The engine that drives SMI’s main strategies (Fund Upgrading, Dynamic Asset Allocation, and Sector Rotation) is momentum, a deceptively simple metric premised on the well-researched idea that an investment’s recent past performance tends to persist. Mutual funds that have been growing in value in the recent past will tend to continue growing, at least into the near future.
Because momentum is a "trend-following" investment approach, it won’t catch a trend right at the beginning, but it’ll catch it eventually, which is why we have long described momentum as a buy high (after the fund has already generated some gains), sell higher (after its momentum has begun to wane) process.
So, it may have come as a bit of a surprise to see our June newsletter article, How SMI’s Process Helps Investors Buy Low and Sell High. Which is it, you may have wondered — buy high and sell higher, or buy low and sell high? Today, it’s some of both. Let me explain.
A little context
For about the first two-thirds of SMI’s 32-year history, Fund Upgrading was SMI’s primary active strategy and the use of momentum within that strategy was primarily focused on capitalizing during bull markets. The strategy kept investors in five stock categories. As the broad market moved higher, momentum helped us identify funds within each category that were doing especially well. By paying attention to the momentum numbers, our intention would be to then ride a particular fund even higher. As its momentum slowed, indicated by its fall below the top quartile in its stock fund category, we would replace it with the then-current highest-momentum fund in the category.
Given that bull markets can last for years, it wouldn’t be unusual for Upgrading to hop from one strong performer to another — thus the "buy high and sell higher" idea.
Upgrading’s success can be seen clearly from 2003 to 2007. In each of those five years, the overall market did well, but Fund Upgrading did even better.
2003 | 2004 | 2005 | 2006 | 2007 | |
Market* | 31.6% | 12.5% | 6.4% | 15.8% | 5.6% |
Upgrading** | 46.7% | 17.3% | 12.0% | 17.4% | 14.3% |
*As measured by the Wilshire 5000. **For a 100% stocks portfolio. | |||||
In declining markets, Upgrading’s track record was more mixed — it performed better than the market during the 2000-2002 bear but fell basically right along with the market in 2008-09. Of course, many investors utilize bonds within their Upgrading portfolio, which has helped offer some downside protection during bear markets by bonds’ tendency to grow in value when stocks are in decline.
During longer bear markets, the momentum process can help Upgrading steer us into more conservative funds, but many corrections are quick enough that this process doesn’t really have time to play out — thus Upgrading’s reputation during the early years as more of a bull market strategy.
A new day
In 2012, largely because of the Fed’s intervention in the markets, we became concerned that bonds might not continue to provide the downside protection they had historically. That led to our introduction of Dynamic Asset Allocation in 2013. Instead of using momentum to switch from one stock fund to another, DAA enabled us to apply momentum signals to six entire asset classes — for the first time allowing us to objectively move completely out of stocks (or bonds) as conditions warranted.
Had DAA been available during the Great Financial Crisis, when the stock market fell 37.2% in 2008, our backtesting shows that DAA would have gained 1.3%.
Further refinements to our use of momentum led to the introduction of Fund Upgrading 2.0 in January of 2018, when we incorporated the ability to use momentum signals to slowly move some of the stock allocations to cash. (In 2021, we refined Fund Upgrading further to allow us to emphasize value or growth funds, again using momentum to guide us to the most profitable choice.) This has bolstered Upgrading’s ability to be an "all-weather strategy" as opposed to its early reputation as more of a bull market star.
These changes, particularly the ability to move a portion of an Upgrading portfolio to cash, as well as our encouragement for most investors to use a blend of SMI strategies, is what led to the "buy low, sell high" article in the June issue of the Sound Mind Investing newsletter. Investors do not have to ride the market down to the same degree as before. Momentum will objectively move DAA investors out of stocks while moving Fund Upgrading investors partially to cash. Then, as the market trends upward, they will have some "dry powder" that can be used to buy low when the objective momentum numbers tell us it’s time.
As is true with every investment strategy, DAA and Fund Upgrading are not silver bullets. There will be times when trends struggle to hold their direction and we will be caught in the occasional whipsaw. But for long-term investors intentional about matching their use of SMI strategies to their time frame, investment temperament, and goals, those strategies are as well-positioned as ever to objectively guide you through the full market cycle and toward the accomplishment of your investment goals.
