SMI offers two primary investing strategies for “basic” members. They are different in philosophy, the amount of attention they require, and the rate of return expected from each. Our preferred investing strategy is called Fund Upgrading, and is based on the idea that if you are willing to regularly monitor your mutual-fund holdings and replace laggards periodically, you can improve your returns. While Upgrading is relatively low-maintenance, it does require you to check your fund holdings each month and replace funds occasionally. If you don’t wish to do this yourself, a professionally-managed version of Upgrading is also available.
SMI also offers an investing strategy based on index funds called Just-the-Basics (JtB). JtB requires attention only once per year. The returns expected from JtB are lower over time than what we expect (and have received) from Upgrading. JtB makes the most sense for those in 401(k) plans that lack a sufficient number of quality fund options to make successful Upgrading within the plan possible. Here are the funds and percentage allocations we recommend for our Just-the-Basics indexing strategy.
In reading through Winning the Loser’s Game, source of this month’s cover article, I was especially taken by a chapter titled simply “Time” (much of which we included in the excerpt). It’s not that what Ellis wrote was new to me, but that he conveyed some familiar truths in provocative ways. For example:
“Time—the length of time investments will be held, the period of time over which investment results will be measured and judged—is the single most powerful factor in any investment program. . . . Given enough time, investments that might otherwise seem unattractive may become highly desirable. ...The patient observer can see the true underlying patterns that make the seemingly random year-by-year, month-by- month, or day-by-day experiences not disconcerting or confusing but splendidly predictable—on average and over time. Like the weather, the average long-term experience in investing is never surprising, but the short-term experience is always surprising.”
I had not thought of it in those terms before, that one’s long-term investing experience is never surprising. He means that, over the long haul, there’s a relatively small gap between what one expects to earn and what one actually earns. Since 1950, the average return from a broadly diversified stock portfolio split evenly between large- and small-company stocks and held for 30 years was +13.0% annually. If you knew that going in, it would have governed your expectations. And, as it turned out, you wouldn’t have been sorely disappointed no matter which 30 year slice of the past 66 years you owned stocks. The worst you could have done was +10.2% per year (7/1986 - 6/2016) while the most you could have earned was +16.7% annually (1/1975 - 12/2004).
The first significant volatility the stock market has faced in months has finally pulled the trigger on the annual seasonality sell signal today. This signal had been getting close to being triggered in recent days, and today's action has pushed it decisively over the edge.
To avoid any confusion, I'm speaking of the MACD signal (read on if you don't know what that is), which gives us slightly different entry and exit points than the traditional "Sell in May and go away" dates.
As this old Introduction to Annual Seasonality article explains, the stock market has historically tended to perform much better on average between November-April than between May-October. This is, of course, an average based on many years of observation, and any specific year can vary dramatically from that long-term trend. But it is a pattern that has persisted long enough, and across global markets as well as here in the U.S., so as to have attracted quite a bit of attention over the past two decades.
The basic idea of annual seasonality, then, is to sell stocks at the end of April and buy back in at the end of October. (“Sell in May and go away.”) SMI makes a further refinement to this basic seasonality approach by looking to "fine tune" the buy and sell signals based on a mechanical indicator called MACD.
Questioning the value of investing seasonality
However, there have been two significant developments in recent years that now lead us to question whether acting based on this seasonality signal information is the best approach. First, our investigation of the impact of the election cycle on annual seasonality found that there is actually only one (out of four) unfavorable periods during which stocks have, on average, lost money. That is the May-October period leading up to the U.S. mid-term elections (which last happened in 2014 and will happen again in 2018). The other three unfavorable periods, including the one we’re entering this year, have still been positive on average. Which leads one to question the wisdom of making significant changes to an otherwise well-designed portfolio during these other unfavorable periods.
In other words, even those who want to apply annual seasonality as part of their investing plan would have a compelling case to only alter their base asset allocation during the mid-term election year unfavorable period (and potentially the following favorable period, which has been abnormally strong, on average). The other three years, they would leave their allocations alone and ignore annual seasonality.
Improving on investing seasonality
The second reason to question the value of continuing to apply annual seasonality signals stems from the research we did that led us to launch our Dynamic Asset Allocation (DAA) strategy in 2013. This strategy has a timing element built into it that triggers changes between six asset classes all year long, irrespective of the annual seasonality cycle.
When owning stocks while applying annual seasonality is compared to simply owning stocks year-round, it’s easy to make an argument in favor of incorporating the annual seasonality modification. However, when comparing the relatively blunt-instrument approach of annual seasonality to the more specific signals generated by Dynamic Asset Allocation, the results aren’t even close. Dynamic Asset Allocation has provided much better signals of when to be invested in stocks and when to be out of them than annual seasonality.
How much better have DAA's signals been than annual seasonality's? We haven’t done exhaustive research on this, but a quick analysis done a few years ago indicated that over the prior two dozen years, using DAA would have produced better than triple the returns of applying simple annual seasonality to stocks. (That's using the standard April 30 and October 31 exit and entry points, not the MACD refinement.)
To be fair, no one ever claimed annual seasonality was a finely-tuned timing instrument. It’s a blunt, simple device to improve on buy-and-hold stock market investing. DAA is purposely designed to give us more specific signals and it requires a lot more — someone has to calculate and track the momentum scores and potentially alter their holdings every single month instead of just twice a year.
But for the SMI member, the issue is quite a bit simpler. The DAA information is available every month in a very simple format. Given that these signals have been significantly better than annual seasonality’s, and they are so easy for SMI readers to obtain, it’s hard to imagine why someone would continue to use the blunt instrument approach of annual seasonality any longer.
Unless, of course, they're applying it to an account where using DAA isn't feasible. It's primarily for these readers that we continue to report on the seasonality MACD buy and sell signals. But for everyone else, we believe DAA offers better timing cues than annual seasonality.
If you do use investing seasonality
Even before the creation of DAA, SMI always maintained that annual seasonality should represent a relatively small refinement to your existing long-term plan, rather than being used as an "all in" vs. "all out" tool. We've seen annual seasonality be painfully out of synch with the market at times. As such, we've recommended making measured changes to your stock/bond allocation, if you choose to implement annual seasonality at all.
For example, someone who would otherwise have a 70/30 stock/bond allocation might choose to lower that to 60/40 during the unfavorable summer period, then raise it to 80/20 during the favorable winter period. That would give them an average allocation close to their ideal, optimized to correspond with the market's long-term statistical pattern. (Some readers have found that using automated versions of the strategies involved makes this semi-annual switching process easier.)
Another idea that has been popular with readers in the past is to switch a portion of their portfolio back and forth between a more aggressive strategy, like Upgrading, and a more conservative one, like DAA. Along those same lines, some might choose to pare back their Sector Rotation allocation during an unfavorable period such as this.
However you approach it, keep in mind this often-overlooked point about annual seasonality: the main objective of annual seasonality is not to improve returns. Rather, the primary objective of annual seasonality is to reduce risk. The data indicate that the overall returns of a portfolio invested in stocks only during the favorable period each year (and in bonds the rest of the year) has produced very similar total returns to a portfolio that was fully invested in stocks year-round.
Confused? Ask a question and we'll try to clarify anything that isn't clear. But bottom-line, if you don't have a compelling reason and desire to use annual seasonality, you can safely skip right by it and pretend it doesn't even exist.
Two random observations to pass along today. They're not related (at least directly). I'm just throwing them into this post together.
Market Breadth Narrowing Again
Much has been written about the "FAANG" stocks — Facebook, Apple, Amazon, Netflix, and Google (Alphabet) — as this tech quintet has dominated this long bull market. While this is anything but a new story, what is new is the fact that these 5 stocks have been about the only ones continuing to advance over the past 10 weeks (since the beginning of March).
The S&P 500 as a whole has gone nowhere since the 1st of March, closing that day at 2,395.96. Yesterday's closing level was 2,397.88. But as the chart below from John Alexander at MacroCharting shows, the FAANG stocks have continued to rise, while the other 495 stocks in the index have declined by a corresponding amount.
There's no specific take-away from this information, although it's generally considered to be a warning sign when the market's breadth (i.e., the percentage of stocks continuing to advance) narrows. As I mentioned, this FAANG phenomenon is nothing new, as these 5 companies have been dominating for several years now. But it's worth noting that the last time the breadth story became enough of an issue that SMI was discussing it was in late 2015. Perhaps coincidentally, perhaps not, that was about the time the market went through a pair of 12% corrections within a span of 7 months. However, there's no particular reason to think the timing of those corrections was specifically tied to any particular measure of market breadth.
If anything, seeing the continued focus of the market being channeled into such a narrow list of really expensive stocks makes me think how vulnerable the indexes generally (and index fund owners by extension) are to adjustments in the pricing of these handful of stocks. Amazon is a phenomenal company, and with a P/E ratio of 180 it had better be! We love the Netflix product too, but a P/E over 200? Wow.
Valuations Look Better Overseas
Sticking with the valuation topic, I'm seeing more and more written about the disparity in valuations between U.S. and foreign markets. This MarketWatch article is a good example, providing the following chart that shows how dramatically the performance of U.S. and Foreign markets has diverged since 2011.
Eyeballing this chart, it appears that over the past 10 years U.S. stocks have gained 62% while Foreign stocks have lost 16%, with most of that gap opening over the past six years. Clearly, owning foriegn stocks lately has been a drag on performance.
But it's worth noting these types of multi-year performance gaps between U.S. and Foreign stocks are common. Here's another chart that shows this clearly.
The upward spikes show the periods when U.S. stocks have had the upper hand, while the downward spikes show the periods when Foreign stocks have been the better performers. While this decade (2011- ) has been dominated by U.S. markets so far, the shoe was on the other foot for much of the prior decade (2001-2010).
Not surprisingly, when one market dominates the other for a period of time, as the U.S. has since 2011, valuations eventually get stretched between the two. This has definite implications for each market's future prospects.
Here are GMO's 7-year projected returns for various asset classes, based largely on today's valuations of those asset classes.
While all of these projections are depressingly low, on the stock side of the chart, you can clearly see how today's elevated valuations have impacted the likely future returns of U.S. stocks (both large and small). GMO projects U.S. stocks will be lower seven years from now than they are today (negative annualized returns). Their prognosis isn't great for International stocks either — slight losses for them as a group — although they expect slightly brighter skies for stocks from the Emerging Markets subset of the international group.
DAA investors have likely noticed that foreign stocks have been 2017's top performing group so far. There's no way to know whether that will continue in the short-term, but the longer-term trends seem to indicate that having the 20%-30% type of foreign allocation included in most of SMI's strategies will be a good idea in the years ahead.
It's May, the month when some investors point to the "Sell in May and go away!" playbook for investing instructions. As we explained a few years ago in Protecting Your Portfolio Against An Unfavorable Election Cycle, we don't think that old adage is worth following for SMI readers, with the possible exception of one out of every four years (which isn't this year). That said, we know some readers still have interest in it, so we continue to watch that "sell in May" indicator as we do every year, and will report on it when it signals that it's time to sell.
While annual seasonality may not be a pressing reason to sell stocks this year, investors have no shortage of other reasons to be nervous. As we've pointed out numerous times, the Fed's interest rate tightening agenda is the key signal we've been watching for as a risk warning for stocks. Investors have plenty else to be concerned about in terms of the market's high valuations, plus the more general concern that comes from the stock market entering the 8th year of this bull market.
There is one change to make to DAA for May. 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 May 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.
Sector Rotation is off to a great start in 2017, up 13.5% after just four months.
There is no change being made to Sector Rotation for May. Here are the details.
To the surprise of many, the post-election rally extended into the new year, with stocks rising mildly in January before pushing forcefully higher in February. While the market leveled out in March, the first quarter as a whole was solidly positive for equity investors who had the courage to stay invested.
SMI investors had plenty to celebrate in the first quarter, as several of SMI’s model portfolios reached new all-time highs. Not surprisingly, the strategies most closely aligned to the stock market’s gains were the ones setting new records: Just-the-Basics, Stock Upgrading, Sector Rotation, and our 50-40-10 portfolio.