My partner and I had lunch with the person who runs one of the preeminent university finance reach centers in the U.S. (really, in the world). He had three (okay, seven) words of wisdom for investing in the stock market: S&P index funds, small cap stock funds and momentum. Let’s take them one at a time.

 

Index funds, as championed by John Bogle and Vanguard, are a way for the investor to track the performance of the market. Indexers argue that most investors can’t beat the market and end up under performing and paying higher fees trying. According to our research guru, all S&P index funds show the same performance, the only difference being expenses, so pick the fund with the lowest expense ratio. 

 

The market for small cap stocks is less efficient due to the more volatile nature of small companies and less analyst coverage. Thus, an insightful mutual fund manager can outperform a small cap average (what would go into that average is not clearly defined, unlike the S&P 500).

 

Momentum is the concept that stocks will continue to move in the same direction over the short term due to technical and/or fundamental factors. It is a difficult and risky investment strategy for a mutual fund investor, but a good small cap stock manager will have this tool in his or her arsenal.

 

One of my rules for success is to listen to those who are richer and/or smarter than I am. I don’t know my friend’s net worth but I do know that he is a heck of a lot smarter than me. You won’t go wrong following his advice in managing your domestic equity portfolio – make an S&P index fund your core holding and supplement it with a couple of good small cap funds. (See MUTUALdecision’s Top Ten lists of small cap stocks.)  

The Dow declined about 2% last week and long term U.S. Treasury rates continued their climb, now yielding about 5.25%. Investors in Blackstone made a lot of money when it went public. I continue to wonder if the money in private equity is in the fees they charge, see Fund of Funds, and not the deals they do. 

 

Going back to interest rates, Bill Gross of Pimco, is halfway to making good on his May 28 prediction that long term Treasury bonds were yielding 50 basis points too low, see Insomnia. They’re up over 25 basis points since then and I wouldn’t bet against them making Gross’ 50.

 

The Bear – Bear Stearns, that is – had to pump $3.2 billion into two of its subprime mortgage funds to prevent them from going belly up (and no Bear likes to be on its back). Back in March, I wrote about the coming subprime debacle, see Yellow Sub(prime)marine. The only surprise is how well contained it has been thus far, but do you really believe that the two Bear Stearns funds are the only ones in trouble?

 

There are two conclusions to be drawn from all this: 1. Stick with your convictions. When you’re right (and I hope you always are), the market may not agree/respond immediately. Don’t be swayed by the crowd – stay with what you believe. 2. Cautious investing is the order of the day. A choppy and correcting/declining stock market is likely over the next few weeks. Interest rates may continue to rise, meaning the prices of long term bonds and bond funds will decrease.

 

 If you’ve rebalanced your mutual fund portfolio and are comfortable with your risk level, it might be a good time to take the kids on a vacation.

Commercial real estate (office buildings, shopping centers, etc.) is considered to be a separate asset class from stocks and bonds. Thus, an investor can gain additional diversification by investing in commercial real estate. If you aren’t able to buy a group of apartment buildings or shopping centers, and most of us aren’t, the way to invest in real estate is through a REIT (Real Estate Investment Trust) which owns a number of properties or mortgages. Equity REITs own properties. Mortgage REITs are similar to long term bond funds. Of course, rather than trying to select one or two REITs, investing in a REIT/real estate fund is hiring a professional manager to do it for you and provides diversification. There are a number of excellent REIT/real estate mutual funds, see MUTUALdecision’s top ten Real Estate Funds list.

 

One attraction of REIT funds is their relatively high current yield. But beware, check the fund to see if its yield is enhanced through the use of debt or preferred stocks. These investments can boost the yield at the expense of long term growth. You need to consider the short-term/long-term trade-off and decide which fund investment profile is right for you. Also, be aware that REITs and REIT/real estate funds have had quite a run over the past few years. Some pundits believe they are fully valued or due for a correction. Lastly, note the “conventional wisdom” that real estate investments go down when interest rates go up. Indeed, REIT stocks/funds have been weak over the past couple of weeks as interest rates increased. I don’t subscribe to the interest rate/real estate stock fund price relationship except on a short term basis. Long term, a good REIT/real estate fund will make investments which will increase in value.

 

REIT/real estate funds should be part of any investor’s portfolio and you also might consider an international real estate fund.

The Dow and the S&P are touching record highs. Not even the specter of rising interest rates can dampen this market. The last downturn in the market occurred in February and there was just a pause for it to catch its breath and run to record highs. Isn’t life wonderful?

 

Well, life isn’t so good if your mortgage lender is foreclosing on you and home foreclosures are rising. Take a look at Home Foreclosures Hit Fresh High which appeared in Friday’s Wall Street Journal. Deficiencies are on the rise and almost at levels last seen in the 2001 – 2002 recession. You’d expect foreclosures to be high during a recession, but not when the economy is growing. Even more ominous is the value of the collateral backing the mortgage. Home prices rose steadily from 2002 through 2005. Real estate was the place to be. Families moved into bigger homes (with bigger mortgages) and investors bought (speculated in) residential real estate. Those who stayed put refinanced, taking out money (and increasing their mortgage payments), as the value of their home increased. 

 

The State of the Nation’s Housing, a study released on June 11 by Harvard University’s Joint Center for Housing Studies, forecasts that home values will continue to decline over the next year. If the Harvard study is correct, more homeowners will find they have no (or negative) equity in their homes, giving them little incentive to continue making their mortgage payments. If interest rates rise, homeowners with adjustable-rate mortgages may not be able to make their payments, even if they want to keep their home. 

 

Beyond the human tragedy, voluntary or involuntary real estate foreclosures are bad for the economy and the stock market. So, as I’ve said before, use the strong stock market to re-balance your mutual fund investments. And, watch the riskiness of your investments. Don’t let a rising market lull you into taking too much risk.

In our last thrilling episode (Too Much Income Can Be Hazardous to Your Financial Health – Part I) we talked about the risks of holding bond (fixed income security) funds. Simply put, the current income is nice but neither the income, not the principal increase over time, absent a good fund manger. So what’s an investor to do?

 

Find a good conservative mutual fund which invests in dividend paying stocks. Why? Because dividends paid by good companies tend to increase over time. Take Bank of America, for example. (I’m using a stock rather than a mutual fund for this illustration because it avoids having to talk about purchases, sales and capital gains distributions.)  In 1997, Bank America paid a $.70 per share dividend. If you bought the stock near its high for that year, you paid $40 per share. Today, B of A pays a $2.24 dividend and its stock sells for around $50.   Notice, the dividend has increased 3x in the past ten years. The price appreciation hasn’t been nearly as exciting, but it has kept pace with inflation. 

 

There are a lot of stocks out there like Bank America, which increase their dividend every (or almost every) year. The investor who bought B of A stock in my example has an investment currently yielding 5.6% and I would expect the yield to continue increasing. You can find many mutual funds that invest in high quality, dividend growing stocks. Start by looking at Big Cap Value funds.  Many such funds have the word income or dividend in their name.

 

As I said on Monday, there are lots of good reasons to invest in bond funds, but if you have a time horizon of ten years or more, you’ll be better off investing in a high quality equity mutual fund. You’ll end up with more principal and income. 

Bonds have higher yields then stocks. Bond funds have higher yields then stock funds. This means more current income for you. Bonds and bond funds are (generally) safer then stocks and stock funds.  They fluctuate less in value. That’s good, too. So what’s wrong with this picture? Bonds are fixed income securities. Their income doesn’t grow, nor does their principal value. As a matter of fact, the real value of their principal declines over time due to inflation. 

 

Now, before you jump all over me, yes, there are inflation-adjusted Treasury securities that increase in value with inflation and floating-rate bank loan funds whose yield should increase if interest rates go up. Also, you can realize a (usually modest) gain in principal value if you buy a bond at less then its face value and hold it until maturity.

 

And, there are some managers who through astute analysis, forecasting and trading, add value and outperform a simple buy and hold strategy. However, superior relative performance becomes harder to achieve as you go up in quality, think: High yield (“junk bonds”) at one end of the scale and U.S. Treasuries at the other.  The same is true for maturities.  There’s not much a manager can do to create relative value with short term bonds. Value can be created by correctly forecasting (good luck!) interest rates and buying, or selling, long term bonds.

 

Bond funds have their place in your portfolio. It’s always wise to have a cushion for unforeseen expenses or just to be able to take advantage of an opportunity in the market or elsewhere. If you’re going to need cash at a certain time for events such as buying a house, college education, or the like, having the safety and certainty of a bond fund is a smart investment. Caveat: if you need funds at a not too distant date don’t speculate with a risky bond fund, you’ll be unpleasantly surprised with its volatility.

 

I fear that too many investors put too much money in bond funds and too soon in their investing careers. The income may be reassuring, or seductive, but the limited appreciation and the inflation purchasing power risk must be considered. There’s one more reason not to put too much capital in bond funds. Come back on Wednesday and I’ll tell you what it is.

As I’ve written before (Parental Discretion is Advised; A Euro, a Yen, a Buck, or a Pound; The CIA Guide to International Investing), international mutual funds are an essential part of any investor’s portfolio. There’s an excellent article on global investing in the June 3rd New York Times: An Around-the-World Ticket for your Portfolio. 

 

As you’d expect, the stock markets of Western Europe are highly correlated to the U.S. market. Makes sense, doesn’t it? A good portion of BMW’s profits come from the U.S., so if the U.S. economy turns down (and the U.S. stock market), so does BMWs profits and its stock price on the German exchange. Also, as you’d expect, the stock market movements of emerging counties, i.e., Brazil (68%), China (53%), India (43%), Russia (35%), are not as closely correlated with the U.S. market as are the Western European markets. (Of course, they’re also more volatile.)

 

There are two surprises in the New York Times article. The first is the degree of correlation. Over 80% for Western Europe. The U.S. and Western European markets move together.   The second surprise is the uniqueness of the Japanese market. Movements in Japanese stock prices have only a 29% correlation with movements in the U.S. stock markets. That’s surprising because Toyota sells so many cars here and we all own at least one Japanese made TV.  But it goes to show that the biggest driver of any economy is what’s going on inside a country, not how much it exports.  Just like the Japanese culture, there are many unique aspects to the Japanese economy.  What’s also nice about Japan is it’s the second largest economy in the world and offers the legal and accounting safeguards of a mature county.   Thus, you can gain diversity without emerging economy risk.

 

Conclusion:   Diversify beyond Europe, and be sure to include Japan, in your international mutual fund investments.

The S&P finally closed at a new high last week. The Dow hit another record high. The Chinese stock market sold off 6% in one day, yet the price of Chinese ADR’s (the shares of Chinese companies traded in the US) actually rose.   Sounds too good to be true, doesn’t it?

 

Against the Gods: The Remarkable Story of Risk tells the story of financial bubbles which have occurred throughout history. The best known is the Dutch tulip bulb craze which took place in the 1600’s. (I know, the Dutch seem like such sensible people.) The Dutch became smitten with tulips imported from Turkey.  The price of bulbs, depending upon color and rarity of the tulip, was bid up to ridiculous levels. After all, they don’t cure cancer and you can’t eat them (they’re poisonous). And this is where the story usually ends. 

 

But there’s more. At one point, you could buy a nice townhouse on a good canal for five of the rare bulbs. However, at the peak of the craze, it only took one rare tulip bulb to buy the same townhouse. The market was overvalued at five bulbs but went up five times higher. This was a financial bubble, not unlike paying hundreds of dollars in the late 1990s for one share of an internet company that never made money and never would. At both events illustrate, bubbles can go on for quite a while.

 

I’m not suggesting the S&P or the Dow are bubbling, although I’m worried about the Chinese market.  But a correction will occur, at some point, and it will be hard and fast.   

 

What to do?   Enjoy the bull market while it lasts because it can take a while to go from a five bulb market to a one bulb market. However, don’t get caught up in the frenzy. Don’t sell your conservative funds to buy “bulbs.” And, use the growth in value of your aggressive funds to rebalance your portfolio.