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September 01, 2009

Will This Year's Rally in the Stock and Bond Markets Continue?
by Tom Madell

Over the last nearly 11 months, the stock market has shown a "V" shaped performance. Specifically, between early Oct. '08 and early March of this year, stocks continued their downward performance intially begun in late 2007. And almost symmetrically, between the rest of March through the end of Aug., a period of nearly 6 mos, subsequent performance has entirely retraced the prior 5 mo. period's losses. As a result, the S&P 500 trades (as of Aug. 31) at about exactly the same level as it did during the day on Oct. 6th, around 1020.

So what will happen next? Obviously, no one can be sure. Therefore, the wisest course of action would seem to be not to make big bets in either direction. Such big bets would include not only those which go overboard in assuming the worst is over, as well as those which, through continually assuming a risk averse position, are possibly letting opportunities for growth in asset values continue to slip by.

In truth, forecasting the overall levels of the stock and the bond markets, nor when they will reach or drop to certain levels, is not a central ingredient of my overall approach to achieving success in investing. I simply can't determine for myself, or anyone else, what the next leg after the current V will be. But the reason I don't concern myself very much with that issue is because I accept the fact that in investing, there will be some manner of "V's" as well as "upside down V's" (that is, downward trajectories that can essentially wipe out prior short-term gains) within almost any 5 year period. While hopefully these V shaped patterns will be smaller on the downside and larger on the upside, to me it's where you are after a full 5 years or more that's far more important. If you can get that right, you really shouldn't have to worry too much about the possible upside down V's that might occur over shorter periods.

But, of course, the questions posed by this article's title are interesting and tempting to try to answer. At the risk of contradicting my statement that I simply don't know, I can at least try to give a very "iffy" sense of whether I think the current stock and bond market rallies will continue thru the remainder of 2009, and more importantly, for a significantly longer time.

One of my favorite approaches to investing is the contrarian approach, entailing going against the crowd. Given what might appear to be the direction the markets will take, based too often on the less than well-thought out expectations held by many investors (especially those typically relying too heavily on short-term thinking), the contrarian approach usually suggests that just the opposite outcome is more likely to happen.

And indeed right now, it looks like a near-perfect opportunity to apply our contrarian bent. Some investors are apparently "chomping at the bit" to get back into stocks. At the same time, as discussed in my article last month, even more new money is going into bond funds than stocks. If these two phenomena are a result of the last 5+ months of momentum in the case of stocks, and in the case of bonds, the aftermath of generally good past 12 mo. performance, both these investor proclivities may be setting up for a fall. But to be honest, I actually have a slightly higher level of agreement with the stock crowd here than the newly adoring bond crowd, while feeling they both may be going too far overboard.

Stocks, while in a huge upswing that appears very ripe for correction, should be at least somewhat more of a favorite to the contrarian thinker than bonds. Why? Because stocks have been underperforming for more than a decade and are therefore more likely, in my opinion, to surprise on the upside than bonds, which have been overperforming, although not to an extreme, for nearly just as long. Thus, while John Q. Public is now more willing to see bonds in a favorable light since any period I can remember, a truly contrarian view would suggest that stocks will likely have a good decade ahead while bonds may suffer a somewhat poor one.

But let's get back to what to expect for the remainder of this year. My short answer would be "more of the same." That is, I expect stocks to continue their current upward trend, but at a slower pace than the typical fund category's 15 to 25% gains shown thus far in 2009. (It wouldn't be surprising to see a 10 to 15% correction before year's end.) I also expect bonds to do reasonably well (or perhaps better in the case of Treasury bonds) for a while longer too, with such performance most likely continuing to at least the end of the year.

While many investors, although not everyone, seem to currently think that a decent recovery is baked into the cake with the futures market recently predicting the Fed funds rate rising to about 0.75% by next June, the contrarian position would be that such a recovery, while still likely, will leave most ordinary citizens (as opposed to just stock investors) not much better off. As a result, while we likely won't retrace to the low level of economic activity previously hit, we are not going to recapture anything near the pre-crisis levels for many years. Perhaps things won't even return to where they were for at least an entire decade.

So long as the majority allows itself to continue to feel relatively sanguine about a recovery, probably thru much of the remainder of the year, the stock market too will continue to recover. But once the "new normal" (as the folks at PIMCO have termed the likely subpar retrenchment of next decade or so) becomes more obvious, returns in the stock market too are likely to be more muted than previously. We have already gone on out on a limb and expressed the view, here in last month's article, that stock prices are likely to average gains in the range of 5 to 8% per year for perhaps the next 5 or so years, not the "old normal" figure of around 9 to 11%. Looking out over such a long, and what we agree will be a transitional period, is fraught with uncertainties. While our "heart" might suggest even worse stock market performance, our "head" (including many years of research data) suggests only somewhat reduced returns.

Longer term, we also expect bond prices, in general, to be more moderate than what has been seen recently. With interest rates hovering near secular lows, if not already having past the lows, investor returns will show less than what now appears in past performance tables. Of course, these past performance tables are what has likely helped make bond funds currently so enticing to many of the new converts. Additionally, with money market rates so low right now, many investors are turning to bonds as a relatively safe way to achieve a better yield. While we agree that bonds will certainly outperform cash, and are a rather obvious alternative at that, we expect the level of bond performance, especially for Treasuries, to be disappointingly low.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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