As regular SMI readers have likely figured out by now, we've gradually shifted over the past couple years from enjoying this bull market run in stocks to increasingly dreading its inevitable end. There's a place in every bull market where the focus has to shift away from maximizing profits through the duration of the upward slope of the cycle (however long that may last), toward an emphasis on capital preservation through the bear market that will eventually follow.

The trick, of course, is to not make that shift too early. At SMI, the "stakes" of that decision haven't tended to be real high, because most of our strategies operate independently of the market's cycle — they're going to do what they're going to do, and our readers, for the most part, are going to follow them and not try to guess what the market is going to do next.

That's important because it's super hard to predict where the market will go next, so taking preemptive action (by moving money out of the market) usually ends up being counter-productive. So if we're modifying our investment level in stocks at all (as DAA does), we're going to rely on a mechanical, objective, price-based signal triggered by what the market is actually doing to make any such adjustment — not how overvalued we think the market is, or any other "squishy" indicator that can keep getting ever more extreme for weeks/months/years longer.

This idea is summed up well in a quote from legendary investor Ben Graham, delivered in a talk more than 50 years ago:

The main need here is for the investor to select some rule which seems to be suitable for his point of view, one which will keep him out of mischief, and one, I insist, which will always maintain some interest in common stocks regardless of how high the market level goes.

For if you had followed one of these older formulas which took you out of common stocks entirely at some level of the market, your disappointment would have been so great because of the ensuing advance as probably to ruin you from the stand point of intelligent investing for the rest of your life.

In other words, historical indicators (P/E ratios, for example) can help us identify when markets are generally cheap or expensive, but they can always get even cheaper or even more expensive. Making investment decisions based on those type of "comparative" indicators is dangerous.

Again, we've detailed how this market's valuation is very expensive by historical measures, and how the lack of volatility seems to indicate a dangerous level of investor complacency. Those factors, coupled with the relatively new factor (within the past 18 months) of the Fed actively removing the monetary policy accommodation that most people attribute much of the credit for this bull market to, have us increasingly focused on the bear market to come — even as we maintain our stock allocations, waiting for the objective signals from our strategies to tell us to make any changes.

But today I wanted to look at the factors supporting the continued bull-market advance. There are several, among them:

1. Political indecision: David Kotok of Cumberland Advisors makes the point that "The U.S. stock market prefers a divided government that cannot do damage to what is a slow-growth but steadily improving economy."
2. Inflation remains muted. Simply put, unless inflation picks up, there's likely a natural cap on interest rates. Again, from the market's perspective, if there's no recession and no pick up in inflation, a slowly growing economy and slowly accelerating earnings are just fine.
3. Earnings are picking up. With more than 90% of second quarter earnings now in, FactSet reports that earnings have grown more than 10% year over year, well above the 6.4% expectation.

It's this last point on earnings that requires a deeper dive though. Bank of America Merrill Lynch strategists pointed out last week that stocks of companies beating earnings and sales forecasts aren't outperforming the S&P 500 as they normally do. In fact, the last time this happened was in the second quarter of 2000, near the top of the dot-com bubble (how's that for an ominous sign?).

While there are some good reasons why that isn't necessarily a foreboding indicator, it does require some sort of explanation. Usually when earnings are growing and beating forecasts, that's good for stock prices. There must be a reason if that's not happening this time, and in fact, there is.

The best explanation I've seen comes from Wolf Richter, who explains that this earnings "growth" is largely a mirage. The reality is that S&P 500 earnings have recently "grown"...back to the levels they were in May 2014:

Yep. More than three years of earnings stagnation. No growth whatsoever, even for “adjusted” earnings. In fact, on a trailing 12-month basis, aggregate EPS of the S&P 500 companies are down about 5% from their peak in Q4 2014. And yet, over the same three-plus years of total earnings stagnation, the S&P 500 index has soared 34%.

This chart shows those “adjusted” earnings per share for the S&P 500 companies (black line) and the S&P 500 index (blue line). Chart via FactSet. I marked August 2012 as the point five years ago, and May 2014:

What happens when earnings stagnate but the market keeps moving higher? The market gets more expensive. The "P" (price) continues going higher, while the "E" (earnings) stays the same. Investors have been bidding prices up higher and higher. This multiple expansion happens during every bull market. But eventually, it ends and multiple contraction sets in during the next bear market.

Or as Wolf sums it up:

No one knows the date when this process kicks off in earnest, though everyone wants to know it so they can scurry out of the way beforehand. But when enough folks are trying to scurry out of the way, they’ll will precipitate the beginning of that process. That’s always how it happens.

As always, the frustrating thing is we can't look at any of this and draw any definitive conclusions about what it means for the immediate future of the market. It could be that no recession hits, slow growth continues, and the political climate continues to deliver just the right blend of conditions for the market to keep grinding ever higher. But like a rubber band stretching further and further, it sure seems like each passing day just brings us another step closer to an eventual market shift.

That's why our eyes are firmly planted on how to best survive the transition through the next bear. We suggest that you have that in mind as well at this stage in the market cycle. We'll continue to unpack exactly what that means in future articles.

There are no changes to the DAA lineup for August. 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 August 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.

There is no change being made to the official SR recommendation for August. Here are the details.

The financial markets were robust across the board during the second quarter, as stocks and bonds alike responded to the “Goldilocks” combination of economic growth being “not too hot and not too cold, but just right.” Foreign markets were the strongest performers, while at home the tech-heavy Nasdaq gave back a bit of its strong quarterly gain with a June swoon. But by and large, investors had a relaxing and profitable quarter.

SMI’s strategies were solid participants in the quarter’s uptrend, with Just-the-Basics (JtB), Stock Upgrading and our 50-40-10 portfolio all beating the market, Dynamic Asset Allocation (DAA) roughly matching it, and only Sector Rotation — surprisingly — lagging among our equity-oriented strategies.

It’s always fun watching our portfolio balances move steadily higher. The second quarter provided new all-time highs for our JtB, Stock Upgrading, Sector Rotation, and 50-40-10 portfolios, while coming within 2% of a new all-time high in DAA. But it’s worth noting that the stock market’s sprint higher over the past year has been highly unusual from the standpoint that there have been no substantial pullbacks or corrections along the way.

One of the keys to successful investing is having appropriate expectations. It's one of the reasons SMI regularly writes about what the market's typical experience is like, whether that's short-term or over the long haul. If you know what normal looks like, it's easier to handle the ups and down along the way to that experience.

The stock market experience over the past year has been decidedly abnormal.

Specifically, I'm referring to the complete absence of downward volatility in the market. It's now been over a year since stocks have suffered even a 5% pullback, the last one occurring in the aftermath of the Brexit vote in June 2016. That makes this just the 6th time since 1950 that stocks have gone a full year without at least a 5% pullback.

Looking at calendar years, Ryan Detrick, senior market strategist at LPL Financial, says the average intra-year correction for the S&P 500 since 1950 has been 13.6%, while 91% of all years have had at least a 5% correction. In fact, more than half of all years — nearly 54% — featured a correction of 10% or more.

While it's hard to say this means anything definitive for the market moving forward, it is a little squirm-inducing to recognize just how unusual the current lack of volatility is. And what it continuing would mean in a historical context.

For instance, today's Wall Street Journal has an article titled "Markets’ Steady Climb in 2017 Defies Historic Odds." (It's locked behind the WSJ paywall, but you can open it via this Twitter link.) Here are a couple of key takeaways:

Three major stock-market benchmarks in the U.S., Europe and Asia have avoided pullbacks this year, commonly defined as 5% declines from recent highs. Never in at least the past 30 years have all three indexes — the S&P 500, MSCI Europe and MSCI Asia-Pacific ex-Japan — gone a calendar year without falling at some point by at least 5%.

Of course, 2017 is only a little more than half over, and plenty can change in the back half of the year. But the last time equity markets went this deep into a year without all three of those benchmark indexes suffering at least 5% pullbacks was nearly a quarter-century ago, in 1993, according to The Wall Street Journal’s Market Data Group.

The article looks at each of the major stock indexes in turn. The MSCI Asia-Pacific ex-Japan, for example, sees an average pullback of 20% each year. This year? 2%. And there have only been three years in the last 30 where the largest intra-year decline didn't reach at least 10%.

Europe has a similar story. The average intra-year decline there is 16%, but the largest decline so far this year has been just 4%. For the U.S. S&P 500, if it were to finish this year with its current worst-decline of 2.8%, it would be the second-smallest intra-year decline in the past 60 years. And the article also relates that the S&P 500 has avoided at least a 5% decline in just five of the past 60 years.

Even small-company stocks have seen a stunning lack of volatility. The Royce Funds, which include one of SMI's current Stock Upgrading recommendations, report that the Russell 2000 (which is a widely watched index of small-company stocks) has experienced an intra-year decline of at least 10% in 18 of the past 20 years. The median (meaning middle, not necessarily average) of those declines was -14.2%. This year's biggest decline for the Russell 2000 has been a mere -4.7%.

What does it all mean? It's hard to say. Obviously, there have been a few cases where these averages haven't panned out. In several of the cases cited above, the statistics reach back to a particular year — whether it be 1993 or 1995 or whatever — and you find that while X almost never happens, it did that year and stocks were up 35% (or some other great figure) that year. So it's not as if these statistics mean the market has to pause or suffer through a 5-10% decline.

But returning to the opening point, setting appropriate expectations is half the battle in investing. And the historical numbers clearly say we're well overdue for at least a 5% pullback if not a 10%+ correction. The market so rarely moves this long in one direction without pulling back that we'd be foolish to expect that to continue. While that blanket may feel a little wet today when the air is warm and the sun is shining, hopefully it will be a helpful reminder should the market winds begin to blow again at some point. A market pullback sometime in the next few months not only shouldn't be a surprise, we should expect it.

In pulling together data for the upcoming strategy report card to be published in the August issue of SMI, I noticed some interesting details about the performance rotation between the various Upgrading fund categories. Since we've expanded our coverage in those quarterly report card articles to include discussions of the Premium Strategies now, I don't usually have room to delve into these types of details anymore, so I thought I'd note them here for those who are interested in a "deeper dive."

The first thing that stands out is the huge contrast in returns between Large/Growth and Small/Value stocks through the first half of 2017. The average large/growth fund tracked by Morningstar was up 14.1% at mid-year. Contrast that to the paltry 0.5% gain of the average small/value fund — a massive difference.

That performance swing is all the more striking given that it's a total reversal of what we saw last year. In 2016, the average large/growth fund was up just 3.2% while the average small/value fund gained 26.0%. They've literally swapped best/worst positions from last year to this year. It's an instructive lesson on the value of diversification, as these pivots can be sharp and there's not always an obvious catalyst to these twists and turns.

Adding some depth to this discussion is the fact that, 2016 aside, growth has been dominating value for quite a while now. I did a quick comparison of the ETFs that track the Russell 2000 Value index (IWN - small/value) and the Russell 1000 Growth index (IWF - large/growth). Over the past three years (thru 6/30 of this year), large/growth has beat small/value by roughly 4% per year. Extending our view out to 10 years, large/growth has led by almost 3% per year.

That's a very significant performance difference, which is immediately obvious after converting those annual percentages into total returns. Over the past 10 years, IWN (small/value) is up 76.1%, while IWF (large/growth) is up 130.7%.

Mark Hulbert wrote an article in a recent edition of Barron's, in which he cites researchers Fama and French (who we wrote about last week), pointing out that over the past 12 years, value lagged growth by an annualized average of 0.7%. Yet over the much longer term, going all the way back to 1926, they note that value has beat growth by an average of 4.8% per year.

Given the long-term edge value investors have had, why don't more investors choose that investing approach? Because of periods like the past 12 years: it's really, really hard to endure prolonged periods when your strategy or approach appears to be failing. Much easier to roll your account into an index fund and go with the flow.

Hulbert goes on to note:

Frustrating as the last dozen years have been, they are not unprecedented. In fact, there was one other 12-year period since 1926 in which value, on balance, lagged growth. That period was — you guessed it — the one that ended in March 2000, the month the dot-com bubble burst.

Hmm, an aging bull market powered by a narrow group of huge tech stocks with obscene valuations, elevating the market indexes while most other stocks get left behind. Meanwhile, the Federal Reserve starts ratcheting up interest rates in the background...haven't we seen this story before?

And yet, as we've pointed out many times, even if this chapter ends in a similar way to the dot-com bubble bursting, the timing aspect is anything but certain. I was worried about a lot of these same factors a year or two ago, so who's to say there won't be another two years of gains before it's over? So instead of trying to predict the endgame, we rely on diversification instead (between strategies as well as asset classes). We know continuing to invest exposes us to the risk of giving back some of our current gains during the next bear market. But we also know that the protective properties built into Dynamic Asset Allocation (and which we continue to explore for our other strategies) have been effective in limiting the damage done by past market downturns.

So until the next bear finally arrives, we encourage you to continue to follow your long-term investing plan, while being mindful that your plan should be structured in such a way that a bear market arriving as soon as next week (or as far off as a few years) won't come as a surprise.

Most of SMI's investing strategies are built on the principle of momentum. Simply put, momentum is the idea that investments which are currently performing well tend to continue performing well, at least in the short-term. The opposite is also true: those investments that are performing poorly typically continue to be poor performers.

Momentum is one of the most studied investing concepts, certainly of the past few decades. Numerous academic studies have been done on all types of momentum, and the findings have repeatedly confirmed that momentum investing works over the near-term (which is typically defined as periods of one year or less).

As the above link clearly demonstrates, this isn't just SMI saying this — these are premier academic researchers arriving at this same conclusion. In fact, some of momentum's highest praise comes from those who specifically wish momentum didn't work. Consider Eugene Fama, a Nobel winner in Economics who is best known for his work promoting the Efficient Markets Hypothesis, which argues that investing factors like momentum don't work (or at least they shouldn't). So you can bet he's looked at momentum every which way. Yet he's said, "The premier market anomaly is momentum. Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns." And in the July issue of SMI, Matt included another quote from Fama acknowledging his inability to explain away momentum's success: "“Momentum is a big embarrassment for market efficiency.”

So momentum is great and momentum has been proven to work. Which leaves us with just one tiny problem. As long-time SMI readers can attest, momentum hasn't worked all that well lately.

Now, to be fair, there are many ways to apply momentum, and some of them have worked fabulously in recent years. Sector Rotation, for example, is an SMI strategy based on momentum that has gained 50% over the past year (thru 5/31/17), and averaged 30% gains per year over the past 5 years. Obviously no problems with momentum there!

But while Sector Rotation has been awesome, Dynamic Asset Allocation has scuffled along the past couple years. And SMI's old "flagship" momentum strategy — Stock Upgrading — has underperformed the market for much of the past decade (after running laps around the market's performance the decade prior to that).

While there are any number of reasons we can suggest as potential reasons why momentum has lost its mojo in recent years, the main question investors want answered is this: Is this is a temporary condition or a permanent change?

To that end, columnist Mark Hulbert wrote an article for The Wall Street Journal last month titled "Why Investors Shouldn’t Give Up on Momentum Investing." The article acknowledges the difficulties that momentum strategies have had over the past decade. For example, our friends Fama and French have found that the highest momentum stocks beat the S&P 500 over the past decade by less than one-fifth their average interval of the past 90 years.

More importantly, Hulbert looks at reasons why momentum is unlikely to be dead, and why momentum investors should be optimistic that this has just been a rare period of underperformance for the strategy. He notes the stunning long-term performance, both of momentum stocks generally (top decile of momentum stocks have beat the S&P 500 by 6.6% annualized from 1927 to March 31, 2017) and momentum newsletters, like No-Load Fund-X, which has beat the market overall during the 35 years of data that Hulbert has been tracking it, despite the weak past decade.

However, I found the following excerpt to be the most persuasive part of the article:

Also, a decade of disappointing performance isn’t unprecedented for momentum strategies. Something broadly similar occurred in the late 1930s and early 1940s, according to Kent Daniel, a finance professor at Columbia University who has extensively studied momentum strategies. (See chart.)

So, as frustrating as recent experience has been, it isn’t a reason in itself to conclude that the momentum strategy has permanently stopped working, Prof. Daniel says in an interview.

The fact is, momentum has suffered similar stretches of subpar performance before, only to bounce back and continue to produce the type of superior performance noted by the long-term research (most of which happened after this prior period of momentum weakness). It's also interesting to me that this other prior stretch of notable underperformance came in the decade following the last major financial crisis. I don't have any evidence to connect those crises (1929, 2008) with their subsequent periods of momentum weakness, but the timing is at least curious.

At any rate, momentum pulled out of that earlier extended funk, and there's every reason to believe it will do so again this time. The article goes on to quote other researchers as saying they haven't been able to detect an increase in the amount of money following the high momentum stocks in the past couple decades, which would be worrisome if they had found it to be true. But because it's not, and because human nature is unchanged, momentum investors can reasonably hope that their underlying strategy choice is sound.

There is one change to make to DAA for July. 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 July are (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.

There is no change being made to the official SR recommendation for July. However, for those in SR's unofficial "alternate" fund, there may be a change. Here are the details.