Fourth Quarter Review:
Strong Finish To A Weak Decade
By Mark Biller
© Sound Mind Investing | February 2010
After the financial crisis of 2008 scuttled our bid to beat the market for a 10th consecutive year, it was good to see SMI's model portfolios get back on the winning track in 2009. Stocks came roaring back to life following the March low, staging a nine-month rally that defied the skeptics with each step higher.
The bond market also had a strong year, though there were very distinct winners and losers within the bond realm (more on that in a moment).
For the year, the stock market, as measured by the Wilshire 5000, was up 29.4%. Upgrading finished comfortably ahead of the market with a gain of 33.6%. And for the first time in a decade, our indexing-focused Just-the-Basics strategy surpassed Upgrading by a hair, gaining 33.9%.
Just-the-Basics was aided by the fact that index funds typically do their best work in strong market advances, as they are always fully-invested. It also helped that JtB's international component, which is not indexed, excelled — Vanguard International Growth was up 41.6% for the year, topping even the strong result of Upgrading's international funds.
The wild year in the bond market merits a closer inspection. In 2008, amidst the chaos in the financial system, our indexed bond funds performed much better than most other bond funds. That was largely because investors were selling everything they could and buying U.S. Treasury bonds, which are always popular during such "flights to safety." As the economy stabilized in 2009, this condition unwound, with Treasuries suffering significant losses as money poured out.
In contrast, other types of bonds did very well as it became clear most companies weren't about to go bankrupt. This gradual realization caused investors to bid corporate bonds (and stocks) higher from the rock-bottom levels they had reached early in the year.
To illustrate how powerful this reversal was in the Treasury market, as well as how strong the market was for corporate bonds, consider the long-term bond market, the most volatile category of bonds that SMI tracks. As you can see in the table below, the average long-term bond fund gained a rather unremarkable 5.7% last year.
What that number obscures however, is that the long-term government-bond funds we track in that category lost anywhere from 11%-22%, while the corporate-only bond funds in that category gained between 22%-32%. That's a 54% gap between the worst of the government bond funds and the best of the corporate bond funds, a stunning difference for any risk category, but even more so for a bond category. While owning more government bonds than most actively-managed bond funds helped our indexed bond funds in 2008, it hurt them in 2009.
We can glean another point about bonds from the 10-year section of the performance table here. Not only have bond holdings helped smooth the ride for investors in recent years, they've done so without costing anything in performance terms. For the first time in a long time, the 80/20 and 60/40 Upgrading portfolios have 10-year performance that rivals and even slightly exceeds that of a 100%-stock Upgrading portfolio.
Of course, that relative parity in returns stems from two of the worst bear markets in a century striking within the same decade. That crippled stock returns, while the Federal Reserve simultaneously helped the bond market by doing everything in its power to push interest rates down and keep them down. In other words, don't count on this being a typical outcome.
Generally, investors shouldn't add bonds to an Upgrading portfolio in an attempt to improve returns. Rather, the motive for adding bonds should be to lower volatility and risk, which — as the year-by-year results indicate — bond holdings have been successful at doing.
In closing, it's worth repeating a theme we've mentioned before regarding this first decade of the 2000s. Many have written it off as "the lost decade" or something similar, based on the fact that the major stock market indexes ended the decade at roughly the same levels as they started. While that is unusual, it is also a completely inaccurate picture of what SMI readers experienced.
Quite unlike the picture of investors treading water for a decade that is becoming the popular narrative, the "Past 10 Years (Total Gain)" line of the historical performance table indicates that most SMI investor portfolios advanced 80%-90% over the last decade (and that's purely investment growth; it doesn't count any additional investments that may have been made).
We admit to preferring the market's long-term average gains of 9%-10%, but the 6.0%-6.5% annualized gains Upgraders earned over the past decade are a lot better than zero. So don't confuse the general narrative with your personal results.
Perhaps most encouragingly, while some people don't like to hear it, the market does tend to gravitate toward its long-term trend line over time. At the end of the 1990s, some warned that the fantastic gains of the prior decade signaled that more tepid results were likely as a result. Many shrugged off these "naysayers" by claiming we had transitioned into a "new economy" that was immune to such historical patterns. A decade later, with little growth in the market indexes to show for it, it looks as though the "regression to the mean" (i.e., return to the average) crew had it right.
Today we seem to be experiencing the opposite attitude. Many investors are fixated on the daunting challenges facing the economy and markets; few see much reason for optimism. These challenges are indeed significant, but the market loves to surprise us with the opposite of what we're expecting!
As Austin's editorial this month reminds us, none of us knows what the future holds. As a result, we desperately need to develop and follow a market "discipline" if we're to succeed as long-term investors. Many abandoned their market discipline at some point over the past two years. Now, with the recovery nearly a year old and stocks up 60%, those investors are afraid to jump back in for fear of doing so just in time for a market correction. They are waiting for a re-entry point that offers a little more certainty about the future.
The problem is we never have enough information about the future to satisfy our emotional desire for safety. We will never have the clarity we would like. A little-understood truth is that the only time stocks feel safe is when everyone seems to agree the market is going higher. At that point, they are actually the most dangerous because most investors are already "all in." With few new buyers remaining, the market is nearing a peak!
At SMI, we caution against making decisions based on your intuition, and lean instead on our time-tested disciplines. That certainly doesn't ensure you won't encounter some bad timing along your investing journey. Most of us do. But it does get you in the habit of making investing decisions for the right reasons, and over time that leads to success more often than not.
If these last paragraphs describe you, it's time to re-engage your market discipline. Because it's a "great time" to buy? No — we don't know if it is or isn't. Rather, now is the right time to buy if your long-term plan says you should be invested in stocks in order to meet long-term goals. 
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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. |
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