Second Quarter Review: A Sigh of Relief

The second quarter was a breath of fresh air for investors in serious need of relief. After six straight quarters of losses for the Wilshire 5000 index, the stock market finally got its act together and rallied impressively.

The top line of the table here details the strength shown by the broad market, as well as the fact that both of SMI's core strategies surpassed those gains by a small margin.

Small-company stocks (as measured by the Russell 2000 index, up 21%) slightly outperformed large-company stocks (as measured by the S&P 500 index, up 16%). And while value funds slightly outperformed their similarly-sized growth fund counterparts during the second quarter, growth still led value by a comfortable margin at the mid-way point of the year.

Despite the strong gains, the psychology of the market remains unsettled. Stocks remain 38% below their October 2007 highs, and skeptics have pointed out that the biggest gains in the recent rally came from "lower quality" stocks, with the market running out of steam before those gains could extend to the rest of the market.

Additionally, a significant portion of the "good news" during the rally consisted of poor economic news that was merely less bad than expected. That's different from actual good news, which is what will likely be required if this bull market is to run another leg.

Needless to say, July's second quarter company earnings reports will be closely examined for clues about the market's direction, as will all of the economic data coming out during the third quarter, which commonly is a difficult period for stocks anyway.

With so much negative sentiment presently weighing on investors, including the implications of huge health-care and energy packages currently rumbling through Congress, many are having trouble seeing how stocks will be able to put together any sort of significant rally over the next few years. As a result, plenty of investors remain hesitant to invest in stocks and continue to look for alternatives.

A quick review of recent history can be instructive here. If someone had told you 10 years ago that the stock market would go through not one, but two wicked bear markets, complete with all the gory details we've witnessed from Enron to AIG, the appropriate response would have been to run away from the stock market screaming, correct?

Well, yes. And no. It's true the stock market as a whole has not been a good place to be over the past decade. As the bottom section of the table below shows, the market has lost a total of -11.9% over the past 10 years.

But how did followers of SMI's Upgrading strategy fare? Their portfolios gained a respectable 78.6% over those 10 years. While that 6.0% annualized return is below the market's long-term average, it looks pretty good compared to most other alternatives.

For example, keeping your money in cash over the past decade would have cut your return nearly in half; Vanguard Prime MMF — consistently one of the best MMF performers — returned just 3.3% annualized.

Perhaps we'd have been better off moving our money to bonds to wait out these bear markets in stocks? Nope — a bond portfolio split 50-50 between SMI's recommended Vanguard Short- and Intermediate-Term Bond Index Funds would have returned an annualized 5.6% over the past decade, still (minimally) less than Upgrading's result.

The point of this discussion is simply to reinforce the basic asset allocation assertion frequently repeated by SMI: if you have at least a 5-10 year time frame, stocks are usually the place to be, particularly if you're utilizing a proven strategy like Upgrading. Again, the proof is in the table.

Over the past five years, despite the most severe bear market since the Great Depression, Upgraders still have made money. Going back further to include the whole past decade — one of the relatively few 10-year periods on record where the stock market actually lost money over that long a stretch — Upgrading looks even better, turning a $100,000 portfolio into one worth more than $178,000.

Imagine, the SMI reader who simply kept adding to his or her Upgrading portfolio month after month could have completely ignored all the periods of intense hand-wringing regarding whether it was a "good" or "bad" time to invest. That reader would have finished the decade with quite reasonable returns — minus all the anxiety. This is why long time-horizons matter so much for stock investors and why we continually emphasize them.

All of this is both relevant and encouraging as we sit here today evaluating the future prospects for the market. It's important to remember that we've already just come through a historically terrible decade for the stock market. Given the fact that stocks tend to perform better than average following periods of poor returns, the odds seem to hint that a repeat of the past decade's stock market weakness is unlikely.

But even if the broad market is destined to be held back by the multitude of big-picture issues weighing on the minds of many SMI readers (and writers!), it's important to recognize that Upgrading is not necessarily destined to share the same fate as the broad stock market.

Obviously the race is more difficult when we run into the headwind of a poorly performing overall market. But Upgrading's past performance should help SMI readers stay the course even as they nervously watch current events.

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.

• Reflections on a History-Making Year for the Economy and Markets 
• 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
• 2009 SMI Allocation Guide: Weighing The Risks 
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