Second Quarter Review: Summer Swoons and Market Turning Points

The second quarter began well enough, with the stock market continuing the strength it had exhibited for more than a year as it reached new highs in late April. But then it abruptly reversed course and dropped sharply, leading to our discussion of bear markets in Questions to Ask Before Deviating from Your Long-Term Investing Plan. 

As the first two lines of the table show, the sharp declines during the second quarter were more than enough to offset the first quarter's gains, leaving the market (and our SMI model portfolios) with losses of 5%-6% for the first half of the year. Not surprisingly, our Just-the-Basics strategy, which is based on index funds that attempt to replicate the market's performance, saw losses quite close to those of the overall market. Upgrading lagged about a percent behind that level.

It's not unusual for Upgrading's performance to lag temporarily when the market experiences a sharp change in direction. That's particularly true when the market has been moving in one direction for a long period of time prior to the shift. That was clearly the situation in this case, as the market had climbed more than 80% since the March 2009 bottom.

Upgrading is a trend-following system. This means it identifies the dominant trends in the market, then leads us to invest in those funds that have been best at taking advantages of those trends. When the market moves up strongly over an extended period of time, Upgrading gradually shifts our holdings to more aggressive funds that are taking full advantage of the market's strength.

Our diversification across five stock risk categories helps keep our model portfolio from tilting too far toward high-risk funds, as does our attention to things such as each fund's relative-risk score. But it's fair to say that, generally speaking, over the course of a sustained bull-market rally, our portfolios gradually become more aggressive.

Given this tendency, it's not hard to understand why market turning points are the biggest weakness in the Upgrading system. Upgrading does a great job positioning us for the dominant trend, whether that's a bullish trend or a bearish trend. But when that trend changes, it takes time for the system to adjust and realign with a new set of funds.

This time lag, while unpleasant during a quarter such as we've just come through, is intentional. There are ways to speed up this process, but we've consciously made the decision to create our Upgrading approach so as to move more slowly, attempting to make sure the primary trend has truly changed.

The current environment provides a perfect example of why we approach Upgrading this way. Following its rally to a new high on April 23, the market fell 16% over the next 10 weeks, culminating in our "Bear Alert" signal on July 2 (see Questions to Ask Before Deviating from Your Long-Term Investing Plan  for more on SMI's Bear Alert indicator). But in the seven trading days after the signal, the market gained nearly half of that back with a 7% rebound!

The goal of our strategy is to be sensitive enough to changes in market direction that we can transition our portfolio appropriately, without being too sensitive so as to risk frustrating whipsaws. (The term "whipsaw" refers to making portfolio changes in response to a short-term market move, only to watch the market reverse and resume its former trend, causing another set of transactions back toward the original holdings). Upgrading does a fairly good job of this balancing act.

The stock market experiences routine setbacks of 10% or so (i.e., "corrections") much more frequently than full-blown bear market declines of 20% or more. It's difficult to distinguish between those two in the early stages (in fact, we don't know anyone who can do so reliably). We have purposely "tuned" Upgrading in an effort to not respond to most short-term corrections. Instead, it usually takes a more prolonged downturn to start a significant change in our fund lineup.

That's not to say Upgrading is perfect — no system is. While Upgrading may avoid getting whipsawed by a 10-week correction, a slower-moving 20-week correction of the same depth may very well "trick" our system into making temporarily unhelpful fund changes. And of course, being slower to respond to market changes does leave Upgrading more vulnerable to those times when the market starts declining and just keeps falling into bear-market territory.

Thankfully, bear markets rarely start with fast declines that simply keep on going. Most do the majority of their damage in the last one-third of their life span. Normally, this provides ample time to Upgrade gradually out of our more aggressive funds and into more conservative ones.

Because we are well aware that any investing strategy is going to have weaknesses, it's comforting to see the strong long-term performance of the Upgrading strategy illustrated in the bottom rows of the table above. Sure, the annualized numbers don't look great in the historical context — if all we ever had to look forward to was 5.2% annualized returns, we'd all be tempted to skip the frustration and just buy bonds instead. But hopefully you realize that the 10-year annualized section of the table, which reflects the difficult 2000-2010 period, represents something close to a "worst-case" scenario.

Decade-long stretches of flat market performance, punctuated by a pair of massive bear markets, are extremely few and far between in market history. Upgrading's performance during this period has shown that an investor who took no defensive action at all could come through a stretch like this, not just with his/her capital intact, but actually showing gains of a little better than 65%. That's not a bad worst-case.

This fact should inspire confidence in those debating what to do with the information in this month's cover article. No one knows what the market will do next. But Upgrading has proven resilient through recent bear markets and subsequent recoveries.

Plot your strategy. Follow your plan. Stay the course. More than just encouraging words, it's an approach that works!

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.

• Questions to Ask Before Deviating from Your Long-Term Investing Plan 
• Balancing Competing Risks as We Look to 2010 
• First Quarter Review: Market Rally Keeps Rolling
• Fourth Quarter Review: Strong Finish To A Weak Decade
• Third Quarter Review: Making Up For Lost Time
• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• Subscription Information

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