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The Fed Is Trying to Influence Your Asset Allocations

Now that many stock funds have risen as much as 125% since the March 2009 lows, and perhaps about 15% from June 1, 2012 low, should investors add to their stock positions, simply do nothing, or perhaps take some off the table? This question becomes even more complicated in light of the Fed's recent statements which are, in part, designed to push investors in riskier asset classes, including stocks.

Naturally, every investor's circumstances are different. For example, some investors may either be approaching retirement or already in retirement. Within this group, some investors may appraise that, while they are where they currently want to be with regard to their total overall assets, a serious and necessarily long-lasting drop in stocks might put them in jeopardy of not having enough in the years ahead. Such individuals might well feel that the risks associated with stocks might not warrant taking too many chances going forward.

In other words, further gains, while perhaps on the horizon, are not as strong a motivating force as the risk of possible losses. But for those individuals who have many years before actually needing to tap their retirement funds, or who still need to rely on further growth in their portfolios to meet their long-range objectives, significantly reducing one's allocation to stocks at this time would seem to be a mistake.

Regardless of the effects of the Fed's actions on other investors' behavior, one needs to decide for oneself what makes the most sense for you. The following discussion of our new Model Portfolios will try to shed some light on what we think will be the best directions for investors' portfolios over the next year or two.


October 2012 Model Portfolios

Overall Allocation to Stocks, Bonds, Cash

If you tend to follow an asset allocation model for stocks, bonds, and cash, such as I present at my website, http://funds-newsletter.com, at the beginning of every quarter, your percentages divvied up to each of these broad asset classes may have changed over the last year even if you took no action at all. This is because whatever you allocated to stocks has likely grown much faster than bonds or cash. For example, if you had 60% in stocks a year ago, 32.5% bonds and the rest in cash as we had recommended at that time, your current allocation to stocks might have risen to as much as 63% today while your allocation to bonds would have gone down several percent as well.

The following tables show approximately where you might want to have your allocations now. As you can see, the only change from our last Model Portfolio is a slight upward adjustment in stock allocation for conservative investors.

For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 67.5% (67.5%)
Bonds 27.5 (27.5)
Cash 5 (5)


For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 85% (85%)
Bonds 10 (10)
Cash 5 (5)


For Conservative Investors

Asset Current (Last Qtr.)
Stocks 47.5% (45%)
Bonds 45 (45)
Cash 7.5 (10)

Note: We realize that many conservative investors may recoil at our high recommended allocation to stocks. Obviously, there are many routes investors may elect and only time will tell which allocation will turn to be the most ideal. And, of course, one must take into account one's comfort level, not just potential returns. But investing in stocks will always require a certain "leap of faith."


Possible Effects of Fed Quantitative Easing on Your Investment Choices

On Sept. 13th, the Fed announced it would go further than it ever has to attempt to change the course of the economy which has been stuck in low gear. So the question becomes what effect, if any, might this radically new policy potentially have with regard to creating a fund portfolio designed to deliver decent returns while always being mindful of the risks over at least the next year?

Is it reasonable to expect the new Fed actions ("QE3") to boost stock prices even further, as they did for the two previous versions of QE1 and QE2?

I believe that given that QE3 may go on for years, it is likely that it will serve as a prop under stock prices since low interest rates almost always work as a stimulant to stocks. Not only is there the potential for stimulus, but many investors sitting on the sidelines are more and more realizing that they can't make a decent return in either cash or many types of bonds. Therefore, like it or not, they will essentially feel "forced" to take the plunge into stocks.

Not all types of bonds will necessarily suffer. Any funds that pay a somewhat higher yield should be the main beneficiaries. These include high yield bonds, corporate bonds, and possibly, municipal bonds and emerging market bond funds that have higher yields than U.S. government bonds. Investors should emphasize mainly intermediate, as well as some longer-term bonds, rather than short-term bonds whose yields are low and likely going even lower. (Lower bond yields can create capital gains, but such gains should be greater for longer-term bonds.) While we view the bond investor's enemy, inflation, as still quite unlikely for the next several years, inflation-protected bonds (TIPS) are still a better way to go than Treasuries.

Since the Fed is specifically going to be buying mortgage-backed securities, we expect that bond funds including them, including GNMA funds, may do somewhat better than expected too. According to published data, the world's biggest and most successful bond fund over the years, PIMCO Total Return, now has about a 50% position in mortgage-backed securities, suggesting this assumption is likely valid.

As far as the types of stocks, and therefore, the type of stock funds that should profit most from QE3, we compiled a list from several knowledgeable sources and here are those that we see being frequently recommended:

1. Income/dividend producing stocks
2. Natural resource funds, including precious metals, energy, and commodities
3. Real estate funds
4. Emerging market funds
5. Cyclical stocks (i.e. those closely tied to the growth of the economy), including financial and consumer discretionary stocks
6. International Stock funds that profit when the dollar is weak ("unhedged" funds; see "Comments" below)


Model Stock Fund Portfolio

Our Specific Stock Fund Recommendations Fund Category Recommended Weighting
Now (vs Last Qtr.)
Fidelity Low-Priced Stock (FLPSX) Mid-Cap/Small-Cap 15% (15%)
Vanguard Internat. Growth (VWIGX) (M)
Vanguard Europe (VWIGX) or Vang. MSCI Europe ETF (VGK) (A)
Tweedy Brown Global Value (TBGVX) (C)
International 22.5 (22.5)
Vanguard 500 Index (VFINX)
Yacktman (YACKX)
Large Blend 17.5 (17.5)
Vanguard Growth Index (VIGRX)
Fidelity Contra (FCNTX)
Large Growth 15 (17.5%)
Vanguard Windsor II (VWNFX) Large Value 15 (12.5)
Vanguard Financials ETF (VFH) (A)
Vanguard REIT ETF (VNQ) or Fund (VGSIX) (M)
Vanguard Consumer Discretionary ETF (VCR) (A)
Sector 15 (15)
Note: (M) indicates mainly for Moderate Risk investors; (A) Aggressive Risk; (C) Conservative Risk

Comments

Of all stock fund categories, those with a Large Value orientation appear to have the best prospects going forward. This would also include ETFs in the Financial sector.

If QE3 has the effect of weakening the dollar as many economists expect, this might be a reason to favor a traditional "unhedged" International fund, such as VWIGX, that profits from such a currency effect. If, however, the dollar remains as a relative safe haven for investors in an otherwise tottering world economy, then a "dollar-hedged" international fund, such as TBGVX, will continue to be a better choice. (TBGVX has outperformed 99% of International Stock funds over the last 5 years, but has dropped to the bottom over the last month, given that the weak dollar has currently re-emerged as a result of QE3 expectations.) Given the uncertainty, we would suggest holding both types of funds.

Incidentally, investors seem to have become much more confident that the euro zone is getting a grip on its problems lately with the European Central Bank having recently come out with a bond-buying program of its own. The region remains highly undervalued in our estimation and we would therefore regard it as one of the best BUYs out there for long-term investors.


Model Bond Fund Portfolio

Our Specific Bond Fund Recommendations Fund Category Recommended Weighting Now
Now (vs Last Qtr.)
PIMCO Total Return Instit (PTTRX) or
Harbor Bond Fund (HABDX)
Vang. Total Bond Mkt. (VBMFX) (C)
Diversified 35% (32.5%)
PIMCO Real Return Instit(PRRIX) or
Harbor Real Return (HARRX)
Inflation 15 (15)
Vang. GNMA (VFIIX) Intermed. Govt. 5 (7.5)
Vang. Intermed. Term Tax-Ex. (VWITX) (See Note 1) Intermed. Term Muni 12.5 (12.5)
Vang. Long-Term Inv. Gr. (VWESX)
Loomis Sayles Retail (LSBRX) (See Note 2)
Long-Term Corporate
and/or Multisector
12.5 (12.5)
Vang High Yield Index (VWEHX) High Yield 15 (15)
PIMCO Foreign Bond (Hedged) Adm (PFRAX) World 5 (5)
Note 1: Instead, if available, select a muni fund that has your own state's bonds for double-tax exemption.
Note 2: LSBRX is mainly for Aggressive Risk investors.

Comments

Many of the above bond funds are having a great 2012 thus far. The exceptions are VBMFX and VFIIX. The problem with these two is simply that their yields are too low to interest investors at this point (about 1.6% and 2.3% respectively, as of this writing.) While these are good funds, we don't expect their returns to improve anytime soon. Of course, VFIIX could get a boost from Fed purchases as noted above, but in this regard, we'd still trust PTTRX to find the best mortgaged-backed opportunities.

 

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