Stock market gains of the degree experienced since the end of the COVID bear market last year are exceedingly rare. From the March 2020 lows, the S&P 500 had gained over +90% through June 30, 2021. SMI investors have seen huge increases in their portfolios over the past 12-16 months.

However, it certainly hasn’t been a case of everything moving up in unison. There have been distinct shifts in the market along the way. From April-September 2020, the largest tech stocks were the runaway leaders. Then in November, the market pivoted sharply on the news that COVID vaccines would be arriving soon. This “re-opening trade” boosted the prices of stocks that stood to benefit most from the resumption of physical economic activities (value stocks and commodities) while also boosting the general risk appetite of investors, driving small-company stocks rapidly higher.

As 2021 has progressed, we’ve seen a narrowing proportion of stocks participating in the continuing rally. First, the most speculative stocks ran into trouble starting in February. Then small-company stocks started slowing down during the second quarter of 2021. And since mid-June, that has extended even to large-company stocks, with the average S&P 500 constituent losing ground even as the largest stocks have continued to push the overall index higher.

Bonds have been signaling a transition as well (although, admittedly, it’s difficult to decipher signals from the bond market anymore given the massive direct purchases of Treasuries by the Federal Reserve). Interest rates soared from August 2020 through March 2021, reflecting the economic optimism of the re-opening trade. But after peaking in March, the 10-year Treasury yield sank from 1.75% to below 1.20% by mid-July. Normally, this would be a clear signal that bond investors expect lower economic growth in the future.

So while the economy is still growing strongly and the broad stock market arrived near its all-time high at mid-year, it’s clearly a market in transition. That’s not surprising, as we’ve expected the market to shift from a “hyper-growth” state immediately following the big recession/bear market into a more normal growth environment. But while expected, it’s still something for investors to be aware of and factor into their thinking.

(Read more about the changes we’re making to Stock Upgrading this month)

Just-the-Basics (JtB) & Stock Upgrading

Both JtB and Stock Upgrading have posted strong absolute gains this year. (Performance updates for all SMI strategies are available each month on the back cover of the print edition of the SMI newsletter, as well as on the Performance tab of the SMI Member homepage at www.soundmindinvesting.com).

Through mid-year, JtB gained +14.25%, slightly less than the U.S. market (Wilshire 5000, +15.45%).

Zooming out six more months to look at returns over the 12-months ended June 30, 2021, is enlightening. Over that longer period, JtB led the broad market by a +48.4% to +44.2% margin. While foreign stocks have been a drag on JtB’s performance over both time intervals, the main thing this shows us is the relationship between large and small stocks. Over the past year, JtB’s overweighting of small-company stocks (small-caps are evenly weighted with large stocks in JtB, whereas the broader market is heavily tilted toward large company stocks) has been beneficial, thus its stronger 12-month return. But looking just at the more recent six months, larger stocks have performed better relative to smaller stocks.

We see this dynamic even more clearly in Stock Upgrading’s returns. Its 12-month performance of +45.9% beat the market (+44.2%) despite Upgrading spending July 2020 still largely in cash. This was largely due to Upgrading’s significant allocations to small company stocks. But its gain of +11.4% over the first six months of 2021, while wonderful in absolute terms, trails the large-stock dominated indexes, showing how small stocks have surrendered their market leadership position in 2021.

The other huge story for Stock Upgrading in 2021 has been the incredible performance of commodities, which gained +31% in the first half of 2021! Unlike small-company stocks and value stocks, the broad commodities index didn’t decline much as mid-year approached. But we did see more dispersion among various commodities as oil/gas continued to rise while the agriculturals and metals pulled back. Adding commodities to Stock Upgrading at the end of 2020 has been one of SMI’s best moves this year.

Bond Upgrading

When interest rates start to rise from super-low levels, it creates a difficult dynamic for bonds. Bonds don’t produce much income when yields are so low, and as yields rise, bond prices fall. Not surprisingly, then, the broad U.S. bond index has posted negative returns over both the past 6-months (-1.6%) and 12-months (-0.3%).

Bond Upgrading did a little better than that for most of the past year, but then lost part of its performance edge over the broader market after the so-called “Fed flinch” in June regarding future inflation. Backing away from its prior “let inflation run hot” rhetoric, Fed leaders backed down (“flinched”) in the face of higher inflation numbers and admitted they might tighten policy sooner than expected. Short-term rates rose sharply while long-term rates fell further on the sudden pivot.

Over the past 12-months, Bond Upgrading managed a small positive return of +0.5%, which was better than the broad bond market’s loss. But June tipped Bond Upgrading’s 6-month performance down to roughly equal the broad market at -1.65%.

Dynamic Asset Allocation (DAA)

While JtB and Stock Upgrading lagged the broader stock market during the second quarter of 2021 due to leadership rotations from smaller stocks to larger ones and from value stocks to growth stocks, DAA largely side-stepped those issues, gaining +8.4% during April-June. That was the best performance of SMI’s strategies and equaled the broad stock market’s gain. DAA’s real estate allocation has been outstanding, gaining +17.4% since being added at the end of February.

As we reported last quarter, the only significant misstep for DAA in 2021 was owning gold while it fell -9.3% in January and February. Other than that, the strategy’s 2021 gain of +10.4% through mid-year was great, considering that DAA isn’t allowed to allocate more than two-thirds of its portfolio directly to stocks (and thus will almost always lag the stock market when stocks are going straight up).

Sector Rotation (SR)

Long-time SMI members know that SR has been our strongest performing strategy for many years, but they also are aware of its struggles over the past few years. Both sides of that coin have been on full display over the past year, as SR rode 2020’s market rebound to tremendous gains through February 2021, then frustratingly gave much of those gains back in the months that followed. SR’s 12-month gain of +26% through mid-year isn’t terrible (though it’s less than the market’s +44.2%), but its 6-month return of -21.9% shows what a struggle 2021 has been.

These swings in recent performance have prompted the most extensive internal review and testing of SR since the strategy was introduced 18 years ago. We hope to have information to share with you regarding our conclusions next month.

50/40/10

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. (Blending multiple strategies adds complexity. Some SMI members may prefer the automated approach offered by SMIPrivateClient.)

When the stock market goes straight up, as it has for the past 16 months, it’s easy to lose sight of why a blended portfolio — or frankly diversification of any type — is helpful or necessary. But long-term investors know that one of the biggest threats to your success is getting blown up when risk suddenly reappears in the market and turns against you. Surviving bear markets and downturns relies heavily on being able to weather those storms, and few portfolios (or investors) can handle those negative periods without significant portfolio diversification.

So while the recent returns of a 50-40-10 don’t look impressive compared to the broad stock market, it’s important to take them in context. This portfolio’s gain of +30.6% over the 12-months ended June 30 was lower than the broad market’s gain of +44.2%. But with the market’s risk environment turning less positive, the real question is what type of portfolio is likely to best handle the path ahead?

Nobody expected the 2020 bear market to end as quickly as it did and few could have imagined the epic rally stocks have experienced since then. Yet despite both of those factors, if we measure from the beginning of the bear market slide in February 2020 through mid-year 2021, the S&P 500 only leads a 50-40-10 portfolio +29.9% to +21.8%.

So don’t be discouraged if your blended portfolio has felt overly cautious as stocks have rapidly advanced over the past year. That’s how risk-focused investors always feel during huge bull market runs! But as surely as day follows night, bear markets follow bull markets, and so forth. A sustainable, repeatable process such as this blended portfolio provides can keep you in the game through all types of market environments, and that’s the first requirement for long-term success. Whether you use the specific 50/40/10 strategy mix or a different combination, most SMI readers can benefit from blending these strategies in some fashion.