FSO Editorials: It's Time to Circle The Wagons by Robert B. Gordon 03/11/2004

There were times in our nation’s history when circling the wagons proved to be helpful against Indian attacks. But those simpler days are long gone and our problems are now much more complex. I decided to use the old term just to dramatize how serious a crisis we are now facing.

Recently, I have had an increase in the number of thoughtful letters from readers taking me to task for sins of omission or commission. It seems that we all see signs of trouble ahead, but cannot agree on how and when it will strike and how we might attempt to minimize its effects.

I have decided to make a new effort to define the financial problems that lie ahead and to suggest some possible ways to minimize the problems facing many investors. I will be happy to receive your thoughts and comments on this essay. The problems facing the entire developed world at this point in time are truly enormous. Yet, only a tiny percentage of investors in this country have any knowledge of the current threat to the wealth of our nation’s investors.

The greatest stock mania in the history of the world is now in its fifth year of correction and will continue to set new records for length and depth in the years ahead. The greatest debt mania is still in full force and awaiting a major interest rate increase to signal its end. The real estate bubble appears to still be in full sway in the U.S. and other foreign countries. What will finally bring it to an abrupt end is not visible as we write, but it too will end.

The huge issuance of corporate and tax free bonds by industry and governments have been transformed into insured, highly-rated income securities being sold to individual investors in huge amounts. If these guaranteed income promises are not kept, the value of these securities will plummet.

The idea of having an insurance company guarantee the interest payments on a bond has never been tested in a major economic slump or depression, but it surely will be tested in coming years and especially in tax-free bonds with many city and state governments in dire financial straights.

The most amazing thing to this writer is that the bullish hype from Washington and Wall Street, spread daily by our public press and TV, has kept the general public from seeing the enormous bubbles in which they have become totally entrapped. When they finally awake to the magnitude of their debt burden, news of our next great depression will be in the headlines of our daily newspapers.

A share in the common stock of the ABC Company represents a piece of the equity ownership of the company. There may be different classes of common shares, some with voting privileges and some without. Common shares may or may not receive dividends from the earnings of the company. Historically, common stocks have been regarded to be too speculative for most small investors. The tremendous growth in stock mutual funds has brought little knowledge of the enormous risks involved in a huge bear market like the one now underway. In the next few years, millions of investors will learn about the huge downside to common stock investing.

A bond is a debt instrument that represents a fixed dollar loan to the company by an outside investor. It has a maturity data at which time the face amount is due and payable to the investor. The bond may have a provision enabling the company to pay off the loan prior to the expiration data. Bonds are issued with a promise to pay a specific amount of interest at stated intervals. AAA bonds have always been considered to be very safe, but that rule only holds as long as the high rating is maintained. The number of highly rated bonds always drops significantly in the presence of a severe drop in the economy. Bond investors will have to become much more concerned about falling quality ratings.

Corporations are required to file detailed quarterly financial reports with the SEC. Firms like Standard and Poor and Moody publish regular corporate ratings based on the company reports. Problems have arisen in recent years with the quality of company earning reports.

A new service now available from Weiss Ratings has raised the quality levels of the reports and hopefully the performance of mutual funds that use them. A summary of Weiss ratings on banks, brokers, insurers etc. can be obtained from www.weissratings.com for just $7.95 per company. These ratings can be of great value to all investors and I recommend them.

The full history of the crimes being perpetrated by Wall Street and many mutual fund companies during the past 50 years of huge growth remains to be told. But the blame also rests on the lack of knowledge and initiative being exercised by the typical American investor. How can hundreds of under-performing funds with terrible 1 or 2-star performance records continue to exist alongside of those with 4 and 5-star consistent winning records? It could only exist with gross mismanagement of their assets by millions of investors. The data is freely available on www.morningstar.com to be read by any interested investor. Please use this valuable information. Just enter the 5 letter fund symbol and read the current report.

I have spent hundreds of hours looking at price performance charts of hundreds of funds in the past 6 months and especially looking at the past 4 years of the bear market. I like straight upward sloping price charts and reject the vast majority that had huge bear market losses since 2000. Bond funds and those with special characteristics like the Permanent Portfolio Fund look the best. I hope the better managed bond funds will lower their average maturity and raise their average quality and continue their excellent performance. But each investor is responsible for managing his or her portfolio. No news on a fund's performance must be considered as reason for a current performance check. No investor whose life savings are involved can afford any lack of current performance data. No news has to be considered to be bad news until it is proven to be wrong.

I make no prior judgments either for or against any asset class. We simply go to the recent performance chart and pick the best funds available. We have short funds that will protect both stocks and bonds from bear market declines and expect to use them. We expect the Hussman Fund hedges to continue to protect their portfolio gains as they have done in the past.

In the next phase of the stock bear market, blue chip stocks with good earnings will fare better than weak stocks, but all will decline. We would not want to own any bond/stock fund owning more than 40% of blue chip stocks. There are several such funds with 5-star ratings in the Morningstar "conservative allocation" group. Get in the habit of checking each of your fund ratings on a regular basis.

Bond funds will have to lower the average maturity and raise the quality of the bonds to counteract any decrease in bond prices. We also plan to use RYJUX, a fund which is short the 30-year Treasury bond, to help protect our bond holdings. With your life savings at stake, this is not the time to abandon an important tool for preserving investor assets.

I have discontinued my efforts to send addresses of licensed advisors to readers who request this information. To each of about 300 inquiries, I sent only the address and phone numbers to the requestors. I typically did not have any further contact with the inquirer. In one case only, I heard from an individual who had cancelled his agreement after losing money.

In retrospect, the objective was good, but the timing was not good as we were in a year-long bear market rally where the bulls made money and the bears did not.

I have concluded that any such test of an advisor must be long enough to cover both an up and down cycle. I also feel the investor must compare the results of the advisor with another standard, perhaps from the investor’s own efforts.

I have tried very hard to convince my readers to start a learning portfolio from which they can gain the experience and confidence to do it on their own. I am happy to report that quite a few are doing this. As we get further into our great financial morass, the shortage of effective bear market financial advisors will become a serious problem.

One of the safest ways to add U.S. Treasury bonds to your portfolio is to own one or more of the American Century Target funds expiring at 5-year intervals between 2005 and 2030. This unique series of funds buy Treasury bonds stripped of their interest coupons.

The share prices start in the low 30’s and finally end up maturing at the price of 100. I have just received a very informative prospectus which answers all possible questions about these interesting investments. I hope that all interested readers will request a copy from American Century. Although their prices are quite volatile early in their lifetime, they settle down with age and have an absolute insured return over their lifetime. Send for this fact-filled brochure.

ASSET CLASSES	Typical 3-yr Annual Return
Stable Assets
US Treasury Bond Funds, short to intermediate maturity	8.3%
Zero Coupon Bond Funds, maturing between 2010 & 2020	9.8%
5-Star Bond Funds with about 65% bonds and 35% stocks*	10.2%
TIP Bond Funds	11.2%
Foreign Bon Funds, short to intermediate maturity	14.9%
Hussman Hedged Total Return & Hedged Strategic Growth Funds	13.2%
Permanent Portfolio Fund	13.3%
Volatile Assets
Pimco Commodity Fund	N/A
Prudent Bear Fund, fully managed short fund	13.7%
Rydex Short Long Bond Fund	-8.3%
Precious Metals **
* Look at Morningstar conservative and moderate allocation funds. ** Since three of the ten listed asset classes already have substantial positions in gold and silver, I would recommend a dollar cost averaging accumulation of whatever amount of precious metals the investor wishes to add.

The 3-year return figures given above are the averages of two separate funds in each category. When interest rates eventually rise, as expected, all stable asset classes should contribute to a substantial portfolio return.

We will let our readers pick the specific funds and percentages from the list given above. With equal quantities of each asset class, the portfolio would be 70% stable and 30% volatile, which is a conservative ratio in our opinion. With at least 4 of the funds owning significant amounts of precious metals, there is no urgent need to add a 100% precious metals fund at the outset. In fact, I believe there are advantages in letting the separate fund managers make the buy and sell decisions.

In a taxable account, the rebalancing should probably be done at the end of a year and a day. In a tax-free account, there might be times when more frequent rebalancing would be desirable, depending on actual experience. It would always be good to actually take sizable paper profits before they whither away.

Please do not delay taking any necessary actions to put your assets into the safest possible asset classes for the next phases of this great bear market. May I suggest that many of you would benefit from a risk-free trial subscription to the ten-page monthly Elliott Wave Financial Forecast. The charts and commentary will help you to understand the big picture. Please remember that each full wave down in this bear market follows the Elliott rules with waves 1, 3 and 5 down and waves 2 and 4 going up. This excellent report will enable you to stay invested for the major down moves that lie ahead. Go to www.elliottwave.com and place your order.