Second Quarter Review:
Prelude to A Bear Market

After a miserable first quarter, the stock market bounced back strongly in April and May. The rally was shortlived though, as stocks came crashing back to their lows for the year in June, once again putting the major indexes within striking distance of a technical bear market — a decline of 20% from their October highs (a level that eventually would be breached in early July).

The past eight months have presented the stock market with a long list of potential problems. The distress in the housing markets has exposed (and deepened) a crisis among U.S. financial institutions. That crisis has put further pressure on an already declining dollar. The falling dollar has hurt consumers, who are already stretched thin as a result of soaring energy and food prices.

It's a combination of challenges without easy answers, and not surprisingly the stock market has been punished more severely than at any time since the bear market of 2000-2002.

That said, some areas of the market have been hit much more severely than others. Financial stocks, for example, have been crushed over the past year. On the other hand, energy stocks soared in the last quarter, as they have for most of the past few years. Growth stocks have held up somewhat better than value stocks.

Thankfully there have been pockets within the market where the damage has been less severe than the broad market averages have experienced.

Just-the-Basics investors have felt the sting of 2008's downturn quite severely, as index funds don't have anywhere to hide when markets decline. The fact that JtB allocates evenly between large stocks and small stocks has helped it a bit relative to the broad market averages (which are weighted closer to 75% to large stocks). Still, it's been a tough year for indexers.

In contrast, the picture has been significantly brighter for Fund Upgraders, who managed a net gain during the quarter and are down considerably less than the broad market so far in 2008.

The primary reason for Upgrading's relatively strong performance is its funds have above average amounts of energy and materials-related stocks.

This isn't something we set out to do on purpose. It's simply the nature of Upgrading that when a certain area sees prolonged strength, as energy and commodities have in recent years, the funds that work their way to the top of the rankings are normally those that have taken advantage of that trend by owning higher concentrations of those stocks than their peers.

It's not as though we're recommending any pure energy funds. It's just that several of the currently recommended funds are among the more energy-heavy funds in their respective risk categories, which is one reason they were at or near the top of the rankings when they were selected as recommendations.

The quarter was also a painful reminder that bonds aren't a perfect safe haven from market losses. The aforementioned list of economic problems also took a toll on bond funds last quarter. As How Should Your Investments Change
As You Move Through the Seasons of Life? makes clear, bonds have had a steadying influence on portfolio returns over extended time periods. But given the economy's specific set of problems today, selling stocks to buy bonds may not be as effective at calming your portfolio as usual.

Realistically, with the stock market already having passed into official bear market territory, it's probably a bit late to be reducing risk by lowering your portfolio allocation, unless the change is going to be a permanent one, rather than temporary.

The experience of Upgraders over every time period shown in the full performance table reinforces one message: Upgrading has been able to weather the ups and downs of the stock market and provide significant added value to investors versus a portfolio of indexed investments.

It's been true so far in the 2008 downturn, and it's been true consistently throughout the past decade. While the market averages sit mired at roughly the same point they were at nine long years ago, Upgrading has been able to provide significant gains for those with the discipline to apply it consistently.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• Lost Decade? Not for SMI Investors
• How Should Your Investments Change
  As You Move Through the Seasons of Life? 
• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• Adjusting Your Allocations For 2008's Market Probabilities 
• How to Make Rational Investing Decisions 
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