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It's Still Very Lonely At The Top
The Great Mania Continues
by Robert B. Gordon, Sc. D.
December 24, 2003

I first used this topic in my fourth essay written in November of 2001 which can be read in my archives at FSO or freebuck.com. Although my position is still lonely, I now have a far greater appreciation for the height of this mania among our Wall Street commentators and the general public. Despite nearly four years in a bear market, the longest in the past century, some measures of stock market bullishness are now at an all time high.

Most the experts I read and respect are still bearish and surprised at the length of the bear rally that has been underway for the past thirteen months. I am unaware of any serious bears who have lost faith in their views. This rally, although tiring, can certainly continue for a while. But those of my readers, who have been net short in their market position, are definitely losing faith in their stance. I hope my comments here will help many of our readers to either hold or modify their investments.

I do not think that any investor should continue to hold either a losing long or short position that is interfering with their sleep. I believe they should cut their losses and wait for a good opportunity to establish a new position. Of course this is never easy, especially the very first time. Millions of investors, failed to sell their losing stocks and funds in the first leg of this bear market and many more millions will fail to sell on the next leg down. Selling of a losing position is the mark of an experienced investor who preserves capital for the next good opportunity. I sincerely hope that our readers will adopt this wise policy.

Those investors who choose to use one of our balanced portfolio suggestions should never find themselves in the position of losing sleep. If it does occur, the balance between stable and volatile asset classes is unsuited to that person. This is why I always have and continue to suggest that novice investors err on the side of safety and stability.

Later on in this essay, we will present the results of an experiment to see if it is possible to design a long term portfolio that can handle both bullish and bearish market periods, each extending for at least several years. We concluded that the results were positive, especially when using 8 portfolio re-balancing steps in a 6 year period.

THE GREAT BEAR MARKET CONTINUES

It is completely impossible for this bear market rally to somehow turn into a new bull market.  The history of every completed mania in the entire world shows that, at the end, stocks ended below the starting level. The bullish Wall Street experts and their millions of followers are doomed to experience a complete boom and bust cycle. There is no other way it can end. Alan Greenspan’s misguided actions have re-ignited the stock bubble. The debt and housing bubbles show little sign of wear and tear and are still going strong. But these bubbles will burst and then join stocks in a total disaster. There will not be any soft landing.

Price earnings ratios on the stock exchanges are nearing the stratosphere when realistic values of earnings are used. The penny stocks volume is now greater than in 1999. I doubt if anyone can guess when the new bubbles will burst. This is a wonderful time for all investors to sell the family heirloom stocks, get rid of their bull market funds and put the money into a winning bear market portfolio like the many examples our past essay have shown. Any readers who are still undecided on what steps to take should write us for help.

A RECENT QUOTE FROM THE ELLIOT WAVE WEB PAGE

By Anna Troupe, For Robert Folsom

"Friday's Wall Street Journal included a small bit about fund firms that are benefiting from the mutual fund scandal; the story quoted a financial adviser's remark that "it's kinda weird this scandal hasn't chased people from funds."

The "weird" part is what interested me, and I'll speak to that in a moment. But let's be accurate -- it's not just that the scandal "hasn't chased" investors away. In fact, you could say it actually drew them in: according to the story, from September 1 through November 30, stock mutual funds took in more than $63 billion. Moreover, mutual funds haven't seen that much cash flow over a three-month period since stock prices peaked in early 2000.

So, is it weird? Well, considering that over the past two decades, index funds have outperformed some 88% of managed funds, I'd say what's really weird is that anyone wants to invest in mutual funds in the first place. A financial writer recently made the point that "the millions of dollars that mutual funds have stolen from their small customers are dwarfed by the billions they have wasted for them."

He was arguing that regulators try to create the illusion of an equal playing field on Wall Street, though in reality, the little guy is always doomed to let some gap-toothed simpleton call the shots with his retirement money.

I say the little guy is doomed to be a victim of his own emotions – and the financial decisions that stem from them. For instance, back in the boom days, a rabbi managed to turn his $50,000 nest egg into a $7 million fortune – and lost it all, almost overnight. Why do I know about it? A newspaper interviewed him because he wrote a book about dealing with the grief.

Now, we can all relate to losing something very valuable, feeling plagued by horrible luck, being on top of the world and then, feeling like the biggest fool. And sure, getting through grief is important, and trying to help others do the same is nice, too. BUT -- did he learn his lesson?

His reasoning for handing his remaining investments over to a money manager speaks for itself:

"I can still be hit by a Mack truck, but at least I won't be driving it."

It still gives me chills when I read it. Dealing with grief taught this rabbi to trust some money manager more than himself. If the truck crashes this time, will he be any less injured riding in the passenger seat?

The stock market is an equal playing field in that its nuances can be learned and used to find opportunities. But it's no place for the "little guy" or the "average investor" who trusts someone else to make retirement money happen over time."

RBG Comment: It is very unfortunate that many investors decide to trust their assets to the unknown ability of an advisor when the truth is that many advisors have learned only to operate in bull markets and have no help to offer in bear markets. As stated in the quote above, seven of eight mutual fund managers do not beat an unmanaged market index in a bull market environment. Almost certainly in a bear market, both the index funds and the advisors of the other seven eighth of funds will do quite poorly. The hard fact is that there are just not enough winning bear market assets except for a minority of smart investors.

This is why we believe that most investors will do better by picking and managing one of our conservative asset mixes than by using a hired advisor. Please take another look at the ultra simple 3 fund portfolio #1 in our previous essay. Although no one can guarantee that it will continue to gain 20% a year, this unorthodox and very simple portfolio is safe enough for the proverbial "widows and orphans" of society. And the 3 mutual funds are widely available at many low cost brokerages. I hope that many readers will start this easy to manage portfolio and then eventually start another conservative portfolio to provide a comparison. This is how easy it is to become an experienced investor. I will be more than happy to answer any questions on any of our portfolio suggestions. Let=E2=80=99s hear from you.

TALES OUR READERS TELL US

The very broad subject range in our daily mail almost defies description. Of course, we are bound not to reveal any one of them in detail. Occasionally we will, with permission of the writer, use partial quotations that we feel have general interest. My reactions run the gamut from the "thrill of victory" to the "pangs of defeat". On one side, we have investors who are closely following one of our suggestions and are optimistic about the future. At the other extreme we are asked to review portfolios that may use just a small part of our examples. We are no longer surprised at the wide variety of responses and are highly motivated to continue our educational efforts.

We are still in our second year of writing and hope to do better in the future as this bear market returns in full force. In giving several dozen portfolio suggestions, we had hoped to induce novice investors to try one of the simple portfolios with just 3 or 4 asset classes that requires very little money to start. We have yet to see much acceptance of our suggestion to run 2 or even 3 portfolios at the same time. We try hard to put ourselves in the place of inexperienced investors and surely could use some help on this from our readers.

DO YOUR OWN RESEARCH

Our own ideas are highly affected by our life long series of research activities, I spent nearly 3 years of 7 day weeks on my doctoral research at MIT that set the example for my entire life. Upon retirement, I spent 18 years developing and selling a series of software programs to optimize moving averages for mutual fund trading. More recently, I have used the facilities available on a number of web pages to run several novel portfolios on paper that are updated daily and provide real time data without any commitment of money. It would not take much effort for our readers to set up half a dozen of my portfolios to be priced daily and printed out for inspection as needed. Over time, this gives a great education.

There are so many tools available now on the internet. Readers who want to know the best fund of a given type can go to Yahoo or Bloomberg and produce a ranking by type e.g. foreign bonds, gold etc. They can also get 3 or 5 year price graphs of groups of five funds or stocks. These graphs, which I see on my FastTrack screen, provide a picture of the price trends which can be more informative than just the latest prices.

My dedication to and enthusiasm for a research approach is best exemplified by a program to help my sons manage their inheritance after my death. I am creating 3 real money portfolios in separate brokerage accounts which I will manage as long as physically able, with monthly reports to my sons. Then after my death, hopefully they will be able to give them expert management. At least I will have done all that I could do to help them.

VANGUARD TRIES A NEW WRINKLE

From the Vanguard web page: "The new Vanguard Target Retirement Funds are a simple way to invest: Select the fund whose maturity date is closest to your retirement date, and the fund automatically adjusts its allocation among stocks, bonds, and cash investments over time. What might not be apparent is the relative sophistication of the investment methodology driving these funds. "In creating the Target Retirement Funds, we applied the essential elements of a successful investment program rebalancing, diversification, inflation protection, and low costs in a fund-of-funds approach," said Catherine Gordon, principal, Investment Counseling & Research.

Automatic rebalancing Five Target Retirement Funds offer asset mixes that gradually reduce equity and increase fixed income over a predetermined schedule, while the sixth, Vanguard Target Retirement Income Fund, maintains a static asset allocation. All are rebalanced automatically to adjust for market movements. "Rebalancing occurs on a regular basis to keep each fund in line with its current target allocation," Ms. Gordon said. "The shift to match the changing target allocation takes place gradually, year by year:"

RBG comment: I have no relation to the Ms. Gordon cited above. It is important to state, that all of the Vanguard good intentions will come to naught if we must endure a long bear market. Rebalancing between losing asset classes over time will create huge losses. With Vanguard’s lead, we may see a new revival in misguided portfolio rebalancing in other fund companies. Rebalancing will not work without a good mix of stable and volatile funds as we teach in our examples.

THREE SIMPLE EFFECTIVE BEAR PORTFOLIOS

We know from our daily mail that we have some readers of both sexes who have little or no experience beyond using cash instruments like CDs and MM accounts. They may never have purchased a stock or a mutual fund. I’ve decided to demonstrate, for novice investors, just how simple a mutual fund portfolio can be. With two fund companies, four funds and five asset classes we can build a number of bear portfolios with quite different market characteristics. The fifth asset class, gold, is due to both Prudent funds owning about 16 to 20% of precious metals. We like this feature because our 30 years experience in precious metals tells us that novice investors have great difficulty handling their often surprising volatility. Because all 4 of these funds are quite unique (no competitors to our knowledge) we assist you by giving their names.

DISCUSSION OF SIMPLE PORTFOLIOS

Please note very carefully the comments below on these very simple and safe portfolios:

1. The performance data is for a period of rising stock prices which gave the Prudent Bear fund a loss despite its 20% gold content. This will not occur in a down market.

2.  The two Hussman funds are protected in down markets by a 100% hedge for the Growth fund and a 30% hedge for the Total Return fund so they are both protected against market loss under adverse market conditions.

3.  Under bear market conditions the Prudent Bear fund should make excellent gains as it has in the past bear periods. So we would expect good gains from all four funds in down markets and positive returns from three of four in up markets.

4.  All four of these funds can be purchased from their fund companies or discount  brokerages for $1000 and $2000 in taxable accounts and half that in tax free accounts.

5.  All of these portfolios will need periodic rebalancing back to their original percentages, not oftener than once per year. The best time for this would not be at regular calendar dates but rather after each up and down cycle in the market. This would slowly but surely increase the overall returns versus no rebalancing.

6.  Despite their simplicity, all 3 of these portfolios contain the necessary asset classes to survive in a bear market environment: hedged U.S. stocks and bonds, foreign government bonds, short stocks and gold. We believe that, in modest dollar amounts, these four funds will make good starting portfolios for novice investors. Please write for help if you have any questions on how to get started.

SEEKING A PERMANENT BEAR MARKET PORTFOLIO

Although my readers have been unaware of the work behind my essays, I have been busy doing what I did for most of my professional life – exciting original research in a field of great interest and importance. This new area of research grew out of my six decades of broad and varied investing experience and bore fruit in the form of many of my essays. I have been well trained by experience to find solutions to difficult problems by using an old, old experimental approach. (1) Pose a question to solve (2) Design an experiment to get data, (3) Perform the experiment and (4) Analyze the results.

If the results were unfavorable, we would design another experiment and try again. If they were partly favorable we would modify the experiment to emphasize the positive areas and eliminate the negative. Often times, a favorable result would also suggest new areas that needed to be investigated. This experimental approach that improved the high temperature strength of jet engine alloys and the corrosion resistance of zirconium alloys five decades ago worked just fine in 2002 and 2003 in developing safe and profitable bear market portfolios.

We have now published many suggested approaches that were very successful thru the past three years of this bear market. A question remains with respect to how well these portfolios would behave under bull market conditions. It is not possible to move the clock ahead since there is no data, so we will try and throw some light on the subject by running a six year experiment from December1997 to date. This gives us about 2 1/2 bullish years followed by 2 ½ bearish years and the most recent year-long bull rally in a bear market.

Now, having long term data on 6000 funds, we could very easily have found enough mutual funds with rising prices to make a very impressive portfolio. But, since we hope to gain some useful knowledge from this experiment, we picked 9 diversified funds before we looked at the performance data. Then, at the end, I needed a well diversified stock fund and went back to an old favorite of mine and checked its price history since I had not owned it in many years. So we ended up with a U.S. bond fund, a Foreign bond fund, a diversified U.S. stock fund, 4 tangible asset securities and 3 quite different short funds. We intend to display the performance of these10 asset classes over the past 6 years both with and without rebalancing. We expect the results to be of interest and value to all our readers. We may do another attempt at a permanent portfolio, do we’ll call this one Permanent #1.

PERMANENT PORTFOLIO #1 FOR BULL AND BEAR MARKETS

As explained above, we selected 10 representative asset classes including a major stock fund, several bond funds, several tangible asset funds, including real estate, energy, gold and silver plus 3 different short funds. We list them below with their individual returns from December 12, 1987 thru December 12, 2003 without any rebalancing.

Please note that 8 of the ten asset classes showed gains over this period. The 3 short funds suffered quite a bit due to the long bear rally of the past 14 months. The bonds, equities and precious metals all did quite well over the past 6 years of volatile markets.

We arbitrarily decided to rebalance this portfolio 8 times at 9 month intervals starting at 3/11/98. The portfolio showed a loss of 9% at the first rebalancing and gains at the other seven. We give below the values of all ten asset classes after each rebalancing.

The total six year return was 12% per year with rebalancing as compared with 7.5% per year with no rebalancing, but that is only part of the unfavorable comparison. After each rebalance, the portfolio was returned to its starting composition. Look especially at the five volatile asset classes, short funds and precious metals. With no rebalancing, two of the assets are below the original$ $7,000 allocation. The short funds are under their planned strength just before the next leg down in the bear market. The two precious metals holdings have increased greatly and are at risk of further losses if the prices drop from here.

EVALUATION OF EXPERIMENTAL RESULTS

The work described above was the largest test so far of the two important ideas we have been propounding for the past months: (1) build a portfolio intended for difficult market conditions from approximately equal amounts of stable and volatile asset classes and (2) rebalance frequently at least once a year, to maintain the original portfolio composition. This idea has now been proven in very small portfolios with just 3 or 4 asset classes as well as in large portfolios with 10 or more asset classes. Experience has proven that a properly selected portfolio will give good results in volatile markets and especially so with periodic rebalancing as described above. This example used 51% of stable classes with 49% of volatile classes. It could be duplicated in both small or large portfolios. I hope that our readers will give it serious consideration.

HAPPY NEW YEAR TO ALL

We look forward to an exciting 2004 and wish all of the best to our widespread readers. Please know that we do not keep a file of our e-mails, so if we accidentally erase a message, we cannot reply. Since we strive to answer all e-mails, please send a second e-mail if you do not get a prompt reply.

Because I lack his e-mail address, I have to use this note to thank Michael for his precious gift of a small book of inspirational words with a final two pages written by his 16 year old daughter. This easy to read book would make a wonderful gift for a student
of either sex in high school or college. It is a nicely bound and illustrated paperback that can be obtained at modest cost. When I receive Michael’s e-mail address, I will send it to anyone who requests it.

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© 2003 Robert B. Gordon, Sc. D.
Dr, Gordon's Editorial Archive

Robert B. Gordon, Sc. D.
Sun City West, Arizona
December 24, 2003
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