Bear Watching

Norman G. Fosback is one of the leading figures in the investment newsletter industry. He edits nine newsletters with a combined 250,000 subscribers. Mutual Fund Forecaster, with a current circulation of about 125,000, is the largest.

He also founded and is editor-in-chief of Mutual Funds magazine, the only independent magazine devoted solely to funds. It counts 780,000 readers.

The stock market has been Fosback’s focus for more than half his life. But for several years he has been among the loudest bearish voices on the market. He anticipates a rough stretch ahead for stocks, and so recommends that investors keep fully 60% of their assets in bond funds and money market funds, and just 40% in stocks.

Fosback believes the U.S. economy is reasonably healthy, but he worries that stock prices have simply become overextended. He also fears that historically low cash positions held by stock fund managers will result in reduced buying power in the future.

He shared his views with Russ Wiles, a mutual fund columnist for The Times.

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Times: Mutual Fund Forecaster does something unusual in that it makes total-return projections for hundreds of funds for the next 12 months and five years. Why this approach, and how do you go about determining those projections?

Fosback: We approach Mutual Fund Forecaster with a background in market timing via our Market Logic newsletter. We have been systematically developing forecasts for the market over those one- and five-year periods, as well as many others.

Once we have a market outlook, we construct models for individual funds based on their relationship to the market. That is, most funds move up and down more or less in concert with the market. It’s just a question of whether they move up more or less than the [market] average. So in addition to projecting where the Standard & Poor’s 500 is likely to be, we forecast where the funds themselves are likely to be.

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Times: So it starts with a forecast for the S&P; 500 itself. Then you measure each fund’s “beta,” or volatility relative to the S&P;?

Fosback: In large part, yes.

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Times: And right now, you’re not very optimistic about the market.

Fosback: That’s right. Our model forecast for the next year points to a downward market. And our projection for the next five years is only modestly positive: We think the market will gain 10% to 20%. As a result, all of our projections for individual funds are bearish too.

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Times: That five-year forecast of 10% to 20% is the full expected return for the period, not an annual return?

Fosback: That’s right. And it includes dividends. So you’re talking about only a trivial price movement.

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Times: Why are you so pessimistic?

Fosback: Among the most important reasons, the market’s own fundamental valuation is extremely high right now, based on price-to-earnings ratios, dividend yields and price-to-book value ratios.

Also, mutual-fund cash reserves are extremely low. That typically has been a sign of a market top. And corporate insiders recently have been selling stock [more than usual], another sign of a top.

Several dozen factors go into our market models, but those are the highlights.

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Times: Are you looking for a sharp decline in the market or a gradual backing and filling?

Fosback: I don’t have a sense for that. We could go down 35% in three months, like in 1987, or a slump might drag out over two years, as in 1973-74.

Either way, the weight of the evidence right now is very bearish, and investors need to be prepared for a decline of 20% to 40%.

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Times: How long have you held this view?

Fosback: We’ve been prematurely bearish. We’ve been bearish for the past two to three years. We gradually downgraded our recommended equity holdings, starting at 100% and moving down to 40%.

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Times: Would you describe Mutual Fund Forecaster as a timing service?

Fosback: No. We use timing, but it’s a mutual fund advisory letter. The focus is on trying to identify the best funds to buy and hold for the market environment that we envision.

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Times: The newsletter seems more optimistic about small-stock funds, several of which are included among your “best buy” recommendations.

Fosback: Yes, but that’s on a relative basis. Small stocks generally have lagged. The result is that hundreds of small companies are more reasonably valued than the stocks in the Dow Jones industrial average or the S&P; 500. But that only means they’re not overvalued as much.

When the market goes down, everything will go. The question then becomes, “What will go down the most?” One lesson we’ve learned is that what went up the most will tend to drop the most.

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Times: So your overall recommended allocation calls for keeping just 40% of a person’s portfolio in stocks or stock funds?

Fosback: For readers who care about our overall outlook, we recommend investing 40% of the portfolio in stock funds and 60% somewhere else, particularly money funds or bond funds.

But let me add that a lot of our readers aren’t interested in market timing at all. They just want to know the best funds to own for the long term, given their propensity for growth or income or whatever.

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Times: You list several model portfolios in the newsletter, yet they all seem to be fully invested in stocks or stock funds.

Fosback: Yes, they are fully invested by definition. So if you’re following our overall advice, you’d simply invest four-tenths as much in each of these funds as you normally would.

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Times: In the model portfolios you recommend just four to five funds each. Why so few?

Fosback: These are convenient numbers for most people. We make sure that the four or five funds we select provide reasonable diversification.

One reason mutual funds have become so popular over the years is that investors have learned that they were not adequately diversified using individual stocks in previous market cycles.

If you buy just one mutual fund, practically at random, you’re likely to be much better off than the vast majority of common stock investors. However, one fund isn’t enough. A lot of things can go wrong with one fund, so you need to diversify among several funds.

I think the average person probably would be best off owning six to 10 funds, but, realistically, most people don’t want to clutter their portfolios that much. We found that four or five are good numbers that meet the needs of most of our subscribers.

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Times: In general, your model portfolios don’t contain very high weightings of international funds. Does that reflect underlying caution on those markets?

Fosback: Not really. The reason they’re not heavily represented is that our focus in Mutual Fund Forecaster is on domestic stock funds because we can relate those funds best to the S&P; 500.

Foreign markets follow different paths. We don’t profess to have any expertise in being able to forecast how various markets around the world will perform.

We recommend foreign funds when we see factors that make them attractive such as, in the case of closed-end funds, whether they trade at significant discounts to net asset value [the true per-share value of the underlying stocks]. We’ve done a lot of research on that subject and have determined that it’s a winning strategy. Most of the foreign funds that you see in our portfolios are closed-end funds purchased for that reason.

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Times: Are you seeing many closed-end discounts now?

Fosback: Yes. We view discounts exceeding 10% as relatively attractive, and more than half of all closed-end equity funds are in that boat, especially many of the Latin American funds. Latin American Equity [ticker symbol: LAQ, on New York Stock Exchange], Mexico Equity & Income [MXE], the Chile Fund [CH] and Latin American Investment [LAM] all are selling at discounts greater than 20%, as are the Taiwan Fund [TWN] and Taiwan Equity [TYW] in Asia.

Among general diversified U.S. closed-end funds, I’d highlight Adams Express [ADX] and Morgan Grenfell SmallCap [MGC]. All of these funds are attractive.

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Times: For the 60% of an investor’s portfolio that you recommend be in money market or bond funds, which funds do you favor now?

Fosback: We prefer money funds that are boosting their yields by subsidizing their expenses. The best funds here would include the Strong Step One Money Fund ([800] 368-1030) and Zurich YieldWise ([800] 621-1048). They’re both yielding just under 6%. But if you’re willing to take more risk, our No. 1 preference in the whole income arena are junk-bond funds. Among the funds we like here are Vanguard High Yield Corporate ([800] 992-8845), Invesco High Yield ([800] 525-8085) and Strong High Yield. These funds all pay out in the neighborhood of 8%. We think they offer the best yield alternative for investors at this stage.

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Times: Some people think of junk-bond funds as too high-risk.

Fosback: If investors want to venture beyond the money market realm, they’re going to take more risk regardless of what type of fund they buy.

One thing that’s not widely appreciated is that high-yield funds are comparable in volatility to high-grade corporate and Treasury-bond funds, which are far more sensitive to interest-rate fluctuations.

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Times: If you’re recommending high-yield funds, you must not think the economy is going to fall off a cliff any time soon.

Fosback: I think we’re good for the next year.

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Times: Do fund expenses and sales charges figure much in your recommendations?

Fosback: We keep an eye on those factors, but ultimately they’re reflected in fund performance, so they don’t lead directly into our recommendations. I think every investor should focus on maximizing returns after expenses and taxes but without necessarily trying to minimize those factors independently.

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Times: Do you invest in mutual funds personally, or do you prefer stocks?

Fosback: I use both.

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Times: Among mutual funds, do you have any favorite managers or families?

Fosback: We long have liked the Mutual Series funds headed by Michael Price. In fact, Mutual Shares was our fund of the decade for the 1980s. We first recommended it back in 1978 in our Market Logic newsletter, and I continue to like it. Price is probably my favorite manager, consistently getting the job done on a low-risk basis.

I also think the Vanguard funds as a group are terrific, simply because their lower expenses give you an edge going in, regardless of which fund you select. We tend to focus on no-load funds, but, again, the important consideration is maximizing your return after loads.

So if you find a great fund that happens to have a load, that’s fine. Besides, some people need the hand-holding advice available from a broker or financial planner.

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Times: Your magazine’s readership of 780,000 in less than five years is impressive. Have your newsletter subscriptions grown in lock-step?

Fosback: No. Mutual Fund Forecaster has 125,000 subscribers, down from a peak of about 250,000 five years ago. The decline in circulation is partly a function of the growing amount of information [on funds] that’s available for free or at very little cost.

General stock and mutual fund newsletters haven’t been in a growth stage during this bull market. Still, Mutual Fund Forecaster is the largest-circulation fund newsletter in the country.

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Times: How do you split fund coverage between the magazine and the newsletters?

Fosback: The newsletters provide advice. The magazine provides color, background and information.

One thing we’ve noticed in publishing the magazine is that retirement is a motivation for many fund investors. Yet the choices of available retirement vehicles--IRAs, Roth IRAs and so on--have confused people just as much as the bewildering choices in mutual funds.

We get hundreds of letters every month. The majority deal with retirement subjects, so we have become expert in this area too.

And while I’m all in favor of choice, it concerns me that these programs have made it easier to make penalty-free withdrawals. I’m disturbed by the fact that a lot of money that should be earmarked for retirement is being siphoned off for other purposes.

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PROFILE

Name: Norman G. Fosback

Company: Institute for Econometric Research, Deerfield Beach, Fla.

Publications: Mutual Funds magazine, published monthly since 1994 (cost: $9.97 per year); nine investment newsletters, including Mutual Fund Forecaster ($49 per year, intrioductory rate), The Insiders, Market Logic and Income Fund Outlook.

Personal: Fosback, 50, has been studying the stock market for more than half his life. He grew up in Portland, Ore., and earned a bachelor’s degree in business from Portland State University. He cut short his graduate studies in 1971 to join Glen King Parker, who at the time worked for an offshore mutual fund group, in a four-year research project on investing. That led to their founding of the newsletters.

Phone: (800) 442-9000

Source: Times research