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What Happened to the U.S. Bull Market?

Examined on a year-over-year basis, almost all types of U.S. and international stock/ETF funds have been down, or at best, flat over the last 12 months. Does this mean the global bull market which began in March 2009 is over? Which categories of funds have bucked this unappealing trend and can they continue their leading performance? These are the important questions we feel investors should be focusing on, not the constant and ever-changing guesses as to what will happen next in the euro zone, and how, or even if, such unresolved issues will continue to impact the U.S. stock market as a whole; simply no one knows how the crisis will evolve nor what its effects on the U.S. will be. In fact, even if the U.S. markets are hit further, perhaps most of the negative repercussions may already be priced in; after any further sudden drop, it may prove to be an excellent buying opportunity.

Looking at the Longer-Term Trends

One year ago, on May 31, 2011, the S&P 500 was up more than 100% from its bear market low of March 2009. And it was up over 23% from its prior year's (May 2010) close. (Neither figure includes dividends.) With performance such as that, it was relatively easy for those who look for strength in the market as a comforting sign as to what might lie ahead to feel upbeat and bullish.

But in spite of a strong 4th quarter of '11 and first quarter of '12, stocks, as measured by the S&P 500, did poorly enough the remainder of the 12 month period that the Index has only barely managed a less than 1% total return over the entire year. (Data cited as of May 30.)

Interestingly enough, though, the unmanaged S&P 500 leads every one of the averages for the nine broader categories of funds that many fund investors focus on by amounts as much as the mid to high single digits over the last 12 months; the latter include funds categorized in terms of market capitalization (large, mid, and small) as well as growth vs. blend vs. value orientation. Of course, this means that attempting to focus on certain categories, or even specific stocks within those categories as managed funds generally do, on average, resulted in considerably poorer performance than just sticking with the nearly unchanging most widely held U.S. stocks. In general, funds with a small-cap and with a value orientation have fared the most poorly. It is likely that those investors who actually invest in individual stocks have tended to prefer the biggest and presumed safest stocks as opposed to the alternatives during this period of on-again, off-again economic and shifting political signals.

Another notable trend has been the extremely poor performance of all categories of international funds over the last 12 months for investors in the U.S. who are generally exposed to both actual market performance as well as currency losses as the dollar has strengthened, as discussed in our April issue. Returns from overseas have been poor no matter where one looks, and in fact, the majority of developing and developed countries have now dropped close to 20% or more for U.S. investors since the highs of last summer. Recently, the index of shares in Brazil, Russia, India, and China (BRIC), fell more than 20% below its level on March 2, putting it officially in a bear market. Since then, it has dropped even further. Unfortunately, many investors chased international stock performance, especially in emerging markets, putting far more into such funds than domestic funds over the last few years. So far, at least, this has proven to be an ill-timed move.

In general, I believe that poor prior 12 month returns are a warning sign that investors should be highly cautious. After all, the on-going direction of stock prices is one of the obvious yardsticks that investors should pay attention to. I also typically believe that it is safer to invest in almost any type of investment when prices have the solid underpinning provided by at least a year of good performance behind them than when prices have fallen for the same amount of time.

Of course, any trend can be highly difficult to ferret out with stocks going up and down in what often seems like a helter-skelter and totally indiscernible pattern. That is why we eschew paying much attention to what happens over short periods such as days, weeks, or even several months. The only way to get a reliable snapshot of meaningful trends is to focus on longer periods: In most instances, we would not settle for periods of less than one full year, although more aggressive investors might accept a six month time frame for judging if the market has enough steam to look like it's on a solid upward track.

On a 6 month basis, the S&P still looks firm having closed Nov. 2011 at 1247 vs. 1313 on May 30th for about a 5.3% return without dividends, or 10.6% annualized. Yet, as noted above, on a 12 month basis, the return is decidedly unimpressive.

What the Economic Fundamentals Suggest

Obviously, an analysis of economic fundamentals also needs to be considered when weighing how much confidence to have in stocks going forward. It is highly likely that the ups and downs of the eurozone crisis as well as U.S. debt and fiscal problems have been responsible for at least some of the movements in US stock prices over the last year and will continue to exert an influence. The on-going crisis, along with the concomitant weak euro as well as slowing emerging market growth, have certainly been responsible for much of the damage to international funds. Until these issues are resolved, which could possibly (although not likely) take years, markets may continue to largely reflect the pessimism and fear generated by thoughts of impending calamities for countries, and by consequence, for their investors.

But on the positive side, interest rates remain extremely low and the U.S. economy in gradual recovery mode. The Fed remains on guard, tilted toward even more stimulative action if circumstances necessitate. These are the same ingredients that have propelled the U.S. market forward since the bull market began over three years ago. Therefore, while the crystal ball remains cloudy, with possible thunderstorms on the horizon, we think that yield-starved investors will likely resume, once the current near panic-rush to safety gradually gravitating toward those investments that offer at least the possibility of inflation-beating gains vs. the near zero after-inflation yields likely on most non-stock investments.

So is the bull market dead? While we certainly think that many international stock funds remain in or near bear market territory, there may still be some hope for U.S. stocks which have proven the best place to be for at least the last three years, especially in a few favored categories.

Those Fund Categories Still Performing Adequately

Which categories of stock funds have bucked the flat or even negative 12 month returns mentioned above, and despite the overall thrashing of stocks during May? Only the following two: Real Estate and Consumer Cyclicals.

I have been positive on Real Estate funds and ETFs since Sept. 2011. Over the last 9 months, our recommended choices, Vanguard REIT Index Fund (VGSIX) and Vanguard REIT ETF (VNQ), have had an annualized total return of more than 12%.

Why should Real Estate funds have done better than all other categories of stock funds? For one thing, as mentioned above, investors are looking for investments that have a higher yield than available in many bond funds and certainly money market funds. REIT funds are able to deliver reliable dividends. For example, Morningstar estimates the yield on VGSIX is currently 3.14% and on VNQ 3.27%, above the yields available on most other types of stock funds, and even for many bond funds.

Of course, the real estate properties included in a REIT fund have nothing to do with the single-family home market which has been in a terrible state ever since the sub-prime and foreclosure crises. Rather, properties are focused on commercial real estate such as ownership of apartments and office buildings, shopping centers, hotels, and the like. As the economy slowly improves, these kinds of holdings are doing much better than during the recession when REIT prices took a big hit.

Aside from owning a sector fund specializing in real estate, one might get a small position in real estate from a small- or mid-cap value fund. For example, the Vanguard Small Cap Value Index Fund (VISVX) has approximately 15% of its portfolio invested in real estate.

Consumer Cyclicals are not a mainstream fund category; therefore, most investors may have not considered having a position in the category before. Why should stocks dependent on whether consumers are opening their wallets be affording bigger profits to companies that cater to these spenders and thus currently be doing well, offering possible further opportunities for investors seeking above average returns?

This category includes stocks of autos, retailers, hotels, restaurants, and others that tend to excel when consumers are of a mind to spend. While consumer spending hasn't been shooting out the lights, it too has definitely been on the mend since the 2009 recession's end.

One can gain major exposure to the Consumer Cyclical sector (also called the Consumer Discretionary sector) only through various sector funds such as those available through Fidelity, or through an ETF focusing on consumer discretionary stocks, such as Vanguard's Consumer Discretionary ETF (VCR). A more diversified fund that holds a solid position in Consumer Cyclicals is Fidelity Low Priced Stock (FLPSX), one of our long-time recommended funds, with a 28% position in the sector according to the Fidelity website. Fidelity Contrafund (FCNTX), also one of our favorites, has a 22% position.

Prospects for These Two Leading Sectors

Can these two fund categories continue to lead the pack over the next year or so?

REITs. Currently, the S&P 500 Index has returned over 100% since its March 2009 low, including dividends. Over the same period,, the price of VNQ and VGSIX have increased by approximately 190%, not including dividends. By the same token, from their bull market highs in early '07 to their 2009 bear market lows, they dropped over 75% compared to a drop of about 56% in price for the S&P 500 during its bear market. What this seems to reveal is that, since 2007, REIT prices have moved in much the same direction as overall stock prices, although to a much stronger degree. Therefore, if this relationship continues, it seems that REIT prices will only be outperformers if the overall trend in stock prices remains positive.

If unemployment does not improve further going forward or if consumers start to retrench, real estate investment trusts, which are dependent on high office, shopping mall, and hotel occupancy rates, may not continue to do well. But recent trends suggest that, on both counts, further inprovement is likely. Therefore, we continue to recommend that investors consider maintaining up to 10% of their stock portfolio in this category.

Consumer Cyclicals. There was good news with regard to where consumer spending may be headed toward the end of May when the Thomson Reuters/University of Michigan consumer sentiment index was released as well as the Conference Board's consumer confidence index. The first showed the highest level of consumer sentiment since October 2007, just before the start of the recession. Economists regard the measure as a proxy for where consumer spending might be headed. Thus, the gain may indicate Americans are more inclined to further raise their purchases, which had already gone up in the first quarter at the quickest rate in over a year. The survey's index of current conditions, reflecting respondents' financial situation and if they perceive it a good time to buy big-ticket items, grew considerably from a month earlier. That part of the survey which more closely projects the direction of consumer spending, consumer expectations six months down the road, increased to its highest level since July 2007. Interestingly, very few responders even mentioned the European financial crisis' potential impact on the domestic economy.

The Conference Board's data seemed to contradict much of the above survey's optimism. However, even it showed those with plans to buy big ticket items were increasing. So, once again, it appears that so long as job growth continues to make at least modest gains and consumers remain in a mode to increase expensive purchases, the Consumer Cyclicals sector may continue to excel.

Thinking Outside of the Box

I realize that the last 12 months have been a discouraging period for stock fund investors, compounded with an even more discouraging five years, and even 10 years, often regardless of the type of stock fund you might have selected. It is not surprising, therefore, that many people are either opting out altogether, severely limiting their exposure to stocks, or otherwise becoming very pessimistic that they, or anyone, can expect to do well in the stock market under the current chaotic economic environment.

But trying to outguess the overall market has been, and continues to be, next to impossible, so investors who wish to have a chance of coming out ahead over the years should give up on thinking that they can beat the extreme odds of predicting either a "good" or "bad" time ahead for stocks as an overall asset class.

Rather than thinking in such broad terms, I suggest investors focus on more manageable market slices to increase their returns. Some of the current sub-areas I expect to offer such opportunities involve seeking out pockets within the market that seem to riding longer-term trends. The above two sector funds would appear to offer such portfolio-enhancing possibilities. This might also be supplemented with a trimming down or avoidance of funds/ETFs that are aversively impacted by a continuing rise in the U.S. dollar, namely most international funds (or those U.S. funds with a substantial foreign allocation). While no one can expect to navigate the markets in a smooth fashion, avoiding all missteps along the way, the possibility of small enhancements to an investor's portfolio performance can add up to a considerable amount over the years.

Using such a targeted approach, ETFs and sector funds can provide a better, or in some cases the only way of focusing in on favored sectors while avoiding others that are hard to avoid in traditional, and typically, more broadly-based mutual funds.


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