can be no guarantees that these predictions will continue to prove accurate looking forward. Successful Stock and Bond Index Predictors Might Not Come From Where You Would Expect What I am referring to as “predictors” were not initially meant to be used to predict how the overall stock or bond markets would do. Rather, they were designed as recommendations, re-evaluated each calendar quarter, as to how much of a “moderate risk” investor’s portfolio should be allocated to stocks and how much to bonds in my Newsletter’s model portfolios. But, in a real sense, a relatively high allocation to stocks vs. bonds (or cash) should generally equate to an expectation that stocks will do relatively well, and the same for bonds. Likewise, relatively low allocations to either should generally suggest the opposite. Regarding a high or low allocation to stocks (or bonds), investors must ask what is the time frame involved. For example, in recommending a 100% allocation to stocks, does this mean one predicts stocks are going to be the best investment over the next few months, years, or over a lifetime? Each assumption has a totally different implication for judging the eventual success of the prediction. Again supposing an advisor recommends a 100% allocation to stocks. Question: Does this imply that he is quite bullish on the future prospects for stocks? Answer: Likely perhaps, but not necessarily. While this might be a logical conclusion, it only necessarily implies that he thinks stocks prospects are relatively better than the remaining alternatives, but not necessarily “high” in an absolute sense. For example: While stocks prospects might not be particularly bright, a 100% allocation would still make sense if one estimated that bond and/or cash returns were going to be even less. Thus, even expecting a 2% return in stocks should be preferable than, say, a negative return expected in bonds, or a near zero return in cash. If one had no expectation as to the future performance of either stocks or bonds, it would not appear to make any sense as a strategy to continually, or even on occasion, raise or lower one’s allocations. Rather, one would just select a single percent allocation that he was comfortable with given his risk tolerance, current financial position, age, years to retirement, etc. He would then only change that allocation when one or more of those variables changed, not because he thought it was a particularly appealing period ahead to hold more stocks, for example. Unlike aforementioned objective data such as current level of interest rates, etc., one’s percent allocations to stocks vs. bonds would seem to be totally subjective, and therefore, hardly useful as predictors. But in spite of the limitations, it does appear to make sense to consider strategic changes to allocations to either stocks or bonds as a type of numerically-based composite summary indicative of my level of confidence in upcoming future performance. I have chosen to define this measured future performance after three years for stocks and two years for bonds. How Do I Arrive at These Predictions? My recommended allocations (i.e. predictions) are based on almost all the information I can lay my hands on. This includes both economic data and, as noted above, whatever “psychological” inferences I can draw from observing how investors have behaved in the past, and therefore, are likely to behave like in the future. What are some examples of the latter? It has long been said that investors act in terms of greed and fear. This means that so long as the markets are going well, there is the tendency for investors to continue to invest accordingly, further pushing up prices. Obviously, the opposite is true as well: Fear, once aroused, can become the overriding emotion and keep on spreading to other investors. But “too much” of a good thing can lead investors to take profits. But “too much” of a reversal can bring out bargain hunters. And importantly, investors should be on the lookout for data that can cause what appears to be an ongoing trend to reverse. How These Past Predictions Have Fared Here are the data showing the effectiveness of using my overall allocation recommendations to stocks vs. bonds as predictors of subsequent stock and bond index performance. The data encompass all full three year periods for stocks and two year periods for bonds beginning back in Jan. 2005 and progressing to include the start of every subsequent calendar quarter. Using Stock Allocations The data is separated into two tables, making it easy to see two sets of outcomes depending upon high vs. low allocations. In Table 1 are shown all quarters in which, beginning the month shown, I recommended a relatively “high” allocation to stocks and the actual subsequent return on the S&P 500 index. A high allocation was defined as 55% or higher of an entire portfolio for moderate risk investors. Table 1: Annualized Returns for the S&P 500 Index 3 Yrs. After “High” Stock Allocation Recommendations Quarter Beginning Allocation to Stocks Annualized Return Quarter Beginning Allocation to Stocks Annualized Return Jan ’13 67.5% 15.1% Oct ’10 62.5 16.3 Oct ’12 67.5 12.4 Jul ’10 60 18.5 Jul ’12 67.5 17.3 Apr ’10 60 12.7 Apr ’12 67.5 16.1 Jan ’10 57.5 10.9 Jan ’12 62.5 20.4 Oct ’07** 55 -7.2 Oct ’11 60 23.0 Jul ’07** 55 -9.8 Jul ’11 62.5 16.6 Apr ’05** 55 +5.8 Apr ’11 65 14.7 Jan ’05 55 8.6 Jan ’11 65 16.2 A relatively high allocation to stocks made at the beginning of each quarter was predictive of a corresponding relatively high return on stocks as measured three years later in the great majority of cases (that is, 14 out of 17). The average annual three year return for all these high allocation predictions was 12.2%. Quarters marked ** show those three where a high stock allocation did not produce a relatively high 3 year annualized return; these returns were each below 6%. In comparison, Table 2 shows all quarters during the same span in which, on the date shown, I recommended a relatively “low” allocation to stocks along with the actual subsequent return. A low allocation was defined as 52.5% or lower for moderate risk investors. Table 2: Annualized Returns for the S&P 500 Index 3 Yrs. After “Low” Stock Allocation Recommendations Quarter Beginning Allocation to Stocks Annualized Return Quarter Beginning Allocation to Stocks Annualized Return Oct ’09** 50% 13.2% Apr ’07 52.5 -4.2 Jul ’09** 50 16.5 Jan ’07 52.5 -5.6 Apr ’09** 45 23.4 Oct ’06 52.5 -5.4 Jan ’09** 37.5 14.2 Jul ’06 50 -8.2 Oct ’08 42.5 1.2 Apr ’06 52.5 -13.0 Jul ’08 45 3.3 Jan ’06 52.5 -8.4 Apr ’08 47.5 2.4 Oct ’05 52.5 0.2 Jan ’08 52.5 -2.9 Jul ’05 52.5 4.4 A relatively low allocation to stocks was predictive of a corresponding relatively low return on stocks as three year subsequent stock index returns were noticeably lower than those shown in Table 1 in the great majority of cases (12 out of 16). The average annual three year return for the low allocation recommendations was a mere 1.9%. Notable exceptions are shown with ** for those four quarters where a low stock allocation did not produce a low three year annualized return, and in fact, where returns were quite positive. These exceptions, as well as those in Table 1, will be discussed in more detail shortly. Bottom line : The subsequent three year annualized returns in stocks originating from high allocation quarters were greater than 6 times more than those originating from low allocation quarters ( 12.2 vs. 1.9% ) in spite of the relatively small percentage of missed predictions. Using Bond Allocations Below are the data when the same type of analyses is applied to my bond allocations. For bonds, a “relatively” high allocation was defined as 35% or higher of an entire portfolio for moderate risk investors, while a “relatively” low allocation was defined as 32.5% or lower. If relatively high allocations to bonds were predictive of relatively high returns on bonds, one would expect to see that reflected in actual performance data shown in Table 3, likewise for relatively low allocations shown in Table 4 which should be associated with relatively low future returns. Bond returns were those reported for the standard bond benchmark, the Barclays Aggregate Bond index, by averaging the returns from year one and year two after the allocation recommendations. Table 3: Average Yearly Return for Bonds 2 Yrs. After “High” Bond Allocation Recommendations Quarter Beginning Allocation to Bonds Avr. Yearly Return Quarter Beginning Allocation to Bonds Avr. Yearly Return Oct ’10** 35% 5.3% Apr ’09 47.5 6.4 Jul ’10** 35 5.7 Jan ’09 50 6.2 Apr ’10 35 6.4 Oct ’08 40 9.4 Jan ’10 37.5 7.2 Jul ’08 35 7.8 Oct ’09 45 6.8 Apr ’08** 35 5.4 Jul ’09 45 6.7 The average yearly return for the high allocation recommendations in Table 3 was 6.7% . In 8 out of 11 cases, the return was at least 6%. Those 3 instances in which the return was less than 6% are marked with **. Table 4: Average Yearly Return for Bonds 2 Yrs. After “Low” Bond Allocation Recommendations Quarter Beginning Allocation to Bonds Avr. Yearly Return Quarter Beginning Allocation to Bonds Avr. Yearly Return Jan ’14 25% 3.3% Jan ’08 30 5.6 Oct ’13 25 3.5 Oct ’07** 30 7.2 Jul ’13 25 3.2 Jul ’07** 22.5 6.6 Apr ’13 27.5 2.8 Apr ’07 25 5.4 Jan ’13 27.5 2.0 Jan ’07** 27.5 6.1 Oct ’12 27.5 1.2 Oct ’06 27.5 4.4 Jul ’12 27.5 1.9 Jul ’06** 27.5 6.6 Apr ’12 25 1.9 Apr ’06** 27.5 7.2 Jan ’12 32.5 1.1 Jan ’06 30 5.7 Oct ’11 32.5 1.8 Oct ’05 27.5 4.4 Jul ’11 30 3.4 Jul ’05 30 2.7 Apr ’11 30 5.8 Apr ’05 25 4.5 Jan ’11** 30 6.0 Jan ’05 25 3.4 The average yearly return for these low allocation recommendations in Table 4 was 4.1% . In contrast to Table 3, in 20 out of 26 cases, the return was less than 6%. The exceptions are marked with **. Bottom line : Bond allocations formulated two years prior to actual bond market returns were available typically were able to predict how high or low bond market returns would be. In fact, high allocations were followed by bond market returns which were approximately 63% higher than when low allocations were recommended. Highly Accurate Predictions For both my stock and bond allocations going back to 2005, separating recommendations into those that were relatively high vs. low allocation would have been able to help investors capture high returns and avoid low ones. The results helped predict stock and bond market performance during both strong markets and weak ones over more than a 10 year period. These findings, along with those prior articles mentioned above, should be regarded as surprising, given what is regarded as the extreme difficulty of predicting stock and bond indexes using any number of other more objective measures. While the data show some exceptions to accurate prediction, even when including these exceptions, the average outperformance of the high vs. low allocations has been large enough to suggest that my allocations are, for the most part, anticipating correctly future strength and weakness within broad market indexes. Most and Least Successful Stock Predictions For stocks, the predictions for high returns were the most accurate from about 1 year after the beginning of the bull market which started in March 2009, a period encompassing 13 consecutive quarters. In the case of predicting low stock returns , they were most accurate for 8 consecutive quarters during the midst of the 2003-2007 bull market as they correctly anticipated that stock prices might begin to underperform for the next several years. They were also highly accurate in predicting low returns for 4 consecutive quarters after the 2007-2009 bear market had begun. The predictions for high stock returns were inaccurate only for a single quarter in the early part of 2005, and at the start of the two quarters preceding the start of the 2007-2009 bear market. The predictions for low stock returns were inaccurate only prior to the beginning of the 2009 bull market and for 3 subsequent quarters. Most and Least Successful Bond Predictions For bonds, the predictions for high returns were most accurate for the 8 consecutive quarters starting in the midst of the 2007-2009 recession and continuing for about a year beyond. They were most accurate in predicting low bond returns during the 12 consecutive quarters after the post 2007-2009 recession and economic expansion was well underway. They were similarly accurate during the ongoing economic expansion in 2005 for 5 consecutive quarters. Predictions of high bond returns were inaccurate during the 2 quarters US economy moved well past the 2007-2009 recession. There were several irregular periods of inaccuracy in predicting low bond returns during the 1 1/2 year period which preceded the 2007-2008 financial crisis. In summary, while my predictions were accurate the great majority of the time, they had the most trouble predicting subsequent returns when the economy “turned” in some significant way, such as when an ongoing bull trend turned to bear, or vice versa. But these inaccurate predictions were usually relatively brief as compared to the times when the predictions were accurate. What This Suggests for Future Stock and Bond Market Returns The above Tables do not show my most recent allocations to stocks and bonds. This is because not enough time has elapsed yet since Apr. 2013 for stocks and Apr. 2014 for bonds to see whether the longer term predictions will prove accurate. Table 5 shows these allocations; instead of showing three (stocks) and two year (bonds) returns, returns for just one year are shown. Table 5. Recent Quarterly Asset Allocations for Stocks and Bonds and Returns After One Year Quarter Beginning Allocation to Stocks S&P 500 Return 1 Yr. Later Quarter Beginning Allocation to Bonds Bond Index Return 1 Yr. Later Jan ’16 52.5% NA Jan ’16 35% NA Oct ’15 50 NA Oct ’15 35 NA Jul ’15 50 NA Jul ’15 25 NA Apr ’15 50 NA Apr ’15 25 NA Jan ’15 50 1.4 Jan ’15 25 0.5 Oct ’14 50 -0.6 Oct ’14 25 2.9 Jul ’14 50 7.4 Jul ’14 25 1.9 Apr ’14** 50 12.7 Apr ’14 27.5 5.7 Jan ’14** 52.5 13.7 Oct ’13 55 19.7 Jul ’13 65 24.6 Apr ’13 67.5 21.9 Note: NA signifies data not yet available. Although we cannot yet see if these predictions will be in line with the data in Tables 1 through 4, highly similar trends are already starting to emerge. For stocks, when allocations were high (55% and above), the average S&P 500 index return one year later was 22.1%; when allocations were low (52.5% and below), the average return one year later was 6.9%. The two instances out of 8 in which the predictions proved inaccurate are marked with **. For bonds, in the 4 instances where data currently exists, when allocations were low (32.5% and below), the average return for the Barclays Aggregate Bond index was 2.8%. Referring back to Table 4, you can see that bond returns have been consistently low for each quarterly two year period since April, 2011. Additionally, current three year returns Additionally, current three year returns on stocks still suggest that having a high allocation to stocks during the early months of 2013 would have been helpful to investors. However, since S&P 500 stocks have not shown any gains over the last a year and a half, it may be that 3 year gains will not be strong as we move forward. It appears that the trend for stocks indeed turned at that time and my allocations, as previously, had some difficulty at first in correctly predicting that turn. In Jan. 2014, my stock allocations dropped to 52.5% and have remained at that level or below ever since. Since stock returns, although initially good, have turned marginal since that date, it again appears that a relatively low allocation to stocks, although somewhat early, may turn out to have been a helpful move. Since Apr. 2014, my allocations to bonds have mostly been low. However, starting in Oct. 15, they turned high. As noted, over the entire period, bond returns have also been relatively low. But it should be pointed out that I raised my allocation to bonds not because I expected high returns on an absolute basis but only relative to cash. If the successful prediction demonstrated in Tables 1 through 4 shows these allocations are tapping into the potential performance of stocks and bonds, it would appear that we may be in for a continued period of low returns for both. Especially for investors in S&P 500 index funds, such as (MUTF: VFINX ) and (NYSEARCA: VOO ), the bond benchmark (NYSEARCA: AGG ), but also all other funds/ETFs that benchmark these two indexes, my findings may be of particular value. Disclosure: I am/we are long VFINX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Highly Overvalued Market? Consider Employing These Strategies

It is one of the hardest things for investors to do. What am I referring to? It’s this: Breaking away from the tendency, in making investment decisions, to be highly influenced by how things have been going lately , and then assuming such observations suggest that the same general type of results will carry forward for at least the next several years, if not indefinitely. While it may often be true that investments that have been doing well lately will continue to do well over the relatively shorter term, investors, in my opinion, should be much more cautious when ETFs/ stock funds appear to be showing signs of moderate to gross overvaluation. Those happenstances may not occur that often: they most likely will occur mainly late in extended bull markets. Investors mindfully, but perhaps just sub-consciously, have much greater tendency to invest more in stocks during a long bull market, and with greater confidence, than when stocks aren’t in one, and instead are either a) just chugging along moderately well but not some downside, b) essentially going nowhere over a considerable period, or c) are in, or near, a bear market. For many, it seems hard to not to invest more during a prolonged bull market, and also not to invest in the prior best performing types of funds under what appear to be highly favorable conditions. People seem naturally inclined to extrapolate past to future. They tend to assume that what has been working well will continue to do so, which in the case of a bull market, is typically stocks in general. Additionally, they also tend to believe those specific categories of stocks which have been performing particularly well, and the best performing market sectors, will continue along the same path. A Re-think Is Often Necessary Under such circumstances, investors, rather than investing as they might have before the overvaluation began, need to think even more than otherwise, about what their returns might be as far as three years ahead, as opposed to, say, merely over the next six months, or even the next year or more. Why? Here are some data showing what might otherwise happen: About a year and a half ago (July 2014), stocks from around the developed world were on a tear. Prior one year returns were at least 20% pretty much no matter where one looked, and even more caution-inducing from my point of view, 5-year annualized returns were generally in the high teens, such as the S&P 500 index, up 18.8%. Virtually all stock fund categories were overvalued, as repeatedly emphasized over many months before that date in articles I authored on my website and elsewhere, including on Seeking Alpha. Which types of stock funds were looking the strongest, and therefore, to the unwary, deemed most likely to continue their sizzling performance? Some sector fund returns were showing near 30% one-year returns or better, including health care, natural resources, and technology. Over the prior 5 years, small- and mid-caps, as well as health care and real estate sector funds were approximately averaging at least 20% annualized returns. So, it is not surprising that back then, aside from investing heavily in the broad market and international stocks, investors had also gravitated toward relatively large positions in small caps, mid caps, and the above sectors through funds and ETFs. By one year later, that is, by July 2015, the returns on these investments presented a mixed picture. While the S&P 500, mid-caps and small-caps were still holding on to moderate one year gains in the 6 to 7% range, international stocks had generally tanked into moderately negative territory. Only health care sector funds continued to sizzle; while technology and real estate funds were still positive, they slowed considerably from their prior performances. Now here we are a little more than another 6 months later. So where do these year and a half ago choices stand today? Most of the above gains have been wiped out, or nearly so, although small health care gains still remain intact. The following table shows prices for some representative Vanguard stock ETFs from the start of the period compared with now (all data in this article thru Jan. 25). The percentage change in price gives one a close approximation as to how each ETF has performed over the period. Such ETF performance can be taken as a close proxy for other identical category funds, both unmanaged and managed: ETF (Symbol) 6-30-14 Price 1-25-16 Price Percent Change Over 1.5+ Years (not annualized) S&P 500 ETF (NYSEARCA: VOO ) 179.46 172.07 -4% Mid-Cap ETF (NYSEARCA: VO ) 118.66 107.64 -9 Small-Cap ETF (NYSEARCA: VB ) 117.12 98.34 -16 Total International Stock ETF (NASDAQ: VXUS ) 54.15 40.96 -24 Health Care ETF (NYSEARCA: VHT ) 111.58 122.31 +10 Materials ETF (NYSEARCA: VAW ) (Natural Resources) 111.77 80.97 -28 Information Technology ETF (NYSEARCA: VGT ) 96.75 98.82 +2 REIT ETF (NYSEARCA: VNQ ) 74.87 75.93 +1 Note: An ETF’s total return, including dividends and capital gains if any, is not reflected when just looking at the above prices alone. So, for example, if a given ETF pays a 2% yearly dividend, you will not see how that dividend affected the fund’s year and a half return. To get a better estimate of actual performance, you would need to add the approximately 3% in dividends for the 1 1/2 year period to the percent change shown above. This also applies to all the percent change figures below. Implications for Stock/Bond/Cash Allocations Are there any other types of investments investors might have considered investing more in back in July 2014? Unfortunately, most other categories of stock ETFs/funds have not performed any better, and some have done even worse. On the other hand, in some cases, where returns for many the above types of stock funds have been negative, at least for the period under consideration, investors would have been better off by just being in cash or money market funds. While such funds hardly returned much more than zero, at least they did not show negative returns. How about bond funds ? The following chart shows prices for some representative ETFs and funds from Vanguard then and now. ETF/Fund (Symbol) 6-30-14 Price 1-25-16 Price Percent Change Over 1.5+ Years (not annualized) Total Bond Market ETF (NYSEARCA: BND ) 82.15 81.31 -1% Total Intl Bd Idx (MUTF: VTIBX ) 10.25 10.62 +4 Interm-Term Tax-Exempt (MUTF: VWITX ) 14.14 14.37 +2 Note: Returns from tax-exempt bond funds should be regarded as higher than they appear because, unlike with taxable bonds, one typically gets the full return rather than the after-tax lowered return that will result from ordinary bonds held in a taxable account. But Short-Term Returns Often Fail to Show the Whole Picture Of course, the above data presents only a snapshot taken at the current point in time. Therefore, one cannot say conclusively that investors will continue to have been better off in non-stock investments because, if held further, the stock investments could well rebound and eventually outpace holding the non-stock investments. Obviously, though, there is no guarantee that stock prices will quickly return to their winning ways. And because it is a fact that many investors do wind up switching out of losing positions and thus missing out on eventual recoveries, it may therefore turn out that many investors would have been better off by not having invested as much as they might have in mid-2014’s overvalued stock funds, and instead, by having reallocated some of these investments to cash or bonds. Thus, while we still don’t know how well stocks will do in the next few years, it is highly possible that there would have been some better options looking forward from mid-2014 than the well-performing, but overvalued, funds/ETFs mentioned above. Instead of investing based on current data which often just suggests, at best, a possible relatively short-term investment direction, it is often better to invest with at least a three year horizon which looks beyond the “here and now” and tries to anticipate where things are more likely to go if and when there is a change in underlying economic data and/or investor sentiment. And over such a lengthier span, it makes sense to consider the downside of sticking with highly “overvalued” fund categories, and the potential upside of any possibly less overvalued categories that may not have performed as well but are still likely to do considerably better in the future. Another possibility is just to become more defensive, increasing one’s allocation to cash, and possibly, bonds. A Flashback to the Past Is there a recent comparable period of time in which investors turned out to have likely mistakenly gravitated toward high-flying stocks? The last time this happened was in the fall of 2007 when, as above, virtually all stock fund categories had become overvalued. The average US stock fund had returned 17.6% over the prior year and 16.1% over the prior 5 years annualized. International stock funds had done even better, showing 26.3% and 22.6% gains over the same periods. Among the standout categories were mid and small caps, technology, communication, utilities, natural resources, and emerging markets. On the other hand, at that time, bond funds weren’t doing terribly, but not particularly well over the prior 5 years with the benchmark (NYSEARCA: AGG ) returning 4.1% annualized. But things turned around sharply over the following three years. Most of the above mentioned stock fund/ETF categories showed deeply negative 3-year returns by the fall of 2010. The AGG bond benchmark, on the other hand, returned better than 21%, or 7% annualized. The following table shows how some of the high-flying stock performers in the fall of 2007 fared over the following three years: ETF (Symbol) 9-28-07 Price 9-30-10 Price Percent Change Over 3 Years (not annualized) S&P 500 ETF 140.61 105.06 -25% Mid-Cap ETF 79.64 66.30 -17 Small-Cap ETF 72.63 63.51 -13 Total International Stock ETF 20.67 14.95 -28 Information Technology ETF 60.68 55.59 -8 Telecommun Serv ETF (NYSEARCA: VOX ) 83.09 62.72 -25 Utilities ETF (NYSEARCA: VPU ) 83.02 66.36 -20 Materials ETF (Natural Resources) 88.05 70.92 -19 FTSE Emerging Markets ETF (NYSEARCA: VWO ) 103.80 45.35 -56 Now, here’s how two Vanguard bond funds and its main money market fund did over the same 3 year period: ETF/Fund (Symbol) 9-28-07 Price 9-30-10 Price Percent Change Over 3 Years (not annualized) Total Bond Market ETF 75.44 82.56 +9% Interm-Term Tax-Exempt 13.19 13.89 +5 Prime Money Market Fund (MUTF: VMMXX ) 1.00 1.00 +5 Note: Return for the money market fund was 1.5% annualized, or approximately 5% non-annualized over the period. Final Thoughts While history unlikely ever exactly repeats itself, and 2007 through 2010 was undoubtedly different than 2014 through 2016 and beyond will be, investors should be on guard against certain similarities. Evidence suggests that once stocks get “ahead of themselves” for too long, returns tend to be subdued, if not outright negative, for a number of years going forward. Research I have conducted suggests that making “contrary-to-the-prevailing-sentiment” decisions based on extreme overvalued (or, for that matter, undervalued) conditions may appear wrong-headed and wrong-footed over the short term. However, over periods of at least three years, these decisions likely will come out ahead of sticking with what the majority of investors opt for as their current favorite choices which are often based heavily on current conditions, relatively devoid of overvaluation considerations.

Investors May Be Doing The Wrong Thing (Again)

Summary In this article, I delve a little deeper into my recommended Model Stock Portfolio funds to try to get a fresh perspective that cannot be found elsewhere. The snapshot that emerges is intended to further help result-seeking investors judge what might be the best choices going forward within a group of already highly recommended funds. Investors often invest heavily in funds whose holdings are tilted toward previously strongly performing but overvalued stocks, rather than from those with a better chance of showing future strength. It should go without saying that no single or even multiple selection criteria hold the key to which funds you should hold on to and with what emphasis in your portfolio. However, in my Newsletters down through more than 15 years, I have tried to make the case that, while there are numerous good funds (or ETFs) to choose from, the best long-term results are more likely when, even within a list of highly rated funds, one focuses on those composed of stocks that are relatively more undervalued vs. those made up of stocks which have already been “discovered,” and therefore, likely have seen most of their potential run-up in prices already. Expressed a little differently, some funds may have achieved their recent success by their emphasis on holding a preponderance of already recognized “winning” stocks and stock categories and continuing to ride those winners. A simple example is funds that hold a relatively large proportion of what has proven to be an amazing stock, Apple (NASDAQ: AAPL ). The same may be said for funds that have a relatively high proportion of recently high-performing technology stocks as a group. Two such funds I have consistently recommended are the Vanguard Growth Index Fund (MUTF: VIGRX ) (or its equivalent ETF) and Fidelity Contra (MUTF: FCNTX ). The former currently holds 7.5% of the fund in Apple and 26% of the fund in Technology companies. The latter holds about 3.8% in Apple and 29% in technology stocks. Given the excellent performance over recent years of these fund components, the heavy weighting has given a boost to both these funds (and many other similarly categorized Large Growth funds), and been a contributing factor as to why these two funds have beaten the S&P 500 Index on average over many years. But another even more striking example can be cited: funds investing heavily in Health Care, such as PRIMECAP Odyssey Growth (MUTF: POGRX ), Vanguard Health Care (MUTF: VGHCX ) or Vanguard Health Care ETF (NYSEARCA: VHT ). Not surprisingly, the latter two highly narrow-focused funds have nearly all their investments in this one sector, a stock subclass that has on average returned over 20% annualized over the last five years. While, unfortunately, I have never included any of these funds in my Model Stock Portfolios, I have recommended at least one fund with greater than a 20% weighting in Health Care currently, namely T. Rowe Price Value Fund (MUTF: TRVLX ), This fund’s track record against its Large Cap Value category peers has been admirable over the last five years. Beyond this, though, is where things get very murky. As an investor, do you want to stick with funds that invest heavily in stocks and categories that have shown a lot of past momentum in the hopes that this outstanding performance will continue? Or, do you want, perhaps, to trim down your holdings of such funds, and instead for at least the next few years, favor funds more heavily invested in stocks and categories that may show even greater potential for success, namely those choosing the majority of their investments in potentially less overvalued segments of the market? Unfortunately, there is no clear-cut answer to this dilemma. Therefore, it is probably wisest to own funds weighted in both, that is, funds that invest heavily in stocks with strong current momentum, and, those that can potentially become better choices when the former momentum-driven stocks start to lose altitude. Unfortunately too, one of investors’ biggest downfalls happen when the winds of change periodically cause a big shift in the performance of previously winning stocks, categories, and the funds investing heavily in them. While we haven’t seen any such sort of massive shift going back perhaps to the 2007-09 financial crisis, or even before, we know that many investors tend to suffer when outsized bets on previous winners turn into outsized losses. While no one can say with any degree of certainty if and when the next reversal of fortune may befall the current crop of big winners in stocks, what follows is an analysis of which of my recently recommended funds are holding stocks perhaps overloaded with past winning, but now likely overvalued, categories of stocks. And, on the other side of the coin, can I identify which of my recommendations are more oriented toward current ownership in categories that seem to be less likely to underperform, when the next big shift in stock market winners and losers takes hold and impacts fund results for possibly years into the future? A Closer Look at My Model Stock Portfolio Funds In the first list of funds below, I analyze broadly diversified domestic stock funds recommended (or recently so) in my Model Stock Portfolio to examine the above issue. I also include some additional funds that I hold in my own personal investment portfolio. Funds more broadly classified as international stock or narrow-focused sector funds, however, are not included. For each listed fund, I have scored the fund on the extent to which it is currently (based on latest data available) invested in either what appear to be fairly priced categories of stocks, or on the other hand, seemingly overvalued categories, based on my own proprietary research. See the note at the bottom of the list for the meaning of scores. Each fund is listed in a descending order of score, starting with those least likely to be overvalued . Those with greater potential for coming out on top over the next 3 to 5 years, assuming my scoring method proves valid, are listed closer to the top; those that may be strong winners recently, but having a greater potential for underperformance when their current chosen and often overvalued stock selections lose momentum, are found further down the list. Note: If one compares the results shown in the list with the allocations shown in my Oct. ’15 Model Stock Portfolio , the results may not completely agree with the recommendations there because the listing below is based on different data. It should come as no surprise that all of the funds below, because they are diversified mixes of stocks, will have a moderate proportion of their investments in overpriced stock categories, given what we have previously labeled as an overall overvalued market. Therefore, inclusion in this list below in no way ensures that most or all of these funds will prove to be great investments over the next few years. But relatively speaking, we chose these funds, that is, those that are managed, aiming to beat market indices, or at least do well against their similarly classified peers. However, it is very possible, too, that perhaps some of the best investments for the next few years instead may turn out to be in funds that are invested internationally, as generally speaking, these fund categories seem to be relatively more undervalued than U.S. domestic funds are at the present time. Best Model Stock Portfolio Choices (from most highly rated* to less highly rated) Fund Name (Symbol) Score 3 Yr. Return (thru 10-27) (ann.) Category 1. T. Rowe Price Equity Income (MUTF: PRFDX ) 76% 10.6% Large Value 2. Vanguard US Value (MUTF: VUVLX ) 74% 16.5% Large Value 3. Fidelity Large Cap Stock (MUTF: FLCSX ) (tie) 70% 15.5% Large Blend 3. Vanguard Equity-Income (MUTF: VEIPX ) (tie) 70% 13.9% Large Value 3. Vanguard Small Cap Index (MUTF: NAESX ) (tie) 70% 14.7% Small Blend 6. Vanguard Extended Market Idx (MUTF: VEXMX ) 68% 15.0% Mid-Cap Blend 7. T. Rowe Price Value (tie) 65% 16.4% Large Value 7. Vanguard Mid Cap Index Adm (MUTF: VIMAX ) (tie) 65% 17.1% Mid-Cap Blend 9. Vanguard Small Cap Growth Index (MUTF: VISGX ) 64% 13.6% Small Growth 10. Vanguard Windsor II (MUTF: VWNFX ) 63% 13.4% Large Value 11. Vanguard 500 Index (MUTF: VFINX ) 62% 15.8% Large Blend 12. Fidelity Contrafund (tie) 58% 17.1% Large Growth 12. Vanguard Growth Index (tie) 58% 16.9% Large Growth 14. Fidelity Low-Priced Stock (MUTF: FLPSX ) 55% 15.2% Mid-Cap Value 15. AMG Yacktman Service (MUTF: YACKX ) 39% 11.7% Large Blend *Note: Top rating possible is 100%; lowest possible rating is 0%. A score of 70%, for example, means that 70% of the stocks in the fund are judged to be within a class of stocks that is fairly valued while 30% are within a category that my research indicates is overvalued. Of course, funds in the above list that are managed (that is, not index funds) will have the option of switching out of overvalued categories if it is decided to make such a switch. Index funds must stick to their mandated benchmark and typically will not change their composition unless the underlying index changes. Funds with the Most Investor Assets As a basis of comparison with the above funds and to see alternative funds chosen by investors that have currently attracted the most investor assets, it is also informative to look at similarly derived scores of the most popular funds using the same criteria to rate each in terms of my measure of fair vs. overvalued stock portfolio composition. (The first list also includes some of the biggest funds; it also includes a few that mirror some of the most important indices such as the S&P 500, so we won’t show funds that are identical or nearly so to those there. And, I again exclude international and sector funds.) Biggest Funds by Assets (from most highly rated* to less highly rated) Fund Name (Symbol) Score 3 Yr. Return (thru 10-27) (ann.) Category 1. Dodge & Cox Stock (MUTF: DODGX ) 71% 16.1% Large Value 2. Vanguard Value ETF (NYSEARCA: VTV ) 69% 15.0% Large Value 3. American Funds Washington Mutual A (MUTF: AWSHX ) 67% 14.4% Large Value 4. American Funds Invmt Co of Amer A (MUTF: AIVSX ) (tie) 64% 15.0% Large Blend 4. Vanguard Total Stock Mkt Idx Adm (MUTF: VTSAX ) (tie) 64% 15.8% Large Blend 6. American Funds Fundamental Inv A (MUTF: ANCFX ) (tie) 61% 15.3% Large Blend 6. American Funds AMCAP A (MUTF: AMCPX ) (tie) 61% 17.0% Large Growth 8. American Funds Growth Fund of Amer A (MUTF: AGTHX ) 54% 16.8% Large Growth 9. Fidelity Growth Company (MUTF: FDGRX ) 50% 19.6% Large Growth 10. T. Rowe Price Growth Stock (MUTF: PRGFX ) 48% 19.9% Large Growth *Note: See the Note under the first table. If you look carefully over these two lists, you will notice that the majority of funds with the highest, that is, best forward-looking scores, are categorized as Large Value funds. And, almost equally noticeable, most of the funds with a large percentage of already “discovered” stock categories, especially in the second list, are Large Growth funds. What this suggests is that the best opportunities for investors for the next several years would appear to lie in US stock funds that are classified as Large Value. Many Large Growth funds, if this analysis is valid, are likely to perform less strongly than Large Value funds because investors may have already realized most of the performance benefits of this category and are more likely to find both a greater degree of safety in Large Value funds when market conditions are no longer as bright, and a greater degree of return potential due to their less overvalued composition. While there is no way to know for sure how long the current “momentum bias” will continue, as it very well may, investors might always want to keep in mind that over long periods of time, the best way to make money in stocks is to establish and maintain your positions when prices are relatively low. It seems apparent, however, that looking at the second list featuring those funds investors have the most money invested in, they seem to be opting for many funds, including unmanaged index funds, with a relatively greater degree of already “stretched” types of stocks.