By all accounts, 2008 was a most unusual year. The economy and financial system were rocked with abnormal events, and the prices of most financial assets fell sharply. Ever since, many have been eagerly anticipating a time when the markets return to normal. Some may even have sold all their stock holdings at that time, and are still waiting until normality returns so they can get off the sidelines and invest again.
There’s only one problem: when it comes to the investment markets, “normal” conditions don’t exist. A generation of investors has been taught that “the stock market averages gains of +10% per year.” Never mind the fact that this statistic applies to only one portion of the stock market—the largest companies that make up the popular S&P 500 index. More importantly, investors have failed to learn how those returns are experienced in real time. We suspect that even among SMI readers, what follows will be something of a surprise.
Noted economist and fund manager John Hussman warns we’ve recently arrived at “the most broadly overvalued moment in market history.” Nobel prize-winner Robert Shiller warns “the market is way overpriced.” Yet plenty of other famous investors disagree. Warren Buffett recently went on record saying “We are not in bubble territory or anything of the sort. Measured against interest rates, stocks are actually on the cheap side.”
Legendary investor Benjamin Graham famously said, “In the short run, the market is a voting maching, but in the long run it is a weighing machine.” His point was that investors “vote” with their dollars for various stocks based on many factors, including popularity. This greatly influences prices in the near term. But ultimately, the stock market rewards investors who appropriately size up the true long-term value of specific companies or markets as a whole and act accordingly. But as the earlier quotes make plain, that’s easier said than done.
It's been a little over two years since SMI revamped our approach to bond investing. This change was explained in the article, Introducing an Upgrading Approach to Bond Investing that Outperforms the Bond Market. Bonds generally haven't been good performers for the past couple years, so we haven't talked about this new strategy all that much. This has caused some readers to overlook the fact that the new Bond Upgrading strategy has handled the new tightening interest rate environment of the past 16 months quite well.
We read a ton of stuff in our quest to stay on top of the financial/investing world for you. As such, it's fairly rare that we see information presented that has much of a "new/wow" factor to it. But the following is something I don't remember seeing framed up quite this way before. The implications are powerful.
Wes Gray of the alpha architect site recently wrote an article slightly sacriligilously titled, Even God Would Get Fired As An Active Investor. In it, Gray creates two impossibly perfect investing vehicles by looking ahead and selecting the most profitable investments ahead of time. In other words, if someone knew in advance what the most profitable investments would be over the next five years, how would their stock fund (or hedge fund, in his second case) do?
Not surprisingly, the answer is they'd do fantastic! Of course they would, as the study cheats and finds the winners ahead of time! But what's interesting about the study is what would have happened along the way to the ridiculously high long-term rate of return these funds would have earned.
What they found was that the short-term drawdowns (losses incurred along the way) of these portfolios were still pretty devastating, despite knowing in advance that all of the investments in the portfolio were going to ultimately be extremely successful! For example, in their first example of a long-only portfolio that simply owned the best-performing stocks in every 5-year period, there were still 10 instances in 90 years where the portfolio lost at least 19%, and sometimes significantly more. (The details of how they built these "perfect" funds are in the article.)
Perhaps more interestingly, at least to those of us who have been engaged with SMI's Dynamic Asset Allocation strategy over the past two years while it has struggled relative to the broad market's strong returns, was their second test. This one set up "the ultimate hedge fund" which applied the same idea of knowing in advance what the best combination of buying stocks "long" and selling them "short" would be.
This portfolio earned 49.24% per year — again, totally impossible without knowing in advance what the winners would be. But despite this being literally the PERFECT hedge fund, along the way it would have lost as much as 60% in a two-month period and would have lost at least 18% on nine other occasions! Perhaps more importantly, the losses in this portfolio weren't correlated to what the broad stock market was doing, meaning that in most cases the stock market was earning a double-digit gain while these losses in the hedge fund were occurring.
What we can we learn from this hypothetical exercise? Well, for starters, even if you designed the PERFECT strategy that would earn impossibly great returns over time, it would still be emotionally difficult to follow it in real-time. Be honest: how many SMI readers would have stuck with this perfect strategy from 2/28/2009 - 8/31/2009 when it was losing -41.9% at a time when the broad market was rising 39.9%? I can hear it now: "The conditions of the past that allowed this strategy's phenomenal gains have obviously changed due to the unprecedented interference by the government and Fed, so what worked in the past isn't working anymore."
Was that really the problem? No. The problem was that any strategy — and this exercise proves we really do mean ANY strategy, even a perfect one invented in a lab — is going to have short-term periods when it doesn't look good.
Piggy-backing on this theme, Justin Sibears of Newfound Research ran a similar test on Warren Buffett's investing performance relative to the S&P 500. He established that from 1980-2016, Buffett's Berkshire Hathaway class A stock virtually doubled the S&P 500's return: 20.3% vs 10.4%. But along the way, Berkshire owners would have had to suffer through periods when their stock underperformed the market by as much as 67%! That happened in the slightly more than a year-and-a-half prior to the end of the tech bubble popping. Along with that gut-wrenching example, there were at least 6 other times when Buffett trailed the S&P 500 by a double-digit margin. That's seven times in 26 years, or about once every 4 years or so.
Translation: if you hitched yourself to the Buffett train and held on, you did great. Double the market's return! But if you constantly analyzed the short-term returns and wondered if the old man had lost his touch every few years, it would have been a tough ride. Most of those in that latter camp probably wouldn't have made it past the tech bubble, if we're honestly assessing it.
AQR's Cliff Asness is quoted in Sibears' article:
“I used to think being great at investing long-term was about genius. Genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it with incredible fortitude through tough times.
Of course [AQR] found [Warren Buffett] was fantastic – but not quite as fantastic. His track record was phenomenal…but human phenomenal.
What was beyond human was him sticking with it for 35 years and rarely, if ever, really retreating from it.
That was a nice little lesson that you have to be good, even very good, but sticking with it and not getting distracted is much more the job.”
SMI's strategies have a long track record of demonstrated success. The success of strategies like Upgrading and Sector Rotation have been earned in real-time, while others likeDynamic Asset Allocation are based on mostly back-tested data. None of them involve the certainty of looking back knowing that they've been successful in the future, which means it's certainly reasonable to constantly assess whether factors have changed sufficiently that their future success is jeopardized.
But if this analysis teaches us anything, it's that an extremely high degree of "stick-to-it-iveness" is required for long-term success with any strategy that is going to outperform the market over time. Think about it: in order for a strategy to outperform the market over time, it has to BE different from the market. If it's truly different from the market, inevitably there are going to be periods like we've discussed in this post when its short-term performance is going to look poor relative to the market.
These are the times you simply have to will yourself through to be successful as a long-term investor. Otherwise, even a perfect strategy won't be of much long-term benefit to you.
The current bull market turns 8 years old tomorrow. It's been quite a run! As is usually the case, it was birthed in terrible circumstances, distrusted by the masses through much of its early rise, and only now when it is getting long-in-the-tooth is it receiving some love from individual investors.
This bull has been extremely unusual in at least one regard though — it's high dependency on Central Bank stimulus. The Wall Street Journal reported last fall that a stunning 60% of the bull market's gains had come not just in response to the Fed, but literally on the exact days the Fed announced its policy decisions! The average gain on those announcement days was 0.49%, 50 times higher than the average gain of 0.01% on other trading days.
Thankfully, the market has been shifting away from that high degree of dependence. Stocks swooned for a couple months when the Fed raised interest rates the first time, back in December of 2015. But the market has largely shrugged off the more recent January rate hike and talk of subsequent hikes to follow as soon as later this month. That's a good sign that things are hopefully returning to a more historically "normal" state from the Fed-dominated Twilight Zone of much of the past decade.
Perhaps not surprisingly, when the market has run up as high and as long as this bull has, comparisons to past bull market tops start becoming more frequent. Comparisons to the late-1990s abound. Those comparisons have a bit of a double-edged sword quality to them. Naturally everyone is aware of the bruising bear market that followed the dot-com bubble — tech stocks in particular were gored to the tune of an 83% decline in the Nasdaq index, with broader stocks falling by roughly half (and longer-term, a second sharp bear market that cumulatively pushed stock market returns negative for over a decade following the early-2000 peak).
But many forget that the warning signs of that bull market's excess were visible long before the market's peak. The now infamous "irrational exuberance" speech by then-Fed President Alan Greenspan was delivered way back in December of 1996 — over 3 years before the market would peak. Passing on the gains delivered by the rest of that bull market would have been a missed opportunity indeed.
It would seem we're revisiting that late 1990s dynamic once again. On the one hand, those who watch the market's oldest and most reliable valuation measures warn that from current valuation levels, the market has always faced dismal future returns — usually by route of significant declines. Some of the most grizzled bearish voices warn that the stock market has just reached "the most broadly overvalued moment in market history" — worse even than 1929 or 1999 when measured based on the average stock.
On the other hand, the economy is showing welcome signs of life, both here at home and globally. U.S. corporate earnings have just snapped an earnings decline that dates back over two years. Government policy seems pointed in a pro-business direction to a degree unseen for the past decade. It's not as if the reasons for stock market optimism are flimsy or unfounded. There are even some who argue we're not entering a 9th year of an old bull market, but rather just the 4th year of a new "secular" bull market — the implication being that this bull could have much further to run.
What's an investor to make of all this?
Thankfully, we have a wealth of experience to draw on here, given that SMI was already a decade old when the market was peaking at the end of the dot-com bubble. Some of that experience was painfully earned, but is instructive to us today.
Back in 1998, SMI suffered through one of its worst relative-performance years in the newsletter's history, with the flagship Stock Upgrading strategy earning just half the return of the index-based Just-the-Basics strategy. (What a bizarre year 1998 was, with the already overpriced large S&P 500 stocks gaining a whopping 28.6%, while the more-reasonably priced small-cap Russell 2000 index actually declined 3.4%.) The reason for that underperformance was primarily our belief that the market was living on borrowed time and had become too richly valued. Which was true, but too early. But back then, SMI had fewer options in our strategy toolbox, and Upgrading didn't have the ability to side-step a plunging market the way we do now with our Dynamic Asset Allocation strategy. So we allocated conservatively in 1998 and "suffered" with returns that lagged the broader market significantly (although Upgrading still made 9.6% that year).
The lesson for today: sometimes even when you know something is going to end badly, you can be premature on your timing. In 1999, we learned from our mistake and offered SMI readers two different sets of allocations — one for "bold" investors and another for "wary" investors. But it's worth noting that even with 1998's relatively poor returns included, along with the lower "wary" returns of 1999, SMI's long-term returns for the periods encompassing both the 2000 and 2008 bear markets were outstanding. A large part of that success is due to not making all-or-nothing decisions like getting out of the market. Fine-tuning in a direction of lower risk? Absolutely we did that. But we stayed invested, and SMI's "wary" Upgraders saw their portfolios gain an additional 58%(!) between the beginning of 1998 and the end of the first quarter in 2000 when the market finally started to roll over.
Trying to time that expensive market would have been a bad move for SMI investors in the late 1990s, and that is likely also true today. SMI isn't going to be recommending separate sets of allocations for those who are bold/wary about the current market. Thankfully, we don't need to, given that we have broader (and better) tools available for SMI members today than we did 20 years ago. SMI members who are allocating reasonably across our main strategies (DAA as well as some combination of Upgrading, JtB, and Sector Rotation) can feel comfortable maintaining their market exposure, knowing they should continue to see gains for the duration of this bull market, while having protection (in proportion to their DAA allocation) whenever this bull market finally does come to an end.
While that positive history lesson should provide some comfort to investors sticking to a well-diversified plan, I'd be remiss not to point out what happened to many investors in the late 1990s and the subsequent bear market. Seeing year after year that "any idiot" could make huge profits in high-flying tech stocks, many investors abandoned the small-company and value stock diversification in their portfolios. Most of these investors lost big as tech fell 83% in the following bear market, while not-coincidentally, small-company and value stocks helped those of us with diversified portfolios escape the worst of the 2000-2002 bear market damage.
The stock market resembles the late-1990s market more with each new milestone and measure of valuation excess. Don't make the same mistakes investors made 20 years ago and jettison your defensive holdings just as you need them most. You can afford to stay invested and harvest any late bull market gains today as long as you're disciplined enough to maintain a slightly defensive posture.
There are no changes to the DAA lineup for March. Read on for the full details.
DAA is a core portfolio strategy that is designed to help SMI readers share in some of a bull market’s gains, while minimizing (or even preventing) losses during bear markets. The strategy involves using exchange-traded funds to rotate among six asset classes, holding three at any one time. DAA is a defensive, low-volatility strategy that nonetheless has generated impressive back-tested results, demonstrating the power of “winning by not losing.”
The recommended categories/ETFs for March remain (in order of current momentum):
Sector Rotation is a high-risk/high-volatility strategy. While its peaks and valleys have been more extreme than SMI's other strategies, it has generated especially impressive long-term returns, as discussed in Sector Rotation is Risky, But Highly Rewarding.
Sector Rotation is off to a great start in 2017, up 8% after just two months.
There is no change being made to Sector Rotation for March. Here are the details.
Last month’s offer from SMI Advisory Services was met with a huge response, as hundreds of SMI premium members signed up in the first weeks it was available. The early feedback has been overwhelmingly positive. A whopping 96% of those who completed the survey at the end of the Lab process rated their experience as either “Easy—I had no problems” (60%) or “Somewhat easy” (36%). Nearly half (48%) said “the process helped me identify personal goals, questions, and concerns” while 59% said they found “the privacy and ability to complete a plan by myself” to be among the most valuable features. Perhaps most importantly, 52% said the process helped them feel more educated, while 67% said it helped them feel more confident. Not bad for $50!
If you’re among those who have already completed the myMoneyGuide® lab process, this follow-up article is for you. It will explain how to transition to the permanent version of MoneyGuidePro®.
If you haven’t yet taken advantage of this offer and gone through a myMoneyGuide® lab, you should do that before proceeding with this article. That process is laid out in the February cover article, An Exciting New Opportunity for SMI Members: Personal Financial Planning via MoneyGuidePro®. Read that article first, complete the video-guided lab process, then come back to this article when you’re ready for step two.