U.S. stocks rose for a sixth straight year, the bond market was surprisingly strong as interest rates unexpectedly declined, and all of SMI’s strategies (except the Optional Inflation Hedges) made money in 2014. Cause for celebration all around, right?

While it was definitely a good year for investors overall, not everything was blue skies and sunshine. For starters, the healthy gains posted by the S&P 500 and other large-company dominated indexes fail to show how difficult 2014 was for small-company and foreign stocks. As the small table below shows, the average foreign stock fund lost about 5% for the year. Small-company stocks performed better than that, but they suffered through a pair of 10%-plus corrections en route to total gains less than half those of their large-cap counterparts (the small-company Russell 2000 index gained +4.9%; the S&P 500 +13.7%).

In short, it was the kind of year when investors were making money, yet feeling like they should be making more. Compounding this effect was the fact that less than 20% of U.S. equity-fund managers beat their respective benchmark, and even fewer could keep up with the S&P 500, which outperformed virtually everything else.

Still, it’s difficult to complain six years into a bull market. To put these grievances in perspective, despite lagging “the market” in 2014, both Just-the-Basics (JtB) and Upgrading have gained more than 60% in the past three years. That’s rarified air, and obviously lagging a benchmark during a period of abnormally strong returns is preferable to the type of problem presented by bear markets!

Performance Table Changes

Before diving into the specifics of each SMI strategy, we want to draw your attention to the new performance table below. In the old days, SMI’s stable of options consisted of only JtB and Upgrading. But over the last decade or so, other strategies have become “mainstream” for SMI readers. We’ve started reflecting that shift by listing them here.

Of course, some of these strategies are relatively new and don’t have long real-time track records. As most SMI readers realize, our strategies are all mechanical. We intentionally design them that way so that action is dictated by performance, rather than our expectations or emotions. This gives us confidence that our back-tested numbers are reasonably close to what would have actually happened if each strategy’s rules had been in place at the time. But there’s still no substitute for live performance. So in those cases where we don’t have 10 full years of live performance to report, you’ll see a footnoted “H” (for “hypothetical”) next to any backtested results included in the table. Again, we think those numbers are valid “what would have happened” numbers, but they aren’t actual, live results.

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SMI’s Bond Upgrading strategy presented a unique challenge. This strategy just launched in January of this year, but more importantly, it replaced a previous method that SMI investors have used to invest in bonds through the Upgrading strategy. We’ve decided to show the backtested Bond Upgrading history rather than the old results from our prior bond approach. Those old results are still available via the old quarterly report card articles on the SMI website. But we think showing the backtested history of the new approach is more helpful from a planning standpoint than reporting actual performance from an approach we no longer follow. That’s why you see the “H” footnotes all down the Bond Upgrading column — we didn’t want anyone to be confused thinking these were the actual performance numbers from the past.

Also, in the past we showed the blended stock/bond results of various Upgrading allocations (80/20, 60/40, etc.). We’ve decided to change that and break the Stock and Bond Upgrading components out separately. This provides greater transparency regarding which component is responsible for what portion of performance. Readers who are allocating a portion of a portfolio to both strategies can use those two base numbers to compute their specific result. For example, if Stock Upgrading gained 10% and Bond Upgrading 5%, a 60/40 reader would take (10% x 0.6) and add that to (5% x 0.4) to calculate their personal 60/40 Upgrading result, which in this case would be 8%. While this adds a step for some readers, it will provide greater clarity and flexibility for readers who choose to use Bond Upgrading either as a stand-alone strategy or in combination with other non-Upgrading strategies.

Just-the-Basics (JtB) & Upgrading

As previously noted, it was tough sledding for both of these strategies in 2014, primarily due to their significant allocations to foreign and small-company stocks. JtB had 60% of its portfolio allocated to those groups, while Upgrading had 54%. Ironically, Upgrading’s allocations were shifted correctly in the right direction, with smaller allocations than in the past to the small-company and foreign categories, but in 2014 having any exposure to those categories hurt performance.

In addition to the allocation issue, the Upgrading process itself just didn’t add much value last year. Usually Upgrading is able to provide significant value in at least a few of the risk categories (for example, in 2013, Upgrading’s results were roughly 5% better than the average fund in four of the five groups). Last year, however, none of the Upgrading results for the five risk categories presented significant improvement over the category averages.

We don’t know why Upgrading’s relative performance was weaker than any other year in recent memory. But we do take encouragement from the research that has shown Upgrading’s “active” fund managers (versus “passive” managers of index funds) have historically lagged the S&P 500 by 2% during years when interest rates have fallen as they have in recent years. In contrast, active managers have historically outperformed the S&P 500 by about 1.5% in years interest rates have risen. We don’t know that interest rates will rise in 2015, but it seems likely that Upgrading will soon be back on the positive side of that interest-rate trend.

From a bigger-picture standpoint, one bad year doesn’t do much to dampen our enthusiasm for a strategy. But admittedly, Upgrading has now trailed the market in three of the past five years. Is it time to switch to a different approach? Not necessarily (although if you haven’t already, you might consider blending one or more other strategies into your portfolio along with Upgrading — see this month’s editorial for an example of that).

We explored this in some detail a few weeks ago and encourage you to read that article if you haven’t already. But to quickly summarize, we reported on the historically streaky nature of Upgrading, showing it wasn’t especially uncommon for the strategy to beat — or lag — the market for three to five years at a time. In fact, Upgrading trailed the market for eight of 11 years once, only to suddenly turn around and beat it the next 10 straight years by a huge cumulative margin! Given that historical track record, we aren’t reading too much into Upgrading’s weakness relative to the market over the past five years, especially given that Upgrading’s absolute returns have been very strong over that time — +12.45% annualized.

Dynamic Asset Allocation (DAA)

If JtB and Upgrading provided unpleasant surprises in 2014, DAA was the opposite. Riding strong returns in real estate as interest rates fell and kept on falling, DAA also adeptly exited foreign stocks at the end of August and benefited from a move into long-term bonds. Of course, the fact that its stock component was invested in the S&P 500 helped as well. All together, DAA’s +13.0% return beat the +12.7% gain of the broad-based Wilshire 5000 index that SMI uses as its measure of the market. For a strategy that doesn’t normally expect to keep pace during rising stock markets, it was a pleasant surprise, and helped offset lower than expected gains from Upgrading for those with blended Upgrading/DAA portfolios.

Sector Rotation (SR)

We’re running out of superlatives to lavish on Sector Rotation — our high-risk, high-reward strategy that rotates between narrowly focused sectors (or “slices” of the economy). For the third year in a row, SR posted an extremely strong gain, following 2013’s breathtaking +65.7% rise with another +49.9% in 2014. (Just for fun, an SMI reader who had $10,000 invested in SR last year made a profit of $4,990. That’s $3,719 more than “the market” gained — enough to pay the extra $5/month cost of a premium membership for the next 62 years!)

SMI readers who have followed this strategy over the past 10 years have earned a total return of +430%! (Those aren’t hypothetical results. This strategy has been active since late 2003.) Such performance is incredible. But as always when discussing SR, you need to be aware of the significant degree of risk and limit your exposure appropriately. SR is great when it’s soaring, but it occasionally makes equally dramatic moves to the downside. It’s important to understand the risks.


This portfolio wasn’t rolled out with the intention of it becoming an official SMI strategy, per se. But after seeing how its three components work together and complement each other, it has gradually grown into something of a de facto starting point for many SMI readers.

For those who are unfamiliar, this oddly titled portfolio refers to the specific 50% DAA, 40% Upgrading, 10% SR blend of strategies examined in detail in our May 2014 cover article. That article found this combination of strategies has worked synergistically in the past to boost returns while simultaneously reducing risk — the holy grail of investing. It accomplished this by adding the high upside of SR and the volatility dampening properties of DAA to an Upgrading base.

In our performance table, we’ll be reporting the results of this portfolio as if the Upgrading portion is 100% stock (no bonds). But in real life, if your risk temperament and season of life call for you to blend stocks and bonds in the Upgrading portion of this portfolio, then by all means do so.

Also, as this month’s editorial makes clear, we value each reader having a personalized mix of strategies that works for him or her, so feel free to customize this. But we also recognize that some people just want a good default plan (or at least a starting point), and this 50/40/10 mix provides that. So while this portfolio may or may not exactly reflect your own blend of SMI strategies, it should be a helpful reference point to show how readers utilizing this type of diversification are performing.


Given that this is the first time all of these strategies are being displayed on a year-by-year, head-to-head basis (see table below), it’s worth pointing out a few things. We’ve written about the value of diversification in many ways over the years, but this table just reinforces the point.

Starting in the center of the performance table, notice how both Bond Upgrading and DAA have managed to avoid losses, even during the worst of the melt-down in 2008. That steadiness speaks to why we (1) gave the largest portion to DAA in designing our 50/40/10 blend, and (2) have recommended for years that the bond portion of an Upgrading portfolio should increase as an investor approaches and enters retirement.

Moving out one column in either direction, the yearly Upgrading and Sector Rotation results show the extra upside these strategies provide in years such as 2009 and 2013. Those tempted by the cumulative returns of SR to emphasize that strategy at the expense of Upgrading should look closely at the year-by-year data: years like 2006, 2009, and 2010 make it clear SR isn’t always the better option, even in rising markets.

The reality is that the performance of each strategy ebbs and flows, marching to the beat of its own drummer to at least some degree. That’s what makes a well-conceived diversification plan work: some parts of the portfolio usually will be performing well if it includes enough dissimilar options. That fact is what drives our contention that rather than an either/or decision process, SMI readers are better served thinking both/and. Having part of your portfolio positioned to take advantage of market strength via Upgrading and SR can help keep discontentment at bay during strong years such as 2009 and 2013, while having a significant allocation to DAA should help limit any damage — financial and emotional — when the next bear market arrives.

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