Mutual Fund Research Newsletter
Copyright 2010 Tom Madell, PhD, Publisher
Sept. 2010

Stock Funds: On-Off Relationship or Long-Term Affair?

By Tom Madell

Let's not mince words. Have you been a long-term holder of one or more stock funds that haven't done well for quite some time? Well, if so, you have a lot of company.

Let's look at how the 10 largest stock funds have done over the last 3, 5, and 10 years (thru Aug 31):

Fund (Fund Symbol) 3 Yr
Tot. Ret.
5 Yr
Tot. Ret.
10 Yr
Tot. Ret.
Tot. Ret.
in Last 12 Mos.
Vang Total Stock Idx VTSMX -8.04 -0.51 -1.13 5.69
Amer Funds Gr A AGTHX -7.93 -0.03 -0.46 3.20
Amer Funds CIB A CAIBX -4.76 2.87 6.69 6.25
Fid Contra FCNTX -5.00 2.38 2.70 9.97
Amer Funds Capital Wrd G/I A CWGIX -6.73 3.43 5.94 2.54
Amer Funds Inc A AMECX -3.83 2.38 5.71 10.44
Vang 500 Idx VFINX -8.70 -0.99 -1.91 4.79
Amer Funds ICA A AIVSX -8.59 -0.38 1.25 2.60
Dodge & Cox Stk DODGX -12.41 -3.13 4.40 1.86
Amer Funds Eur/Pac A AEPGX -5.76 4.63 3.64 2.50

Given that most of these funds haven't changed much in popularity over the last 5 years, it is safe to assume a high degree of long-term ownership. As you can see, none of these funds would have enhanced their owners' bottom lines very much, especially over the last 5 yrs. (Note that 2 of the 3 best performing funds over 10 yrs. included bonds.)

Unfortunatelty, this degree of poor performance has been almost universal throughout the stock fund universe. To have done significantly better, you would have had to have held the very rare fund indeed, estimated at no more than 1 out of 100, that managed to return as much as 7% or more annualized over the decade.

Does this mean, perhaps with the possible exception of these rare funds, that investors, current and potential, would be wise to minimize stock investments, at least until some future time when it will be more profitable to invest? It will be necessary for you to examine your thoughts on two separate questions to enable you to answer this bigger question:

Question 1: Are you able and willing to be extremely patient in waiting for good returns, or do you believe that putting/keeping your money into a fund is tantamount to expecting desired results within a relatively short time span (eg. 6 mos., a year, or even several years)? In other words, before investing do you fully accept that there may well be significant stretches of down performance? Or do you believe that it is wisest to restrict your stock fund investing only to when market conditions seem to offer highly favorable prospects, steering clear otherwise.

Naturally, one hopes one's investments will be working positively most of the time. But the overall stock market has always been an up-down affair. Yet, in spite of the propensity for fear-inducing losses, our just completed detailed of study of US stock performance, discussed below, shows that stocks tend to go through long stretches of uninterrupted rises followed by shorter downward thrusts.

In other words, historically, uptrends have been far longer than downtrends. It is during these relatively shorter but still significantly long-lasting down periods that many people find themselves questioning an investment's utility. (Remember though that we are now discussing market averages, not individual funds; a given fund may do poorly indefinitely, mainly as a result of poor management policies, bad stock picks, and/or exorbitant fees.)

So why then not just invest in stocks during an up period and avoid investing during a down period? Not a bad idea, except that initially, it is extremely difficult to identify when an up period has indeed morphed into a longer running down period, and vice versa. That is, the dividing line between such periods is very "fuzzy."

In fact, that is the very issue investors face today. As we now all realize, stocks were in a prolonged up phase between the beginning of 2003 and the latter half of 2007. During that period, they were sloping continuously upward over 45 mos, while marching downward for only 8 mos. They then began an uninterrupted down phase which lasted until March '09, or for 19 mos.

But no trend within the market lasts forever. Thus, stocks again entered an up phase taking the S&P 500 up 81% from the March '09 lows. None of these facts can be disputed. But what can be disputed is whether we are still in that up phase, merely having "paused" lately, or did late April mark the start of a possible considerably longer-term multi-month down phase? (You can look at this chart of recent price movements of the S&P 500 Index to see what I mean.)

The data show that at the end of this April, the Mar. '09 uptrend seemed to stop. Since then, it has retraced about 14% (through 8-31). So does this mean that the uptrend has ended and a downtrend has begun? Hard to say for sure since the downward movement has lasted only about 4 mos. thus far. Our research suggests that uptrends typically tend to last longer than just 14 mos. we just witnessed before a new significant downtrend begins. (The average length for established uptrends is close to 20 mos., with the longest being 43 straight mos. between July '62 and Feb. '66.) So while possible that a new lengthy downtrend has begun, based on past trends it is actually more likely that after the current pause, the March '09 uptrend will continue. In other words, merely by looking at our current 4 mo. downward path, one cannot readily discern what type of longer-term trend we really are in, up or down.

Since 1950, the S&P 500 has had what we count as 23 downturns lasting 6 mos. or more. The current pause does not yet qualify. The average length of such a downturn was a little less than one year. This means that over the last 60 years, the market has been in confirmed downtrends a little more than one-third of the time. The rest of the time, the Index has essentially been in upward trends.

Since once a "pause" reaches 6 mos., it, on average, continues for another 5 to 6 mos., we should hope that the current pause doesn't last two months longer which will confirm a significant chance of becoming a considerably longer downtrend. (The longest uninterrupted downturn since 1950 lasted 21 mos. between Jan. '73 and Oct. '74.)

But in order for the S&P 500 to prevent this from happening, it will need to recapture the April '10 high within the next few mos. However, due to the 14% "hole" the Index has dug for itself, this has become a tall order indeed. For the Index to rise to its previous high from April, it will have to rise about 170 points from where it closed on 8-31 which would represent a gain of over 16% during the next two months. This would seem to be highly improbable. On the other hand, historically, in a little more than 25% of the time, an already established 6 mo. downward trend wound up only lasting 1 or 2 mos. more, allowing the 16% gain a much more realistic amount of time to happen.

But this article isn't really for stock history buffs so let's get back to helping figure out an appropriate course of action. Once an investor identifies one of these longer-term trends, he/she could theoretically only choose to be significantly committed to the market during an uptrend and basically be out during a downtrend. Strategy-wise, we believe there can be some usefulness to adopting such an approach.

So, for example, upon identifying the 2003 thru 2007 uptrend, it would have helped to have been nearly fully invested. And during the late 2007 thru early '09 bear market, it would have helped to have greatly reduced one's allocation to stocks.

But given the significant (fuzzy) period after an apparent shift where the true trend is pretty much unknown, it would have been hard to know what action to take well into the yrs. 2003 and 2009 as the longer-lasting uptrends first started; likewise during the early portion of '08 until a longer lasting downtrend became more readily apparent. That said, if one can adopt a strategy of identifying a positive longer-lasting trend (rising market for at least 6 mos.) and then increasing one's allocation to stocks, as well as lowering your allocation as a result of a longer-lasting 6 mo. downtrend, you should be rewarded by virtue of the persistent nature of these longer-term trends.

So much for Question 1. The 2nd question raised by the title of this article is this:

Question 2: How much trading/exchanging are you willing to do? Even upon acknowledging multi-month periods as either bullish or bearish, do you have the inclination to actually make the kinds of trades that will permit you to capitalize on that information? Some people do not want the bother of closely following the market. Many others do not want the possible added anxiety that they might be doing the wrong thing. After all, no one can be guaranteed that by making a given adjustment to their portfolio that the action won't later turn out to have been a losing choice. Therefore, perhaps the lack of a guarantee no matter how positive the historical odds, coupled with the personally unacceptible negative consequences of making such an unprofitable exchange, can keep some people from acting.

Thus, many people would rather not trade at all. (Note: When one is considering any stock market strategy, including this one, it should be realized that the suggestions being offered are a form of favorable "probability statement." That is, while either a good or bad outcome is possible, one should have considerably more confidence in the good one occuring than the bad one.)

Another reason not to trade: Each fund trade, at least in a non-retirement account, is a taxable event and must be accounted for on your tax returns, adding some degree of complexity. And if the trade is for a gain, you obviously must cough up a share of your profit to Uncle Sam.

Of course, readers of my Newsletter should realize that we always like to focus on long-term investment strategies. But this just described research adds to the evidence we have continually presented that there are often recognizable opportunities to do better in one's investing than just holding your investments indefinitely and hoping for the best.

All this brings us back to the present moment. Are stocks likely starting an extended longer-term slide, or, are we still likely to continue the "paused" 14 mo. uptrend? And further, does the poor 3, 5, and 10 yr. performance of the stock market as a whole augur ill for investing in stocks at all?

If you need to be assured that you can make a significant return in a short period of time (Question 1), then today's market is clearly not for you. At a minimum, you should wait until the market has reverted to an uptrend, up and over the Apr. '10 high. If you are sufficiently convinced by the above data, and willing to follow what it implies by making strategic moves (Question 2), then assuming as we do that the history of investor behavior regarding stocks tends to repeat itself, you have a good chance of coming out ahead of mere "buy and hold."

If however you are able and willing to be extremely patient, we still think you will be able to profit in the long run. In spite of the current slide, many funds are still up around 5-6% over the last year which isn't that bad in an environment of currently low returns nearly everywhere. (In our Aug. '09, Newsletter we projected that stock returns would average about 5-8% over the next several yrs.)

Rather than dwelling on poor past returns as a reason for pessimism, our on-going research shows a clear positive relationship between sustained (5 or even 10 yrs) poor prior overall stock market performance and subsequent good performance, and vice versa. We especially think the S&P 500 will be even more attractive beginning if it retraces back to 1000, or below. (It is at about 1050 now.)

New Readings on Our BUY, HOLD, and SELL Indicators

For those who are considering buying stock funds at today's levels, our research suggests there has been a change in our indicators since last month. At that time, we found that most categories of stock funds should be considered BUYS except for Large Cap stocks and most International funds which were to be regarded as HOLDS (While BUYS have more potential, HOLDS are still favorable for long-term investors). This means that Small and Mid Cap domestic funds were offering the best potential.

However, as a result of Aug.'s sell off, our research suggests that ALL the major categories of stock funds are now HOLDS. (Our research regards performance over the last 12 mos. as a significant factor and will respond to a drop in such performance by lowering a category's attractiveness. Since nearly all categories have shown worse performance over the prior 12 mos. as compared to just a month ago, although still positive as of 8-31, this is why such a change in our designations occurred.)


Click here to read Part II of this month's Newsletter