The Stock Market’s Way Up, What Do I Do Now?

Since the March lows in the stock market, the major averages have staged a remarkable rally. Per CNBC through the end of July:

US markets hit the highest levels of 2009 enforcing a summer rally, and turned in the best July since 1989 for the Dow and 1997 for the S&P; and NASDAQ. Additionally, July was the best monthly performance for the Dow since October, 2002, and April, 2009 for the S&P; and NASDAQ.

The S&P; and NASDAQ turned in positive monthly gains for the 5th consecutive month.

Since March 9th lows, the S&P; is up 45.96%, the Dow is up 40.09%, and the NASDAQ is up 55.96%.

Additionally major foreign stock indices including developed and emerging markets have experienced solid gains, as has oil and the price of many commodities.

What does this all mean to me as an investor?

First, even though the major averages are up for the year, your portfolio is still likely down over the last year and possibly lower than it was 3-5 years ago.

If you haven’t rebalanced your portfolio in awhile, you may find that your portfolio is out of balance with regard to your desired allocation between stocks, bonds, and cash.

If saving for retirement or college are major goals for your investments, you should review where you are with regard to those goals.

Overall, it is tempting to want to “…get back my losses…” My suggestion is to forget about where you were and focus on where you are trying to get to. In the end this may be a question of semantics, but for years I have stressed to clients that they should make investment decisions with an eye to future and not focus on the past, the exception to this being that we should absolutely take the lessons learned from the past and incorporate those lessons into our strategy going forward.

Lessons learned and relearned

Some, including perpetual market bull Abby Joseph Cohen of Goldman Sachs think the next Bull market has begun. Barron’s just ran an article intimating that the S&P; 500 could reach 1200 (it closed at 1010 on August 7).

I would submit that controlling downside risk is at least as, if not more important than squeezing out every bit of possible upside. Investors should look at their returns over 5-10 year periods or longer. Being a winner over these longer time periods means that you will need to limit downside risk during periods of extreme market upheaval like the past year and 2000-2002.

Discipline is critical in an up market. Invariably many investors feel overly confident that their investments will continue to rise. As we have seen twice in this decade the market has a way of punishing those investors severely. If your desired equity allocation is 60% and a market rally pushes that up to 75% you should bring the allocation back in line as a way of keeping risk in line with your original strategy. Many investors lost staggering amounts of money over the past year by being over allocated to stocks.

True diversification is key. Owning several different types of stock funds or ETFs did little for investors during the worst months of the market decline. Unlike in 2000-2002 when value oriented funds held up fairly well, this recent market downturn took its toll uniformly on all equity categories as well as real estate and natural resources. Correlations tended toward 100% across many asset classes previously thought to be somewhat uncorrelated.

If you want diversification you will need to own investments that are not highly correlated to one another. This means in addition to equities, you should consider asset classes such as bonds and alternative investments. For example, let’s look at four mutual funds. Vanguard Total Stock Market Index tracks the broad US stock market. Vanguard Total International Stock Index tracks the broad non-US market. PIMco Total Return is a diversified bond fund. Hussman Strategic Growth is an equity based fund that uses derivatives and options to reduce its correlation to broad stock indexes.

Vanguard Total Stock and Total International Stock show a 93% correlation to each other over the past three years. PIMco Total Return, however, shows a 43% correlation to Total International Stock and a 34% correlation to Total Stock. Hussman’s correlation to Total International Stock is 27% and 36% to Total Stock Market. The PIMco fund and the Hussman Fund have a correlation of -2%, meaning they are virtually uncorrelated.

As an example of how this might have worked, if we had invested $10,000 in each of the four funds on January 1, 2008 the portfolio would have been worth $35,034 at July 31, 2009. If we had invested the entire $40,000 in any one of the funds over the same time period, the value as of July 31, 2009 would have been:

PIMco Total Return
$45,568

Hussman Strategic Growth
$39,248

Vanguard Total Stock
$28,348

Vanguard Total International Stock
$27,228If the past 19 months had been an up period for the market, we likely would have seen this portfolio underperform the two stock funds.This is a very quick and simplified example of a somewhat diversified portfolio. As you can see even in this simplified example, diversification softened the blow to this hypothetical investor.