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First Quarter Review: Market Rally Keeps Rolling© Sound Mind Investing | May 2010
Despite hitting a speed bump in February, the market's first-quarter 2010 results looked a lot like the end of 2009: big gains, widely distributed. And despite being slightly weighed down by our foreign stock allocations, both of SMI's model portfolios were able to take advantage. Just-the-Basics, our index-fund-based strategy, did what it is designed to do, roughly matching the market's performance during the first quarter (see first row of the table below).  Fund Upgrading slightly outperformed the market during the first quarter, posting better-than-average fund returns in four of SMI's five stock-risk categories (as shown in the table below).  Both strategies were likely kept from even stronger performance by the first-quarter rally in the dollar. As many readers are aware, the dollar has been weakening relative to other currencies for most of the decade. In fact, from the beginning of 2002 through Thanksgiving of 2009, the dollar had fallen roughly 40%. The weakening dollar has helped our foreign fund returns in recent years, as those foreign currency gains boosted the returns of most international stock funds. During the first quarter of this year, however, the dollar reversed course, gaining about 4%. This meant that foreign fund returns were lower as a result of the strengthening dollar. As the table above shows, Upgrading's fund selection process helped us overcome the relatively poor results experienced by most foreign stock funds. The close of the first quarter marks almost perfectly the 10-year anniversary of the market peak back in March 2000. We can glean several important lessons when looking at the performance of the market — as well as the SMI strategies — over this past decade. For starters, it's easy to see why an untrained investor might give up on long-term investing if all he or she did was observe the popular market indexes. Consider that the S&P 500 index closed at 1,498.58 on March 31, 2000. Ten years later, it closed at 1,169.43. That would seem to indicate the broad market lost roughly 22% over the past decade. Unfortunately, simply comparing index levels in this way produces a distorted result because it ignores the value of dividends. This is a common mistake, however, whether done intentionally to promote a certain point of view (a favorite trick of market timers), or unintentionally because many people simply don't know better. For example, it has been widely and repeatedly reported that it took 25 years for the market to recover from the Crash of 1929. Likewise, many have read or heard that the market was flat for 14 years from 1968 to 1982. Both of these examples are true only of the market-index levels themselves. Neither is an accurate depiction of the actual returns an investor would have received if he or she had invested during those periods. With that in mind, let's shift our attention back to the past decade. Although you can't invest directly in an index, you could have been invested in Vanguard's 500 Index fund, a close proxy for the index. If you had owned that fund, your total loss over the decade would have been -7.1%. No picnic, to be sure, but far better than the -22% loss of the raw index. Again, the difference is that reinvested dividends are included in the Vanguard fund's return, but not in the index's. Even that -7.1% loss overstates the negative a bit, as the S&P 500 index measures only the performance of the largest stocks. When we include the slightly better performing smaller stocks, as the broader Wilshire 5000 index does, we see that the total return of the whole market was virtually flat (+0.6%) for the decade. Adding small-company stocks and the strongly performing foreign stocks (as we do in Just-the-Basics) is what made it possible for that strategy to produce a small (+8.9%) gain for the decade. Nothing to get excited about, but quite a bit better than the 22% loss implied by the S&P 500. That flat-market result points out another takeaway from the past decade: those who invest via index funds are reliant on a rising market for positive returns. This may sound obvious, but a decade such as we've just experienced really drives the point home. A decade ago, following several strong years in a row, the indexing "story" had come to dominate the thinking of most investors. It's important to recognize the limitation of the indexing approach. It's hard to imagine a worse decade for stock investors than the one just ended, given that it contained not one, but two, huge bear markets. That's extremely unusual, if not unprecedented. Granted, those declines came from an all-time high after a phenomenal stock market advance over the prior decade. But it was still a very tough decade for stock investors. Yet despite this "worst of times" environment, there was still money to be made in stocks, if you knew how to do it. Our Upgrading strategy was able to consistently add value, posting total profits of 79.2% for the decade. Seeing value added consistently above and beyond the market's rate of advance should build your confidence in the long-term validity of the Upgrading approach. This isn't a strategy that had just one big year, or occasionally parlays a lucky pick into big gains. Rather, if followed diligently, Upgrading has shown that it can generate significant profits by steadily growing a portfolio year by year. That said, SMI has long cautioned readers that they need to have at least a five-year time horizon if they plan to invest in the stock market — and a 10-year time frame is even better. The past decade illustrates why we've stuck with that seemingly cautious stance, even through exciting bull markets such as in the late 1990s. It's important to recognize that the market doesn't normally climb in a calm, peaceful manner. Rather, it advances and declines in emotional, often gut-wrenching, fits and starts. Despite the viciousness of the 2008-2009 bear market — as nasty and emotional a bear market as we've seen in decades — the table here shows that readers who started investing five years ago still have reasonable profits to show for their efforts (assuming they didn't bail out a year ago!). And as we noted earlier, a 10-year holding period has produced sizeable gains for Upgraders, despite being invested through two nasty markets. One unsung benefit of having a long-term perspective is that it helps you to ride out bear markets without making the type of timing errors individual investors are notorious for. Paired with a superior strategy such as Upgrading, you can have confidence that even if you end up putting money into the market at poor times (like at the market peak ten years ago!), you can still wind up with solid long-term performance. For those who have watched from the sidelines as this past year's bull market has passed them by, that may be the most important takeaway of all.
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