Third Quarter Review: Another Summer Swoon

For the second year in a row, a sharp summer swoon sent many nervous investors running to the bomb shelters. While this drop technically didn't reach full-blown correction status (the closing prices of the major indexes never quite reached the 10% decline mark), the market's dive from July 19 to August 16 surely met the psychological qualifications of a genuine correction. Fear was in the air as the crunch in the credit markets appeared ready to drag down the investment markets, and perhaps even the entire economy.

Sound dire? It was. Sort of. While scary (let's be honest, losing 10% in a month is always at least a little frightening), there was always another way to view the slide. As our September cover article on bear markets and corrections pointed out, market corrections aren't that unusual, occurring once every 12-15 months, on average. It also isn't unusual for those corrections to be sharp and fast. So it wasn't totally surprising that the market, which had sprinted roughly 13% higher over just the prior four months, was vulnerable to some selling at that point. That's how markets often work, and exactly what happened in this case. After bottoming in mid-August, the market recovered most of its lost ground by the end of the quarter, aided by a September 18 half-point Fed rate cut that was more generous than expected.

As the table below shows, the market actually managed a 1.4% gain for the quarter overall, surprising given the nearly 10% haircut it got in July-August. Actually, with the exception of two short but sharp drops in the first and third quarters, it's been a pretty good year to be a stock investor.

While the stock market has done reasonably well this year, readers following the SMI model portfolios have done even better. Our Just-the-Basics indexing strategy carried a 10.4% gain into the 4th quarter, and Upgrading extended its lead over the market to more than 5% for the year (14.2% YTD vs. 9.1% for the market).

As we've alluded to several times before, market leadership has really shifted 180 degrees from a few years ago. Most of the 2000s saw small company stocks trounce large ones while "value" investors ran circles around "growth" managers. Not any longer. This year, big has been beautiful and growth has definitely regained the upper hand. Given how long the scales were tilted the other way, we wouldn't be surprised to see these trends continue for a while. This trend is somewhat obscured in the first table by the fact that SMI includes mid-cap funds in our small-company categories. Mid-caps have performed much better than true small-caps this year, making the difference between the small- and large-company categories appear less pronounced.

This wild quarter reminds us of a simple investment truth: slow and steady wins the race. Getting flustered by the constantly changing market environment and trying to "fix things" through reactive buying or selling is not the path to investing success. What is? Settling on an investing strategy like Upgrading with a demonstrated track record of excellence is the first step. (Compare Upgrading's performance vs. the market over the past 5- and 10-year periods in the table above.) The difficult, but pivotal, second step is continuing to follow through with that strategy regardless of what the market is doing. Investors who cut and ran for the bomb shelter with their portfolios down 10% in August missed the sharp recovery to new record highs over the following six weeks.

We spend a lot of time reiterating this basic theme in these reports. That's because we know how difficult it can be to stick with your plan when the market gets rough and your emotions get involved. The reality is head knowledge will only carry you so far as an investor. Mastering your emotions is what separates successful investors from the rest. Many investors don't know how to get the type of returns shown in the table above. As an SMI reader, you do. But simply knowing how doesn't mean it will be easy; you've still got to master your emotions—each and every time the market gets rough. Hopefully being regularly reminded of what Upgrading has accomplished in the past will help you tune out the market's short-term noise the next time it threatens to pull you away from your predetermined plan.

• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• How to Make Rational Investing Decisions 
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