FSO Editorials: Managing Investment Problems... by Robert B. Gordon 05/24/2004

Managing Investment Problems in a Long Bear Market
by Robert B. Gordon, Sc. D.
May 24, 2004

The current investment climate is nearing the point of a dramatic decline in all the stock market averages, It will change a few minds about the market direction but will induce very little selling from the bullish majority. That will probably come much later at lower prices. The small bearish minority which includes our readers will have to manage their portfolios in a steadfast manner, ignoring the local press and CNBC "know nothings."

Read what Martin Weiss, publisher of a leading advisory, told his subscribers recently:

"One of the most reliable signals of future market trouble is when investors become so complacent, they fail to recognize a market turn even after it's well underway. That's precisely what's happening to most investors right now, especially those in tech stocks. The Nasdaq has plunged 7.4% in six consecutive weeks -- its longest and sharpest decline in nearly 2 years! But most investors still think it's just a "pullback" -- a "consolidation before the next leg up." They're in denial. They still think the political season will save their rear ... or that the Federal Reserve will come to their rescue. The facts:

First, the Fed is now way behind the curve in fighting inflation. Even if the Fed is tough and jacks up interest rates by a full two percentage points, it will still be far behind.

Second, the 7.4% six-week decline in the Nasdaq I just told you about is a watershed event that indicates the major trend has turned back down.

Third, the horrible shape of the Federal deficit -- coupled with the worst trade deficit in the history of any industrialized country ever -- is finally prompting overseas investors to head for the hills.

According to latest data from the U.S. Treasury, overseas investors recently dumped over $13 billion of U.S. stocks, the worst selling by overseas investors in recorded history! They don't like the balance sheet of the U.S. government. They don't like the prospects of the Iraq war and the additional tens of billions it will cost the U.S. They are packing up their money, heading out the door, and saying goodbye.

Fourth: Oil prices are on a rampage, driving worldwide inflation and interest rates through the roof. All of this spells bad news for U.S. stocks -- for domestic and overseas investors. Earlier this year, the bulls laughed at me. Now, they're silent."

In a very long and difficult bear market such as this one, It will be impossible to plan and execute a perfect strategy that will have no bumps in the road. A conservative course will surely be easier and more trouble-free than an aggressive one. So, for those in or near retirement, we offer a conservative capital preservation plan that should safely bring a modest return. We also offer a conservative portfolio for those with 30 years to retirement, knowing full well that changes will probably be necessary along the way. But this will be no problem for anyone who manages the first few years quite well, as we fully expect they will.

We then move to a fairly aggressive "gentlemen’s risk" portfolio which is quite a bit simpler than one given in an earlier essay. As we find new stable or semi-stable funds it becomes easier to build a better portfolio. Finally, we use two old but newly discovered securities to create an exciting accumulation portfolio for young investors. Oh, if I could only find that illusive fountain of youth!

As we write, a Minor wave 2 up is topping in all the major indices and the coming wave 3 down should gather a little attention from a few bullish investors who are still buying on price dips. Then a wave 4 corrective structure may bring in more buying from amateurs. When this five wave down structure is complete there will be a 3 wave corrective formation before the next wave begins which will be another 5 wave impulse structure down.

There is not much of anything that can be done at this late date to prevent the real amateurs from buying high and selling low. We can all offer sorrow over their fate but the important thing to remember is not to react prematurely to the minor waves as they unfold. When a major bottom comes, months from now, it will be signaled by the EW experts and it will be a good time to rebalance for those that hold volatile or short asset classes.

Investors of all ages must be able to tolerate at least a modest decline in any of their holdings, even the most stable. But please know that the mistake of selling too soon is much better than waiting to sell at the bottom. The first thing we want to tell our readers is that both stable and volatile asset classes can go down in price over a certain time period. The difference, however, is (1) that the stable assets are considerably more stable and (2) are much more apt to bounce back quicker after a price dip.

A good example can be cited in the Hussman Total Return fund which has suffered the first major decline in its history. Now, for a long term holder, it has only lost part of it’s gain of the past 10 months but, for a recent buyer. the loss could have been as great as 7.8%. As of a recent chart, the fund is already making back it’s loss. Presumably HSTRX is invested in dividend paying stocks and bonds that are capable of lowering or eliminating the temporary loss. Anyone who cannot tolerate this amount of volatility should buy either Treasury bills or a bank CD which will not lose principal but will lose their purchasing power in an inflationary period such as the one we are now entering.

It appears at this writing we are going to have to deal with a big dose of inflation in the near future. This will put a premium on things like precious metals, natural resources like oil and gas, timber etc. The stocks and funds covering these areas will be very volatile in the short term but may be stable in the long term. My favorite example of a stock, volatile in the short term but with assured growth over the long term is Plum Creek Timber (PCL) with huge assets in live trees. Right now it is undergoing a rapid price increase due to the threat of higher lumber costs.

I have recently revisited an old friend, a five star ultra conservative fund that is an ideal conservative stable holding for the long term, FDFAX, which holds stocks in the food production industry. Since people have to eat, this fund is a good choice for investors who can tolerate some volatility in the short term. At certain stages in a severe bear market, nearly everything goes down to some degree. But, so will cash go down in purchasing power during the inflationary period that looms ahead. So, in the illustrative portfolios provided in this essay, we use the few funds we feel to be the most attractive over the intended time period.

We do not wish to alarm our readers, but there is a potential very serious problem from an unexpected "accident" in the over 200 trillion dollars of derivatives now existent in the world. For more information, read the two recent articles in FSO by John McKenzie who writes that no investment is completely safe except precious metal bullion. Of course, if a huge destruction of paper assets were to occur, holding gold would still leave you like a single survivor on a desert island. You would still need much more than your gold to survive since it is not edible. So, it is best to not lose too much sleep over this. Have a diversified portfolio with some physical gold and sleep well at night.

I have been bothered by the very small number of really stable funds which can be counted on one hand. So, as mentioned above, I intend to name another desirable group of funds that can be considered stable over a period of, say, 30 or more years. These can then be considered by younger investors who are in a position to gain from temporary price swings, both up and down, and have reasonable assurance of their long term price being stable or gaining.

The first member of the new group is a great example of a survivor over the long term, namely, the Permanent Portfolio with a remarkable 33 year record to date. But it has a weakness that has not yet been tested but may very well appear in the coming big bear market. It holds 25% gold and silver and 30% common stocks, which may be great in the long run but could be troublesome if both groups dropped at the same time. This makes a fine example of a fund that is stable over the long term and suitable for younger investors. If it drops in the coming bear market, it will provide good profits thru portfolio rebalancing.

The second fund that comes to mind is FDFAX, a five star fund of long standing, that holds the least volatile stocks on the exchange, namely, food and agricultural companies. It’s long term price growth rate is a modest 13% but its has demonstrated fairly small price drops in the current bear market which were more than recovered in last years bear rally. So, it makes no sense for me to buy it at my age, but many readers can consider it for both growth and rebalancing profits over the next 30 years.

A third strong candidate for this category is the stock of Plum Creek Timber, a most unusual long term growth prospect for our younger readers to own. It is one of the very largest firms owning vast tracts of growing trees but the only one able to pay high dividends because it is a REIT, paying 90% of its earnings, tax free to the Company. Its wide-spread forests cover more than the total area of our smallest 3 states. Can you guess who they are?

A fourth interesting group of candidates is that of the very few 5 star funds with long successful records holding about 65% high grade bonds and 35% major stocks. There are at least two such funds now holding Morningstar’s highest ratings. They have a long record of growing about 11% per year over the long bull market. Their price will fall in each down phase of the bear market and will rise in each up phase. They can be held for the long term and provide profits thru periodic rebalancing, providing the investor’s age permits a long time horizon.

It would be hard to pick more such exciting funds or stocks, stable over the long term but with periodic volatility that can create good profit opportunities. This limited group will be hard to beat over the intermediate to long term. However, If my life could be extended for 30 more years, I would always add at least 15% of a short fund for disaster protection. We will be putting this in numerous portfolio examples given below.

The above four are all the good ideas I have to date, but I’m sure others will turn up with further study. As a final word, now that the second stage of this great bear market is underway, please remember as a general rule, to keep all of your investment decisions at least a little on the conservative side. Do not push into uncharted areas and do not fall for any crazy "get rich quick" ideas. Keeping everything on the conservative side and building your assets slowly is the best way I know to preserve assets in a difficult environment.

For this example, we will assume investors in the sixties or seventies age group who are primarily interested in holding the purchasing value of their current assets. To do this they must assume some market risk but this may be better than holding cash assets since the amount of future inflation is unknowable in advance. Three of the five funds below either own gold or have the right to own gold. This could turn out to be very beneficial.

PERFORMANCE FROM 9/18/2002 TO 5/21/2004
Allocation	Percent	Fund	Weighted %
Stable Assets
Hussman Strategic Growth Fund	28%	12.3%	3.4%
Hussman Total Return	28%	6.5%	1.8%
Prudent Global Income Fund	28%	11.2%	3.1%
Total	84%		8.3%
Volatile Short Assets
Prudent Bear Fund	10%	-12.3%	-1.2%
Reverse Bond Fund	6%	0.5%	0.0%
Total	16%		-1.2%
Grand Total	100%	14.2%	7.2%

We used a limited period for the data in order to include the full history of Hussman Total Return fund. The two short funds are on the verge of supplying a meaningful return during the coming bear leg either directly or thru portfolio rebalancing which will be best done at both market bottoms and tops. The rebalancing steps are easily done and will add welcome profits to this portfolio. There should be no hesitation on any reader’s part in owning the 16% short position. It is a very important insurance policy against losses in a bear market. Profits from both funds will be accumulated at each market bottom, at which point the profits should be transferred to the stable assets by a simple rebalancing step in which all asset classes are returned to their original percentages. Please know that ownership of a short fund is just like owning a long fund. There is no risk as in shorting a stock in the stock market.

At market tops, the short funds will be low in price and their assets should be replenished by rebalancing. This, then, adds to the gain that will be taken at the next bottom. Over ten or fifteen years, which this bear market may easily last, rebalancing should be an important source of added returns. It is very easy to do in a five fund portfolio in a tax free account. In a taxable account, an attempt should be made to rebalance when gains are long term.

This portfolio is somewhat similar to others described in earlier essays. It uses Permanent Portfolio as its principal fund based on the assumption that this portfolio will exist for at least 30 years so that any period of underperformance will be regained during rebalancing. I think this is the first time we have used Permanent Portfolio in such a major way and I have great confidence that it will do a great job for the investor. These 6 funds are really the minimum number needed for a balanced long term portfolio. We use each fund where it can work the very best.

PERFORMANCE FROM 9/18/2002 TO 5/21/2004
Allocation	Percent	Fund	Weighted %
Stable Assets
Hussman Strategic Growth Fund	20%	12.3%	2.5%
Hussman Total Return Fund	15%	6.5%	1.0%
Prudent Global Income fund	15%	11.2%	1.7%
Total	50%		5.2%
Long Term Stable Assets
Permanent Portfolio	30%	13.6%	4.1%
Volatile Short Assets
Prudent Bear Fund	12%	-12.3%	-1.5%
Reverse Bond Fund	8%	0.5%	0.0%
Total	20%		-1.5%
Grand Total	100%	14.2%	7.8%

We expect that the Prudent Bear Fund will quickly regain a positive return and that the two short funds, with suitable rebalancing, will make a very major contribution to this portfolio’s success. As long as I am here to receive them, I would appreciate receiving your reports on this and other portfolio’s results.

PERFORMANCE FROM 9/18/2002 TO 5/21/2004
Allocation	Percent	Fund	Weighted %
Stable Assets
Hussman Strategic Growth Fund	40%	12.3%	4.9%
Stable / Volatile Assets
Permanent Portfolio	10%	13.6%	1.4%
FDFAX Fd/Ag Fund	10%	11.2%	1.1%
PCL Timber REIT	10%	22.2%	2.2%
Total	30%		4.7%
Short Assets
Prudent Bear Fund	20%	-12.3%	-2.5%
Reverse Bond Fund	10%	0.5%	0.1%
Total	30%		-2.4%
Grand Total	100%	14.2%	7.2%

Like the previous two portfolios, this one is also handicapped at this time by the negative performance of the Prudent Bear Fund, but this picture will change very soon as the bear market gathers speed. The large percentage of bear funds will have a big payoff through regular rebalancing steps at the market bottoms and tops.

This portfolio is considerably different in its size and makeup from one presented a few months ago. It holds just six funds in 3 categories and would be very easy to manage. The lone stable fund will be very steady in price as the fund manager has had plenty of experience in hedging his fund to prevent loss. The 3 stable/volatile funds will perform as described earlier and may have their modest ups and downs at different times. The relatively high percentage of short stocks is done deliberately to fully protect the 3 stable/ volatile funds.

If I were 25 again, and possessed my current knowledge, I would start to build the portfolio shown below. I would thoroughly enjoy doing it and expect to accumulate a substantial sum by my retirement.

PERFORMANCE FROM 9/18/2002 TO 5/21/2004
Allocation	Percent	Fund	Weighted %
Stable Assets
Hussman Growth Fund	40%	12.0%	4.8%
Long Term Stable Assets
Food / Agriculture Fund	10%	11.2%	1.1%
PCL Timber REIT	10%	22.2%	2.2%
Total	20%		3.3%
Volatile Assets
ASA Gold Stock	10%	5.4%	0.5%
CEF Gold/Ag Stock	10%	13.0%	1.3%
Total	20%		1.8%
Volatile Short Assets
Prudent Bear Fund	20%	-12.3%	-2.5%
Grand Total	100%	14.2%	7.4%

These six funds are all expected to build assets over the long term. Based on its fine record to date, Hussman Growth is expected to be a fine performer. The two long term stable assets are about as safe as any over an unknown future. The two precious metal stocks are closed end and will not grow to a huge size that impairs their performance. Further, they may trade at a discount or premium in price which will enhance a dollar-cost averaging program. We consider the Prudent Bear fund is a very essential part of a portfolio intended to face a difficult future. We choose David Tice as the best manager because he will undoubtedly vary the short position to suit the market climate. Of course, if during the accumulation period, the bear market ends, the short fund should be sold.

Now, of course, any young investor does not have to start with all six funds, I would suggest starting with the Hussman Growth fund and one or two precious metals funds and then adding other asset classes as more purchase money becomes available.

The full six fund portfolio will have many opportunities for profitable rebalancing with 3 quite volatile and 2 moderately volatile assets and a safe core holding in the Hussman fund.

The usual gold "bugs" are in a quandary right now since the gold price has dropped quite a bit from it’s recent high price. Robert Prechter has stated that gold has finished 5 waves up and is now facing a large bear market drop in coming months to significantly lower prices. I have sold most of my precious metals and am awaiting lower prices to re-purchase. So we have omitted all gold funds from the first 3 portfolio above. They can be added later.

I see absolutely nothing wrong with anyone accumulating gold with a dollar cost averaging approach or you can hold off and await lower prices. Remember that gold appears to have started a corrective wave to higher prices just now. This may provide the best last chance to sell gold. The bearish wave sequence is a mirror image of a bullish sequence. Please remember that the following funds either do hold or have the right to hold gold: Hussman Total Return, Prudent Bear and Prudent Global Income, and Permanent Portfolio fund.

I use this caption to remind you to slow down and consider each of your investment steps slowly and carefully. Decisions you make now could effect how you live twenty, thirty or more years from now. Here are several suggestions to consider:

1. Write down your objective and time schedule.
2. List your investment alternatives in detail.
3. Gather as much detailed information as possible
4. Choose one or more courses of action.
5. Set a time period for a first review of results.
6. Make any on-course corrections as needed.

View the bear market action as objectively and emotion-free as possible. Remember that, as long as some elements of your portfolio are doing well, rebalancing will prove to be beneficial. Even if all of your asset classes show some losses, rebalancing may be beneficial thru asset transfer to a future winner. The bear funds will be big gainers in down markets and big losers in up markets. Do not be surprised by this normal behavior.

David Tice, manager of the two Prudent funds, is one of the most experienced managers on Wall Street. For quite a few years before 2000, his firm was selling shorting advice to major Wall St. firms for their use during the late bull market. So I hope that you will use his expertise in the years ahead as I am sure his recommendations will be profitable.

We know from your e-mails that many of you have older or younger family members who have laughed or turned away from your attempts to warn them of the troubles ahead. The public press and TV is still not carrying the real truth about our economy and bear market and there are tremendous efforts underway to keep the truth from the public until after the November election. Please make another strong effort to reach them with the true story of an approaching huge bear market and resulting depression. This problem is not just about the U.S., but will hit the entire group of developed nations in the globe. It will be very deep and last very long due to the many bubbles that must corrected. Try and get them to read the expert publishing on websites such FinancialSense, Safehaven, Fiendbear, Prudentbear etc.

My dearest wife of 62 years of marriage died this past week after a long illness and her service will be on May 29. I will return to writing after a lapse of time, but for several weeks will be involved with personal affairs. I have given priority to finishing this essay for your information in the current bear market. I would appreciate your holding e-mails for at least the next ten days. Thank you.