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Third Quarter Review: Financial Earthquake!© Sound Mind Investing | November 2008
It's difficult to know where to begin to describe the events of the third quarter. Much of the financial landscape as we knew it a year ago has changed, and a good deal of that change happened during the July-September period. Three of Wall Street's "Big 5" investment banks are now gone or merged. A huge insurance company, AIG, was basically taken over by the government and is now being auctioned off. Mortgage giants Freddie Mac and Fannie Mae have gone from being implicitly backed by the government to explicitly government-owned. We've seen a retail money market fund "break the buck" for the first time, which resulted in the government stepping in to guarantee MMF deposits. A $700 billion Federal bailout package finally passed, which the government has since used to become a part-owner in the nation's nine largest banks. And the changes to the financial system probably aren't finished yet. Not surprisingly, the stock market was hit very hard in the third quarter (and continued to fall in October). SMI's Upgrading model portfolios, which had held up very well through mid-year on the strength of their energy holdings, gave back that advantage and then some, ending the quarter trailing the market by a few percent. But all of this is information you already know if you've been watching the markets and your portfolio. Rather than expound on that further, it is probably more productive to have a frank discussion of the market's current condition and how you should respond to it. We don't know when this bear market is going to hit bottom, and neither does anyone else. While that specific information is simply unavailable, there are similarities and patterns we can look to from past bear markets that offer some reassurance, and perhaps even some guidance. In the SMI Weblog, Austin recently listed a number of New York Times' headlines that read as if they were lifted out of last week's paper. In fact, however, they were from July 2002, when the last bear market was 90% complete. The point of that post was to illustrate that bear markets typically follow the same pattern. The stock market sells off sharply. Eventually, while the news is still at its worst, the market finds bottom and the bear market is over, though hardly anyone recognizes it at the time. This bottoming process happens when most investors have already given up hope and sold, leaving no more sellers. While we have to go all the way back to the 1930s to find a similar level of government intervention during a financial crisis, the actual stock market losses have, to this point, not been very different from past severe bear markets. Both the 1973-74 and 2000-2002 bear markets caused losses of roughly 48%. On October 10, the total market decline approached that depth during the day before rallying back higher. In other words, while the recent market losses have been swift and unsettling, they haven't been out of character for a significant bear market. So what do we recommend you do at this point? Stay the course. If that involves Upgrading, we strongly suggest that you continue its discipline of making unemotional decisions driven by the fund performance rankings. Most individual investors under-perform the market by a significant margin over time, primarily due to making emotional decisions when fear is high. A great example is the fact that September saw the largest wave of net redemptions ever in the mutual fund industry. It is impossible to "buy low and sell high" over time if you sell when prices have already fallen significantly in a bear market! Instead of following your emotions, stick with your long-term plan and continue to follow the Upgrading discipline. Stocks are offering value in a way they haven't in a decade or more. And they should, given that we've suffered through two tough bear markets to get back to these valuations. It is critically important that you be invested when the market does eventually turn around. Those early gains can help significantly in repairing the damage done to your portfolio by the bear market. Bull markets inevitably follow bear markets. This, too, shall pass. Upgraders have found little shelter in this year's market storm. But that doesn't mean the strategy has lost its way. As the table below shows, while the market as a whole is lower today than it was near its peak at the end of March 2000, Upgraders still show decent profits (this is still true even when October's further slide of ~20% is factored in). We've seen before in years like 1999 and 2003 how Upgrading can soar when the market takes off. After nearly a decade of working off the valuation excesses of the 1990s bull market, chances are good that brighter stock market days lie ahead. You don't want to have your money on the sidelines when those brighter days arrive.
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