Turning Lemons into Lemonade

Don't let a "lost decade" turn your investment portfolio into a loser

When major market averages are moving up, most people are relative investors. In other words, they want to beat the market averages.

However, when major market averages start moving down over protracted periods of time, most people instantly transform themselves into absolute investors. They don't want to lose money, and will take any gain, even a small one, just to be able to boast that they are making money.

Of course, there is no existing investment strategy that we know of that gives strong relative performance in up markets and good absolute returns in down markets. Index funds and exchange-traded funds (ETFs) that track indices emulate the performance of those indices in up and down markets. In other words, they are specifically built to lose money in down markets.

Meanwhile, so-called "safe" securities that seek to deliver positive absolute returns are often huge underperformers in rapidly rising markets.

The only way someone could successfully be a relative investor in up markets and an absolute investor in down markets would be to know ahead of time whether the market is going to move up or down.

And therein lies the rub. It is impossible to accurately forecast market ups and downs 100% of the time.

Over the past few weeks, various media outlets have been making much out of the "lost decade" concept, which holds that after the effects of inflation, investors in the S&P 500 index for the last 10 years have made no money at all. It is certainly true that if you purchased an S&P 500 SPDR on April 1, 1998 and sold it on March 31, 2008, your small gain was erased by the effects of inflation in that time.

We know that now, but it was impossible to know that on April 1, 1998. If you had looked into a crystal ball a decade ago, you may have been tempted to sell your S&P 500 index fund on April 1, 1998.

If you had done so, you probably would have been kicking yourself a year later when you had missed out on a 16% gain.

"There are often huge rallies during secular bear markets, just as there are big down days in secular bull markets," explains Sam Stovall, Standard & Poor's chief investment strategist. "The most successful investors turn this volatility into opportunity."

So if we currently are in the midst of a secular bear market, as many commentators seem to think, what's an investor to do? Selling our equity holdings and placing the cash under our mattresses is not the recommended solution. Why? Because, if history is any guide (it should never be viewed as gospel), money can still be made during both cyclical and secular bull and bear markets.

One way is through smart stock picking. Even as the S&P 500 index had its so-called lost decade, stocks with the coveted five-STARS ranking from S&P Equity Research gained a whopping 148%, not including reinvested dividends.

Or, you can identify sectors or industries that have performed well in the past. Take a look at the table (see cover table), which shows the average price change for selected industries and sectors in the S&P 500 during the secular bear market from 1966-1982, which actually comprised four cyclical bull markets and five cyclical bear markets.

What we find is that during the average cyclical bull market (there were four, posting advances ranging from 48% to 74%), economically-sensitive areas came out on top. Energy and energy services were the best performing categories, in particular, due primarily to the OPEC-induced oil crisis of the 1970s.

During the cyclical bear phases, one thing should immediately jump out at the reader — there is almost no place to hide in a bear market. Except for precious metals (gold) stocks, which posted an average increase of 11% only because of the 144% surge during the bear market of 1973-74, even the traditionally defensive consumer staples (food, beverage, and household products) and health care categories posted declines on average. These sectors are also known as "defensive," not because they traditionally rise during stock market declines, but because they usually lose less than the average. Leisure stocks, surprisingly, held up fairly well in market downtrends, primarily due to the support offered by the alcoholic beverage and tobacco issues.

Bear markets can be a scary time to go it alone as an investor. Many prefer the assistance of professional management and turn to mutual funds.

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