Second Quarter Review:
Strong Stocks, Weak Bonds
The stock market turned in very strong performance across the board in the second quarter ending June 30. The bond market was a totally different story. Fears regarding the scope of the subprime mortgage lending problems and the potential of those problems to spread throughout the financial system put pressure on bond prices all quarter. Adding to this pressure, economic news improved steadily as the quarter went along. In a classic case of "good news is bad news," bond investors recognized this improving economic outlook was likely to scuttle their hopes of the Federal Reserve cutting interest rates soon. With those rate cuts looking less and less likely, bond selling picked up, pushing prices lower and yields higher.
The result of all this selling pressure in the bond market was the benchmark 10-year Treasury yield, which had put in a low at 4.50% in March, soared all the way up to 5.31% in June, a stunning rise for such a short period. That impact, as usual, was felt more acutely in longer-term bonds than short-term. All in all, the quarter provided a jarring reminder that while many investors think of bonds as "safe" investments, they can be quite volatile in the short run. The table below details the damage done to intermediate- and long-term bonds last quarter.
On the bright side, the table reflects how stock funds were up strongly across the board, though they did waver a bit in June when the bond market was swooning. The quarter provided further evidence that leadership is shifting, specifically in the following areas:
• Growth has been beating value. For the second quarter in a row, growth stocks beat their value counterparts. Notice in the table how small/growth funds beat small/value, and large/growth beat large/value. For most of the past seven years, the opposite has been the case.
• Large company stocks are gaining on small company stocks. This trend isn't as obvious when looking at the table. It's clear that large/value beat small/value, but it doesn't appear that the relationship held among growth funds. Obscuring this leadership change in our table is the role of mid-cap funds, that is, those funds investing in medium-sized companies. SMI lumps mid-cap funds into the small-company categories. Last quarter, large-cap stocks tied with mid-cap stocks for the performance lead, with both groups running ahead of small-caps. Without this quirk of SMI's risk category system, the shift from small-company leadership to large-companies would be more pronounced.
Leadership changes like these have significant implications for those trying to predict in advance what areas of the market will be in favor. In fact, many experts have been predicting both of these leadership reversals for the past few years. Obviously, being wrong for three years before finally having your predictions come true is a difficult way to succeed in the stock market. Upgraders take a different approach. Rather than trying to predict where the trend will lead in the future, we respond to what is already happening in the market. As market leadership rotates from one size or style to another, Upgrading leads us to those funds already taking advantage of these new trends.
One reason our Upgrading fund selections can respond in this way is because we categorize the domestic fund market into just four broad categories (large/value, large/growth, small/value, and small/growth). By foregoing the further distinctions of having separate "medium" size and "blend" style categories, we purposely include a wider variety of funds in each of our four domestic risk categories. As we noted earlier, this breadth has helped lately by allowing us to invest in some of the better performing mid-cap funds within our small-company categories.
The Upgrading system consistently uses this flexibility, along with numerous other strengths, to deliver above-average returns. The above table shows how our Upgrading recommendations outperform their peers incrementally—category by category, quarter by quarter. Our fund selections don't beat the average funds in every category, every quarter. But they do more often than not, and those small advantages compound and build into the type of stunning long-term performance shown in the table below.
As we noted last quarter, the benefits of compounding accrue to the long-term investor. Despite the brutal bear market of 2000-2002, investors who have stayed invested and managed to earn the same rate of return as the overall stock market have seen their money double over the past ten years (a gain of $109,921 on an investment of $100,000).
Upgraders have done significantly better than that, with their money more than tripling over the past decade (a gain of $241,817 on an investment of $100,000). Recognizing that Upgrading's gains have been more than double those of the overall market makes clear that Upgraders are earning an outstanding rate of return on the small amount of additional time and effort the strategy requires. 
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