Tough Summer for Upgrading Puts
Winning Streak In Jeopardy

It's been a rough summer for Upgrading. As we reported in August, the year began in promising fashion, with Upgrading racing out to a significant lead over the market. But between May and July that performance lead evaporated. As the table below shows, after nine months Upgrading trails the market by 1.0%. That's certainly not an insurmountable hurdle, so our streak of beating the market seven straight years could still continue, but Upgrading will have to turn it around in the 4th quarter for that to happen.

Digging into the details of Upgrading's summer swoon is instructive. The small-company and foreign segments of our Upgrading portfolios really hurt us relative to the broad market indexes. Those funds were the primary reason we soared far above the market early in the year, and are the primary reason we've lagged it since.

To understand this, recognize that the indexes most people watch—the S&P 500 and Dow Jones Industrial Average (DJIA)—measure the performance of only the largest stocks. The index SMI uses to measure "the market" is the Wilshire 5000. That index does a better job of measuring the whole U.S. market, but is still tilted towards the large companies, being composed of roughly 75% large company stocks and just 25% of small companies.

This means the S&P 500 and DJIA are poor benchmarks for Upgrading, which this year has been allocated 42% large-companies, 38% small-companies, and 20% foreign companies. And while our Wilshire 5000 measure is better, it isn't ideal either. This isn't a new thing, but naturally it only bothers us when it makes Upgrading look bad!

Kidding aside, the effect of this is Upgrading has an advantage when compared to "the market" during periods when small-company and foreign stocks perform better than large-company stocks. That's been the case in recent years, and is why we've cautioned that Upgrading won't always beat the market by such a wide margin. Basically, we've had the wind at our back in recent years, but we've known eventually that would change and large-company stocks would once again come back into favor. (Note that we're not totally at the mercy of these market currents—we're able to adjust somewhat to longer-term patterns through our annual allocation changes in January.)

Portfolio allocation percentages aren't the whole story though. At the same time this "big picture" scenario was unfolding, other factors were causing problems as well. As we hope most of you realize, Upgrading makes no effort to predict what the market will do next. It is strictly a trend-following system, responding to what has already happened, trying to catch each significant market trend as it unfolds. We know in advance that we'll never get all of the profit from a new market trend because we won't recognize it initially. Upgrading is intentionally designed to not respond to every apparent reversal the market makes, so it takes time for Upgrading to believe a new trend is for real and start switching into those funds best positioned to take advantage of it.

With that in mind, let's quickly review 2006 so far. The first four months were great—mostly up, with Upgrading owning funds which were taking maximum advantage of the rally. When the market turned in mid-May, it went down quickly. Too quickly, really, for Upgrading to respond before most of the damage was done. That's because the largest part of the market decline happened within the first five weeks. Upgrading went through that period with the same high-flying funds that had been soaring before the market turned, and they quickly gave back much of their prior gains. While that's disappointing, we know it can happen at turning points in Upgrading, and it's nothing that we haven't experienced before.

After the initial decline, stocks traded up and down in a narrow range for the next two months, essentially moving sideways. During this period, Upgrading began replacing the old aggressive funds with mostly conservative funds that had held up well in the downturn and subsequent choppiness. But, as we noted earlier, the market decline was actually relatively short-lived and stocks eventually broke out of their summer trading range to the upside. Unfortunately, that meant we got whipsawed—just as we were moving into more conservative funds, the popular large-company market indexes started moving higher again.

Adding insult to injury, the reason many of those conservative funds had held up so well in the downturn was they had larger than normal positions in energy, commodity, and industrial stocks. So in some cases, the conservative funds we had turned to for shelter in the downturn started leaking money shortly thereafter as energy prices plummeted. That wasn't the case with all our funds, but enough fit that description to cause a drag on Upgrading's recent returns. That is why we're taking such unusually swift action replacing the Fairholme and Salomon Bros. Opportunity funds this month, as each have roughly 30% of their assets in these types of stocks (see November's New Fund Recommendations ).

To summarize, what has happened in Upgrading over the summer is what often happens at market turning points or when market leadership changes (e.g., from small to large company stocks or from value to growth stocks). What's surprising isn't that it happens, but that it doesn't happen more often. The market follows a "two steps forwards, one step back" pattern more often than not, and occasional periods of lagging the market indices are part of the process.

In recent years Upgrading has trailed the Wilshire 5000 during roughly one out of every three six-month periods. Yet despite that, Upgrading has managed to beat the market by a wide margin over the entire period. Trailing the market over the short-term isn't a problem unless you (1) need to take your money out of the market, or (2) get panicky and do something foolish. That first point is why we strongly advise not to invest money in stocks that you can't leave alone for at least five years. The second point is why most investors dramatically underperform the market over time—they succumb to the emotional desire to "do something" at exactly the wrong time, those moments of maximum optimism and pessimism, and the market punishes them for it.

If you've settled on Upgrading as an appropriate strategy and your stock/bond allocation is roughly accurate for your investing temperament and season of life, this should be encouraging news. It means that the activity of the past several months, while perhaps frustrating, isn't cause for particular concern. It's an unpleasant aspect of stock market investing, and it's true that this period has been more trying than most—the last six months have been Upgrading's worst period of performance relative to the Wilshire 5000 in the past several years. But it's not unusual for Upgrading to go through six-month doldrums from time to time before resuming the next leg up. Looking at the longer-term returns in the table below, it's clear that this latest speed bump hasn't had much of an impact on our long-term results. There's no reason to believe Upgrading won't pick up the scent once again as the next big market trend unfolds, leaving us with increasingly faint memories of this summer's market weakness.

• Overview of SMI's Upgrading Strategy
• Performance History
• How to Take Market Turbulence in Stride
• How to Make Rational Investing Decisions 

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