The first quarter of 2016 revealed how quickly stock-market sentiment can swing from one extreme to the other. The first six weeks were rough, with major stock indexes down more than 10%. Extreme fear was evident in the sentiment indicators as investors considered the risks of a brewing recession.
Then, with an oil rally and a few benevolent words from Fed Chair Janet Yellen, investors decided the world wasn’t about to end after all. Stocks raced back up, with the Wilshire 5000 index rocketing +13.7% higher from its February low through the end of March, a span of only seven weeks.
What do you get when you follow a six-week correction with a seven-week recovery? A more or less flat quarter overall — but an emotional roller-coaster for investors. This is the type of violent emotional whipsaw that makes some investors wonder if there’s any rhyme or reason to the market at all. But to seasoned investors, this type of action just reinforces one of the main pillars of SMI’s investing approach: the importance of a diversified portfolio.
In recent years, SMI has encouraged readers to combine multiple strategies within their portfolios, precisely to guard against the type of emotional extremes produced by the first quarter’s action. When the market was already down 11% just six weeks into the new year, many investors were a half-step from a panic attack. But not SMI investors who had heeded the suggestion to diversify their portfolios using SMI's Dynamic Asset Allocation (DAA) strategy. DAA was down only -3.4% at that lowest point, and was positioned such that further stock-market losses were unlikely to cause significantly more damage. There was a huge peace-of-mind dividend that came along with that conservative portfolio allocation!
Naturally, when the market shifted in mid-February and started racing higher, conservative positions such as DAA languished while more aggressive strategies like Stock Upgrading and Sector Rotation benefitted. And while it can be frustrating to see a portion of your portfolio lagging, emotional extremes such as we experienced during the first quarter are a helpful reminder that it’s much easier to stick with a long-term investing plan when it is balanced enough that you don’t feel like the next bear market is likely to undo all your progress.
New performance table reminder
Last year, we made a change to how the performance of the SMI strategies is reported. We now include an updated performance table on the back cover of each monthly issue (it’s also available on the homepage of the SMI website for members who are logged in — look for the "Performance" tab just below the four small pictures). This table expands the previous reporting of SMI’s strategy results to include all of SMI’s strategies and is updated every month rather than quarterly. Referring to that table may be helpful as you read this article.
Just-the-Basics (JtB) & Stock Upgrading
Investors who choose index funds, including those who follow our JtB recommendations, know that their experience is going to be essentially the same as the overall market. So JtB investors felt the full brunt of the market swings during the first quarter. Overall, performance of JtB lagged the broad U.S. market slightly as a result of small and foreign stocks each posting small losses for the quarter, while the large-stock indexes posted small gains.
Stock Upgrading’s first-quarter loss of -0.6% isn’t dramatically different in absolute terms from the +0.2% gain of JtB or the +1.2% gain of the Wilshire 5000 stock index, but it does continue a period of frustration that extends back at least a year and a half. The large-company dominated S&P 500 index peaked roughly a year ago (May 2015), but many stocks peaked even earlier, back in the fall of 2014. While the market has provided some sharp moves since then, there’s been no consistent long-term direction for quite some time now. Stock Upgrading is a trend-following strategy, and it’s going to underperform when the market bounces up and down sharply without really going anywhere. It’s impossible to know when the stock market will break out of this trading range, but eventually it will. Our task is to stay disciplined and continue to keep our portfolios aligned with the recent trends, so that when the market does eventually break out, we’ll be positioned to benefit from it.
The bond market was strong during the first quarter, benefitting early from the flight-to-safety response of investors moving money out of stocks and into bonds, and later from the clear signal given by the Federal Reserve that it no longer intends to raise interest rates as rapidly as it had previously signaled. Bond Upgraders earned solid quarterly gains of +2.7%, once again illustrating the value of a diversified portfolio.
Those gains would have been slightly higher had the system not moved us to the relative safety of the Vanguard GNMA fund just a few weeks prior to the Fed’s announcement that interest rates were going to stay lower for longer. That news sent riskier bond prices higher.
As we mentioned in last month’s Bond Upgrading new fund write-up, we’ve spent quite a bit of time recently fine-tuning the Bond Upgrading system in an effort to minimize the type of short-term trades we’ve experienced over the past year. We’re optimistic that we’ve found a way to tweak things that will maintain the basic substance of the system while cutting back the number of trades a bit.
Dynamic Asset Allocation (DAA)
As we noted earlier, DAA did exactly what we expect it to during market corrections: significantly limiting losses and helping SMI investors avoid the deep dread many others felt when the market appeared ready to dive over the cliff. Once again, the Fed stepped in and kept that from happening. But part of the reason investors have grown so nervous is they intuitively know that central bankers can’t hold off bear markets forever.
While DAA fulfilled its primary purpose in readers’ portfolios during the first quarter, the strategy has also produced its own flavor of frustration. The stock market has thrown two 10%+ corrections and subsequent recoveries at us in less than a year. These rapid shifts between “risk-on” and “risk-off” have produced more trades and whipsaws than DAA normally sees, and it’s been frustrating to feel like DAA is a step behind the curve. A look at the quarterly returns of the six asset classes used by DAA shows why it’s frustrating for DAA investors to have lost even a small amount during the first quarter, when simply buying and holding any combination of the six classes for the entire period would have produced a better result.
Bottom-line, the system simply isn’t designed to respond to such rapid changes in market sentiment. But there’s a reason for that: historically, these types of sharp, fast, repeated swings are unusual. What we’ve experienced over the past year is about as challenging an environment as you could possibly design for a strategy like DAA. So we’re not especially surprised that its recent 12-month performance is among the poorer-performing of such periods in the past 40 years.
Yet despite these challenges, when the market corrected last August and again in February, DAA provided powerful reminders of its value and the protective properties it adds to a diversified portfolio. The type of unusual market behavior we’ve seen recently has rarely been repeated in the historical record, but DAA’s value as a firewall against large losses is consistently evident throughout its backtested history.
Sector Rotation (SR)
It was a rather bland quarter for this normally spicy strategy, as SR lost -0.35%. Perhaps the only surprise was that its path to that result wasn’t more dramatic, losing less than the market early in the quarter and gaining less during the subsequent rebound. Bland doesn’t usually last long in this strategy though, and true to form, SR moved on to a new recommendation at the end of March. While SR has been stuck in the doldrums with most everything else since the market started churning last summer, it’s worth pointing out that despite a loss of -6.7% over the past 12 months, SR’s gains over the past three years are still nearly +23% per year. That’s stunning.
This oddly titled portfolio refers to the specific blend of SMI strategies — 50% DAA, 40% Upgrading, 10% Sector Rotation — examined in detail in our May 2014 cover article, Higher Returns With Less Risk: The Best Combinations of SMI’s Most Popular Strategies. For all of the reasons we’ve discussed in this article, it’s become the poster-child for the type of diversified portfolio we encourage most SMI readers to consider as they become more comfortable following our strategies. The market can shift suddenly between rewarding risk-taking and punishing it, so a blend of risk-courting and risk-averse strategies can help smooth your long-term path and promote the type of emotional stability that is so important to sustained investing success.
Not surprisingly, with DAA, Upgrading and SR all slightly underperforming the broad market during the first quarter of 2016, so did a 50/40/10 portfolio. But the portfolio did its job from the standpoint of significantly limiting losses during the first six weeks of the year. At its worst, a 50/40/10 portfolio was down less than -7%, while an Upgrading or indexing portfolio would have been down more than -11%.
The performance of the three strategies will vary significantly over time, but a portfolio diversified among them will smooth the ride along the way. Whether you’re using this 50/40/10 blend or a different allocation combination tailored to your specific risk preferences, we think many SMI readers can benefit from combining these strategies in some fashion.