Winning Streak for Upgraders Ends After Nine Years

After beating the market nine consecutive years, Upgrading's winning streak came to an end in 2008. If there's any consolation in this disappointment, it's that it took the worst losses for the stock market in over 75 years to finally break Upgrading's streak.

Indeed, you have to go all the way back to 1931 to find a worse calendar year performance for the stock market. Not surprisingly, it took an extreme shock to the financial system to produce such extreme behavior in the markets.

Most readers are already well aware of the details: the government rescue of Fannie Mae and Freddie Mac, the failure/merging of three of Wall Street's "Big 5" investment banks, the bailout of insurance giant AIG, a retail money market fund "breaking the buck," the $700 billion government TARP spending to re-capitalize the nation's banking system.

The primary difference between 2008 and prior bear markets was that, at least for a time, the entire financial system seemed to be in danger of collapsing. That's a different scenario entirely than what normally occurs during a bear market, when the focus is on estimating things like how long a recession may last, how many jobs will be lost, and so on.

The financial markets priced the higher risk accordingly, driving prices of all financial assets down violently late in the year.

As a result, equity investors simply didn't have any safe havens. Upgrading came through the 2000-2002 bear market in relatively good standing, largely because its trend-following system steered us to funds that held up better than most. But in 2008, nothing held up well at all, leaving Upgrading to fall right alongside the market.

Proof of this is found in the funds performance table below. Every stock risk category was bludgeoned.

Ironically, Upgrading's fund selections actually performed better than the average fund in four of the five categories. But this simply shows that professional managers, who are often able to take defensive measures during market downturns, were unable to get any traction at all in this extreme environment.

When the final bell rang on 2008, Upgrading finished 1.5% behind the market (Wilshire 5000) for the year. Upgrading's loss of -38.8% was slightly better than Just-the-Basics, which lost -39.3%. Both narrowly lagged the market, as both strategies are exposed to foreign funds (which lost an average of -44.9% on the year) while the Wilshire index is not.

Thankfully, the very survival of the financial system no longer seems to be in question, and the analysis of this bear market seems to be returning to the more familiar territory of the recession and its impact on the stock/bond markets.

That's not to say the discussion is pleasant, by any means. Many still expect the recession to last throughout 2009 and cause significant economic damage. Others are concerned that a shift in household finances from borrowing to increased saving could be a drag on spending and economic growth for years to come. Needless to say, extreme government spending may create problems of its own.

While all of the above may be true, keep in mind that the market weighs all of that information and prices assets accordingly. In other words, the prospect of the economy performing poorly, consumers being spent out, and the government spending wildly, is already reflected — to at least some degree — in today's stock prices.

The stock market's performance over the past 10 years has been extremely unusual by historical standards. Over past 80 years, only 3% of the 10-year periods have seen the stock market suffer a loss (see Market Probabilities: What the Past Suggests About the Future). Yet, after two brutal bear markets in the past decade, that's the situation we find ourselves in.

Thankfully, Upgrading has performed significantly better than the markets over that decade (6.1% average annual gain vs. the market's -0.6% loss), but even Upgrading's gains have been well below the market's long-term 11% average annual return.

When assessing what this means for investors today, it's important to acknowledge there's no guarantee that this bear market is over. It's too soon to definitively call that. But it's worth noting that an investor's personal returns can change quickly.

A year ago, we reported that Upgrading's average gain over the prior nine years (1999-2007) was 12.8%. The losses of 2008 cut that number by more than half, dropping Upgrading's 10-year annualized return to 6.1%. That's the negative side of stock volatility.

However, the positive side of stock volatility is that the last time we emerged from a bear market, Upgrading gained 52% in just nine months. (Technically, the last bear market ended in October 2002, then retested those lows in March 2003. The 52% gain occurred in the nine months following that March retest, from April-December 2003.)

The problem with exciting market rebounds like that is "you must be present to win." Those who sell during the bear-market descent invariably miss out on the big gains immediately following the bear market's end. We don't know when those gains are coming, but it's typical new bull-market behavior for those sharp gains to come quickly, before investors have time to get over their fears and jump back into the market.

Not surprisingly then, we encourage you to stick with your long-term plan. Yes, the economic news still looks scary. Your brokerage account statements may look awful. But there's also positive input at hand, if you look for it.

Note the year-by-year and 10-year results for Upgrading in the table here. There were nine pretty good years before 2008's misery.

Also, take some comfort from the fact that your investment experience during the past decade has been on the negative extreme of historical market behavior compared to the rest of the last century. The stock market isn't normally so punishing. That should be a relief!

The past year delivered tough reminders of important investment truths. Among them: Investing in stocks involves significant short-term risk; diversification away from stocks and into bonds is critical as you approach retirement age; and even good strategies such as Upgrading are vulnerable to steep losses when the market spins out of control.

These are the obvious lessons of 2008. But they come coupled with less obvious observations. Like the fact that for long-term investors, ownership shares of good companies can now be purchased at prices 35%-40% lower than a year ago.

For those still in the "accumulation" phase of their investing lives, this is really good news. Investing in flat and declining markets doesn't "feel" fun at all. We all like the immediate positive feedback of rising prices. But in the long run, the chance to accumulate shares during a period of exceptionally low returns can be a profitable opportunity.

If your plan calls for you to be invested in stocks and making regular additional purchases through a 401(k) plan, IRA, or other long-term savings vehicle, we strongly encourage you to continue to do so.

While the economic clouds are still dark, for those with at least a five-year investing horizon, there are a number of reasons to feel optimistic despite the recent losses.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• How Should Your Investments Change
  As You Move Through the Seasons of Life? 
• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• 2009 SMI Allocation Guide: Weighing The Risks 
• Subscription Information

• Got a question or comment about this article? Discuss it on our Message Boards.