With market reeling, get more aggressive

Despite a sharp pullback at the end of February that left investors worried about what might happen next, it appears the stock market will finish the first quarter in the black.

Even better for people who follow my investing suggestions, my model of exchange-traded funds (ETFs) has managed to zip ahead 3.4%, more than twice the market's gain.

The outperformance came from several places, notably foreign stocks, energy and real estate. But I also managed a meaningful incremental gain by shifting part of my domestic large-capitalization allocation from the S&P 500 Index ($INX), as represented by S&P Depositary Receipts (SPY, news, msgs), to an enhanced index, PowerShares FTSE RAFI US 1000 (PRF, news, msgs).

I began this year worried about a correction in stocks, but that textbook 10% decline did not occur in the first quarter. Instead, the midquarter pullback was between 5% and 8%, depending on the market segment. So I remain somewhat cautious looking forward, although I'm willing to become a bit more aggressive because it has become clear the Federal Reserve Board is not going to increase interest rates, and almost certainly will cut them.

"Financial crises are often bullish for stocks because the Fed usually stops raising the federal funds rate and often lowers it," notes Edward Yardeni, economist and president of Yardeni Research. "Financial crises are only bearish for stocks if they precipitate a financial contagion, a widespread credit crunch and a recession."

Here's how the portfolio ended the first quarter and how I intend to tweak it for the second. (For production reasons, these data reflect changes from Dec. 21, 2006, when I closed the books on the portfolio for last year, through March 22.)

(Note: Due to a data error in the report on the portfolio published in December, the portfolio purchased 313 shares of the PowerShares fund at that time, not 330. The cash residual was $17,371, not $17,378.)

The portfolio breaks down to be 27% income instruments and 73% stocks. I count real estate investment trusts (REITs,) represented here by the iShares C&S Realty Majors, as an income investment. Although REITs have stocklike characteristics, this fund is only 30% correlated to the stock market.

I am going to cut the income allocation back to 20% by trimming my cash hoard of $18,518, which increased from $17,371 one quarter ago because of dividends and money-fund interest.

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As represented by iShares MSCI EAFE Fund (EFA, news, msgs), foreign stocks did substantially better than their domestic rivals in the first period. Instead of adding to them, however, I'm going to re-establish a 5% position in iShares MSCI Emerging Markets Index Fund (EEM, news, msgs).

I eliminated this fund last year and have been penalized for doing so: It is ahead 20.4% in the 12 months ended March 22. If the global economy continues to perk -- and lower U.S. interest rates wouldn't hurt -- this fund should be a prime beneficiary.

I'll take the balance of the money I raise by cutting cash to bring up my position in Nasdaq-100 Trust (QQQQ, news, msgs) a couple of percentage points. This has the effect of boosting my exposure to the technology sector, and tech is another winner if the economy chugs comfortably along.

Therefore, effective with the March 22 close, I purchased 63 shares of Emerging Markets at $116.38, and paid an assumed trading commission of $10. I bought an additional 67 shares of the Nasdaq Trust at $44.26, also paying $10 in commissions.

Here's how the portfolio enters the new quarter:

After the Federal Open Market Committee (FOMC) announced March 21 it was not raising interest rates, it also signaled a slight shift in emphasis away from the fear of inflation to the fear of economic weakness.

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By the end of the trading sessions, interest-rate futures contracts were priced on an 85% probability that the Fed will cut rates a quarter-point by the time the FOMC meets in August.

I expect to get a bigger bang out of this move in stocks than bonds, so I'm not otherwise altering my income holdings. At 20%, they are at the bottom of the range I use to decide between equities and income. This portfolio is designed for an investor with a moderate appetite for risk.

A more aggressive investor would probably eliminate iShares Lehman Aggregate Bond (AGG, news, msgs) from the mix and boost the stock allocations proportionately.

But this portfolio has demonstrated that moderate investors don't have to sacrifice returns for peace of mind. In the three years and four months since it was launched, it has appreciated 47.1%, or 12.34% annually.

In the same period, according to Morningstar, the average moderate allocation mutual fund, the type the portfolio most resembles, has gained 34.4%, or 9.28% annually. Vanguard 500 Index Fund (VFINX), a popular market-tracking fund, is ahead 43.33%, or 11.47% annually.

Less risk, in short, doesn't necessarily mean lower returns.

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.

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