Given the scary October we've endured, the third quarter (July-September) may feel like ancient history. It’s easy to forget how strong the market was during the typically weaker second and third quarters this year. That strength — and unusual lack of volatility — certainly contributed to the shock value of October’s volatile slide.

In July, the third quarter picked up where the second left off, with strong economic data driving the stock market relentlessly forward. August’s unemployment rate of 3.9%, for example, was the best seen in nearly two decades (since December 2000). Strong growth in the U.S. economy coupled with the resolution of some of the simmering trade disputes (most notably the re-working of NAFTA with Mexico and Canada) kept the market indices climbing steadily higher.

This positive backdrop resulted in the S&P 500 index setting a new all-time high late in the quarter (September 20). SMI investors clearly benefited from this strength as well, as all-time highs were reached during the third quarter in SMI’s Just-the-Basics, Stock Upgrading, DAA, and 50/40/10 model portfolios.

Just-the-Basics (JtB) & Stock Upgrading

The strength of the U.S. stock market was the headline of the third quarter. But the primary subplots were 1) the extreme divergence in foreign-stock performance throughout the quarter, and 2) the sharp turn lower in smaller-company stocks in September.

Both JtB and Stock Upgrading posted solid gains for the third quarter as a whole. JtB gained +4.9%, which is a great return for a single quarter. But it masks a stark split between JtB’s three components. JtB uses an S&P 500 index fund as its U.S. stock component, which rose a whopping +7.6% during the third quarter. Its “extended market” component, which covers small and medium-sized stocks, was up a solid (but significantly lower) +4.5%. And its foreign stock component barely squeaked out a gain of just +0.3%. Obviously, comparing that combined output with the large-company dominated indexes (like the S&P 500 and Wilshire 5000), JtB’s return doesn’t seem so great, but that was the cost of diversification this quarter.

The story was similar for Upgrading, which gained a solid +4.8%. As the table below shows, SMI’s recommended funds matched or exceeded the gain of the average fund in all four domestic fund categories. But whereas Upgrading’s small-stock diversification helped it beat the broad market indices during the second quarter, those diversified holdings (along with Stock Upgrading’s foreign component), pulled down its overall return in the third quarter.

Third Quarter Performance of Stock Funds by Risk Category

Risk Category SMI Funds1 Average Fund2
NOTES: 1Average of the three recommended funds for each risk category, assuming any suggested changes were made on the last trading day of each month. 2An average of all the mutual funds in the SMI risk category shown, including both load and no-load funds.
Cat 5: Foreign Stock Funds -1.3% -0.4%
Cat 4: Small Company/Growth 9.1% 7.1%
Cat 3: Small Company/Value 1.3% 1.0%
Cat 2: Large Company/Growth 7.5% 7.5%
Cat 1: Large Company/Value 6.4% 5.5%

Growth stocks trounced value stocks in the third quarter, continuing a theme that has run through most of 2018. As of mid-October, SMI’s two growth-fund categories had strong positive returns of better than +7% so far in 2018, while both value categories had posted small losses for the year.

While the growth/value divide is easily observed in the table, what isn’t obvious is the split between large- and small-company stocks that showed up in September. While the small/growth group posted strong returns for the third quarter as a whole, performance for both small-company categories turned negative in September (and suffered larger losses in the October slide).

Given that the most popular stock market indices are dominated by large/growth stocks (i.e., the market standouts in 2018), those indices have been tough benchmarks for diversified strategies to measure up to. While they’ve trailed these indexes, thru the end of the third quarter both Stock Upgrading and JtB had gained roughly +14% over the past year (and +14 to +15% annualized over the prior three years). So sometimes diversification costs us in the short-term, but we still feel it’s the right way to set up these core strategies.

Bond Upgrading

After a brief reprieve over the summer, interest rates started rising again in September (before spiking rapidly higher during the opening week of October). The “core” holdings of SMI’s Bond Upgrading portfolio ended the third quarter with small gains. But our Upgrading bond holding took a hit as stronger economic news brought with it expectations of higher interest rates than investors had previously expected.

The Federal Reserve hiked its short-term rate in September for the eighth time in this cycle. That rate of 2.25% is the highest short-term rates have been since 2011. While short-term rates have been slowly rising for two years now, the big shift in September (and October) was that longer-term rates finally started moving higher as well.

Increasing interest rates hurt bond investors, because the higher rates push down the value of existing bonds. But there are two “good news” aspects of the recent interest-rate moves. First, we’re getting closer to “normal” interest rates after a decade of artificially low ones. Believe it or not, most experts still consider today’s rates — even after two years of increases — to be lower than what would historically be expected given current economic and market conditions. Second, while higher rates hurt the value of current bonds, they help the returns of new bonds, as those bonds are issued with today’s higher yields. This higher earning power slowly trickles through to create higher bond income over time. That’s already being felt in savings yields (the shortest end of the yield curve), and it presumably will begin to positively impact returns of short-term bond funds at some point. For now though, at most bond funds the losses in current principal due to rising rates outweigh the greater income being generated from those same higher yields.

3rd Quarter 2018
DAA ETF Universe

Ticker & Category 3Q Result
SPY U.S. Stocks 7.7%
EFA Foreign Stocks 1.5%
VNQ Real Estate 0.5%
BLV Long-Term Bonds -0.4%
SHY Money Market 0.1%
GLD Gold -5.0%

Dynamic Asset Allocation (DAA)

The DAA universe was split like a “barbell” during most of the third quarter: there was one very good class, one very bad class, and the other four didn’t do much of anything. The good news for DAA investors is the strategy was positioned on the right side of both of the big moves, owning U.S. Stocks and avoiding Gold. Looking at DAA’s long-term history, getting those big trends right has been the key to its success. While we’d love to perfectly navigate all the minor twists and turns as well, their impact has been much less significant over time.

The abrupt performance reversal of small-company stocks in September (followed by broader losses in October) is an important reminder of the importance of playing solid defense via strategies such as DAA. While the October drop has been relatively mild to this point, someday a pull-back like this will follow through and turn into the next full-fledged bear market. So while we’d rather earn 100% stock returns whenever stocks are rising, October has provided a good reminder that less-volatile strategies such as DAA should have a place in our portfolio as well. (The fact that a third of the DAA portfolio was safely in cash certainly was a mental balm as stock losses mounted during the October decline.)

Sector Rotation (SR)

Sector Rotation was the main exception to the string of new all-time highs set by SMI strategies during the third quarter. SR was solid, gaining +3.4% during the quarter, but that still left it a bit below its May peak. The recommended SR holding changed at the end of August, after two years in the previous recommendation. But with stocks generally sluggish in September and the recent top performers being among the hardest hit once stocks turned lower, the new recommendation isn’t off to a great start.

That said, at the end of the third quarter SR still sported a market-beating year-to-date gain of +9.4%. As long-time SR investors will attest, volatility is part of the bargain when shooting for the type of long-term returns SR has generated historically.


This portfolio refers to the specific blend of SMI strategies — 50% DAA, 40% Upgrading, 10% Sector Rotation — discussed in our April 2018 cover article, Higher Returns With Less Risk, Re-Examined. It’s a great example of the type of diversified portfolio we encourage most SMI readers to consider. As we’ve seen repeatedly in recent years — and again just recently — the markets can shift suddenly between rewarding risk-taking and punishing it, so a blend of higher-risk and lower-risk strategies can help smooth your long-term path and promote the type of emotional stability that is so important to sustained investing success. (Blending multiple strategies adds complexity. Some members may prefer an automated approach.)

A 50/40/10 portfolio would have gained +3.7% during the third quarter, en route to a new all-time high for this strategy. That’s considerably less than the Wilshire 5000 index’s gain of +7.3%. As we’ve discussed, diversification didn’t pay off this quarter for Stock Upgrading or DAA as compared to the large/growth dominated indexes.

Given the recent market volatility, it’s worth reiterating that 50-40-10 investors have the lion’s share of their portfolio protected via some type of defensive protocol. Like any type of insurance, its cost (in the form of lower returns during the third quarter) can be annoying — until you need the insurance. Over the full market cycle (bull and bear market), we remain confident that the performance of a 50-40-10 portfolio likely will wind up ahead of the broad market, and the emotional toll of the journey will be reduced significantly. Whether you’re using this specific 50/40/10 blend or a different combination, we think most SMI readers can benefit from blending these strategies in some fashion.