FSO Editorials: Severe Bear Markets Ahead by Robert B. Gordon 08/20/2003

Severe Bear Markets Ahead
Investors: Check Your Portfolios
by Robert B. Gordon, Sc. D.
August 20, 2003

This is our second anniversary of web publishing to alert investors to the perils of this vicious bear market. We are nearing our first hundred essays in issuing warnings to those willing to read them. In recent months, while recovering our health, we asked FSO to republish our first seven essays starting with #1 written in August 2001. These information and warning messages are still valid due to the slow progress of the bear market to date. But recent events indicate this big bear is about to speed up and may surprise many investors by creating major problems in their present portfolios. Every serious investor needs to recognize the dangers ahead and take adequate steps to protect their assets.

While stocks prepare to renew their bear market trend, bonds appear to have ended their 22-year bull market of rising prices and lower interest rates. In just the past two months, interest rates on bonds of all maturities have risen sharply; while their prices dropped. If this trend continues, as now seems likely, it will create havoc for corporate and government bond issuers. And the fall in bond yields will cause very serious problems for individual and corporate bond holders such as banks and insurance companies, pension funds etc.

The increase in yields on newly issued bonds will have serious negative effects on the federal and state governments which need to sell new issues to reduce their huge deficits. So with the specter of falling prices in both stocks and bonds, what can an ordinary investor do to keep their assets from dwindling? That is the problem that we will deal with in this essay.

The crashing of the debt bubble in bonds is bringing closer the end of the huge bubble in home mortgages. Thirty year mortgage interest rates have risen by over a full percentage point in recent weeks. This will have the effect of slowing down both new and used home sales and prices and bring closer the bursting of the housing bubble.

Experts in bonds and derivative securities have recently been publishing scary stories about serious problems ahead for the GSEs, Fanny Mae and Freddy Mac, who own most of the mortgages written in the last several years. Some major banks, heavily involved in bonds and derivatives, are also on lists of financial institutions with a precarious failure potential.

The abrupt end of the credit and housing bubbles now in sight will have an adverse effect on consumer spending and on the economy as a whole. Consumer confidence will drop and end all hope of an economic recovery. This will intensify the problems of the 50 states who currently think selling bonds will be a good solution to their short-term deficits. When they can no longer sell bonds, it will force large scale cut backs in employment for both government and business and bring on the specter of another Depression Era like that in the 1930s. The fact that hardly anyone expects this outcome will shatter public confidence.

We do not have a time table for the coming depression, but have been expecting it as part of the aftermath of the largest stock market mania in world history. Robert Prechter’s prophetic book At the Crest of the Tidal Wave published in 1995 forecast not only the Crash, but the Depression that would follow it. This great book and its 2002 follow up, Conquer the Crash, have long been essential reading for any investor trying to understand current events. Buy them right now or read them at your local library. These two books when read carefully will, as they did for me, change your whole perspective on the stock market and the economy.

Since no one has invented any new investment classes lately, we will have to use the very best of the old ones in combination to meet the expected difficult environment. In our view, the most important asset classes are as follows:

Short-term Government Bonds of highest quality, in equal quantities of U.S. Treasury and Foreign Government issues to protect against depreciation of the Dollar. There are a number of mutual funds available to American investors that can readily fill this requirement. I have an essay on foreign government bond funds in my archive at www.freebuck.com. Go to this site and click on Commentaries and then on my name to reach the archive.

Short mutual funds designed to profit in a declining stock market. There is a small number of short funds that are fully managed by their managers. There are a larger number of funds that follow a policy of being short several market indices such as the S&P500 or the NASDAQ. A listing of these funds with their daily prices can be found on www.bearmarketcentral.com. I have written quite a few essays on short funds over the past year which will be helpful.

There are two ways to profit from a declining bond market. Buying mutual fund RYJUX will give you a position that is short the 30-year U.S. bond. Selling short an Exchange Traded Fund (ETF) that holds U. S. bonds in several maturities is another way to gain a short position in bonds.

Precious metals will be a very important major asset class for the stormy conditions ahead. Two closed end funds with fixed assets ASA (NYSE) and CEF (AMEX) have been used in our portfolios in the past because they trade on their current exchange selling price, not at a daily offering price. In recent years they have traded both below and above the market value of their portfolio. So knowledgeable investors can use this greater price volatility in buying and selling CEF and in both buying, selling and selling short ASA.

Later in this essay, we will provide a table of the recent and longer price performance of a group of no load gold funds. There are also two important funds, managed by the same person and firm, whose portfolios each contain one of the asset classes described above plus a minor position in precious metals - in other words hybrid funds. To make our dear readers look before they buy these two funds, we supply only the phone number to order their prospectuses: (800) 711-1848.

	Short-Term U. S. Treasury Bonds	30%
	Short-Term Foreign Gov't Bonds	30%
	Reverse Index S&P 500 Short Fund	10%
	Reverse Index 30-Year Bond Fund	10%
	ASA Closed End Gold Fund	10%
	CEF Closed End Bullion Fund	10%
	Total	100%

This 6 asset portfolio is not intended to be bought and held indefinitely, but to be followed at least quarterly and rebalanced regularly to take advantage of one or more asset classes growing faster than the others. During the regular rebalancing, profits are transferred from the volatile to the stable classes, probably the bonds, where they will be available for a reverse transfer later to an under performing asset. Eventually, thru rebalancing, the entire portfolio can grow, steadily and quite safely, thru numerous periodic transfers. This very important process keeps the asset classes fixed at the desired initial level

The 60% allocation to short term bonds provides a safe core position which can transfer assets periodically to other asset classes which may be under performing. At a later date when the more volatile short or gold classes are outperforming, rebalancing then returns the gains to the bond classes. In this simple way, over time, this conservative portfolio will be capable of making slow steady overall gains as it is intended to do.

The percentage allocations given above are not meant to be mandatory for any investor. The bond allocation could be increased, for example, to 70%; while the short or gold funds are reduced in their percentage. This portfolio intentionally holds no ordinary equity positions since it is our expectation, borne out in 1932, that over the bear market years to come, nearly all stocks will fall to extremely low prices. Instead of being long stocks, we prefer to hold a small short position that will slowly grow thru the rebalancing process and normal market volatility.

	Short-Term U. S. Treasury Bonds	25%
	Short-Term Foreign Gov't Bonds	25%
	Reverse Index S&P 500 Short Fund	6%
	Reverse Index NASDAQ Short Fund	6%
	Reverse Index 30-Year Bond Fund	6%
	ASA Closed End Gold Fund	8%
	CEF Closed End Bullion Fund	8%
	Gold Stocks or Funds	8%
	Silver Stocks	8%
	Total	100%

This larger portfolio features a larger position in precious metals and smaller positions in bonds and short positions. However in my view it is well balanced although slightly more volatile than the example above. It should grow well thru periodic rebalancing which will transfer gains from the precious metals and short funds to the stable bond funds. There will also be frequent asset transfers between the 4 precious metals classes which will "march to different drummers." Each modest transfer eventually adds up to significant overall portfolio growth.

	Short-Term U. S. Treasury Bonds	35%
	Short-Term Foreign Gov't Bonds	35%
	Reverse Index S&P 500 Short Fund	7.5%
	Reverse Index 30-Year Bond Fund	7.5%
	ASA Closed End Gold Fund	7.5%
	CEF Closed End Bullion Fund	7.5%
	Total	100%

This portfolio, as well as the others above, is designed to provide safety of principal together with modest gains over time. The bond funds in equal amounts will protect assets against loss from a declining dollar. The short funds and the gold funds will gain when their asset classes are rising and lose when they are falling. But, in a major bear market, the primary direction is down so they will be gaining more often than losing. Thus, we expect that the example portfolios will gain in value slowly over time and protect the invested assets.

We have written quite a few essays on the benefits of portfolio rebalancing which can be viewed in our archives. We, very definitely, do not use the term as does Wall Street when they say "let us rebalance your portfolio." The main purpose of our periodic rebalancing is to retain the original asset allocation over time - to keep the growth classes from becoming an unplanned large part of your portfolio. In all the examples given above, the short and gold asset classes would gain in percentage and the conservative bond allocation would be diminished if no rebalancing were done.

A secondary purpose, and a very desirable one, is to grow the portfolio assets slowly over time. Unlike the stable bond sector, the short and gold assets are very volatile. Their prices are usually going either up or down. So, periodically thru the rebalancing process, we transfer their gains to the bonds and then later transfer them back when they have declined to a lower price level and need more capital. Such rebalancing then returns assets from the bonds to the short and gold sectors under favorable price circumstances. Then the transfer process repeats again and again its main goal of wealth building and capital preservation.

Our rebalancing plan will only achieve its goal if the investor does it periodically like annually or when required by the different asset growth rates. Over twenty years, an annual rebalancing would be adequate for growth in most portfolios. I prefer to do it irregularly when one or more asset classes have developed a size that is out of balance with the initial plan. The absolutely best time to transfer assets is when one sub-class has grown rapidly and is at a peak price.

It is important to remind you that even our first small portfolio example has many growth possibilities. We list the potential rebalancing/growth opportunities:

Bonds: Transfers between the two bond classes. Transfers in and out from and to the short and gold classes.
Short: Transfers between the two short classes plus transfers both in and out from and to the bonds and gold.
Gold: Transfers between the two gold classes as well as in and out from both shorts and bonds.

We urge readers to go to our archive and read earlier essays which demonstrate the slow growth over time thru rebalancing. Portfolios such as those given above with very dissimilar asset classes will completely lose their original asset mix over time without rebalancing.

In small portfolios, say under $10,000, rebalancing is easily done by simply adding new cash to the under performing asset classes. Larger portfolios require sales and repurchases which is conveniently done with all the assets in one discount brokerage account.

For our readers information, we have periodically published performance data on gold stocks and funds. In the table below we list our favored 2 closed end funds and a group of no load open end mutual funds. The funds are ranked by order in the 3 year column.

% Total Return For Periods Ending August 15, 2003
Fund	Assets ($Mil)	3 Years	1 Year	3 Months
GOLDX	193	173.8	39.7	19.0
ASA	347	169.2	46.1	15.6
USAGX	172	167.5	44.3	25.6
TGLDX	251	161.9	42.3	19.9
SCGDX	203	158.6	57.6	31.6
BGEIX	196	148.7	38.4	21.6
USERX	47	118.8	41.1	25.3
UNWPX	97	103.8	44.5	25.6
FGLDX	113	96.6	27.6	19.1
RYPMX	128	88.7	28.4	21.1
FGADX	419	88.1	36.3	20.9
MIDSX	50	78.7	30.2	20.0
CEF	173	48.7	17.6	8.7
PSPFX	17	44.6	49.4	21.4

Our guess is that as soon as the gold price tops $400, many open end funds will have huge inflows of new money which will quickly limit their ability to buy small, fast growing gold and silver mining companies in volume. On the other hand, ASA is closed to new investors and does not have this disadvantage. Both ASA and CEF (which owns only gold and silver bullion), make great trading partners as used in our portfolios because one (ASA) is volatile and the other is not. Profits from ASA at a price peak are transferred to stable CEF and later returned to buy more ASA, perhaps at lower prices. All data is from Investor’s FastTrack.

It is extremely difficult for both new and older investors to appreciate the value of an adviser who has the ability and experience to manage their assets safely thru the troubled bear market that lies ahead. In the early years of my investing that started in1940, I probably made every mistake that can be made but eventually by 1972, I made it safely thru the second biggest bear market of the last century. Very few investors, active today, have benefited by that experience. One of them surely is Richard Russell who, at age 79, is the most respected financial writer on the scene today. Like me, he is bearish for the long term. Subscription to his service is quite expensive, but could be helpful to those who, for whatever reason, choose not to use an advisor.

Trillions of dollars have been lost so far because 99% or more of financial advisors and investors were swept up into the ‘90s stock mania. Many of them still are bullish. The number of investors who have studied market history and understand what is now underway, the biggest bear market in world history, is extremely small. Equally small in numbers are advisors whose ability and experience can help others get thru a very difficult market period. Fortunately, I found two advisors of this rare breed thru their extensive web writings on the web and a third thru private communications.

Whether you choose an advisor to help is solely up to you. If, after deducting their fees, your assets are greater than they would have been under your own management, the arrangement will have been a success. The choice is yours.

The exact course the bear markets in stocks, bonds and housing will take from here is not known. Will prices plunge in a great panic crash or will it be slow and nerve wracking? Investors or advisors managing their assets have to stress safety and flexibility. One goal can be clearly stated. Preservation of capital has to be the main goal. It has to be return OF your capital, not return ON your capital.

Despite my extensive experience and reading of history, I cannot predict the future. Based on what has happened so far one can predict several probable aspects of the tragedy ahead. Additional trillions of dollars of investor assets will almost surely go down the drain, along with many conventional stock and bond mutual funds, financial companies of all kinds and major corporations. Among the survivors will be specialized mutual funds like those in our suggested portfolios, along with investors and advisors who use them to preserve capital.