A Seesaw Quarter

Written by Dave Young, President of Paragon

September is known as the worst month to be in the stock market. At the end of August, many media outlets and TV talking heads ran stories about how bad this September would likely be. Investors moved money into bonds and gold and avoided stocks. Some of our clients called and asked to be taken out of the market purely because it was September.

What did the market do? Of course, it did what it had to do in order to cause the most grief to the majority. Since everyone expected it to go down... it went up. In short, we just had the strongest September since 1939. The S&P 500 gained nine percent for the month. Unfortunately, because of outflows into bonds and gold, many investors did not participate in the stock rally.

Overall, it was a seesaw quarter. The markets were up sharply in July, down sharply in August and then up even harder in September. The back and forth movement has been more difficult than usual this year with the S&P 500 either gaining or losing at least four percent in each of the last five months. 

Those extreme up and down swings make our life much more complicated. When the markets are weakening, we make adjustments to protect ourselves. When they are strengthening, we make adjustments to prepare for upside movement. We have been stuck in this back and forth no man’s land since April.

We prefer trending markets. Either trend up or trend down, but just be consistent. When the market is trending, it allows us to capitalize on the trend and ride it as long as it lasts. When it is whipsawing back and forth, we are forced to make constant adjustments, but it is difficult to make progress.  Effectively capitalizing on the trend is how we have significantly beaten the S&P 500 historically. 

MANAGED INCOME AND TOP FLIGHT PERFORMANCE

Our conservative portfolio, Managed Income, has done well for the first three quarters of this year with a 4.8 percent return, net of fees. This has been a very challenging year for our conservative portfolio. With interest rates at extreme lows, it has been difficult to generate safe returns and still avoid the potential danger posed by increasing interest rates.

You might be wondering why potentially increasing interest rates are such a problem. If interest rates go up one percent, then a 10 year maturity bond will lose about 10 percent of its value. Likewise, an increase of two percent would create about a 20 percent loss and an increase of three percent would create about a 30 percent loss.

With interest rates at all time lows, many supposedly safe bonds are really ticking time bombs. Investors have been piling into bonds in a big way. Since the start of 2009 investors have put a net $620 billion into bond funds while they have withdrawn $100 billion from stock funds. When rates do eventually go up, investors who ran to bonds for safety will be surprised to find themselves saddled with big losses they thought they were immune to. 

Most conservative funds simply buy and hold bonds. Those types of funds will likely get hurt when rates go up. In contrast, Managed Income attempts to own bonds when they have favorable risk/reward characteristics and avoid them when they are unfavorable. That is why this has been a challenging environment for Managed Income. We have been forced to pull returns from other conservative areas while avoiding the majority of corporate and treasury bonds. Managed Income has performed well year-to-date.

Our growth portfolio, Top Flight, has had challenges as well. It is at a virtual breakeven for the year, with a -0.4 percent return year-to-date. Its benchmark, the S&P 500, is up 3.9 percent year-to-date. Most of that lag in performance can be attributed to difficulty in two months, January and July. If you break it down further, it is the back and forth whipsaw characteristic of this year’s market that has made it difficult.   

We have spent a lot of the year adjusting and changing direction, right before the market reverses direction. As I mentioned earlier, at some point the choppiness usually ends and the trending begins. Unfortunately, we aren’t notified in advance when that will be. That is why we are forced to constantly adjust so that we will be in position to capitalize on the change in trend when it occurs.

Even though Top Flight has slightly underperformed through the third quarter,  we are not terribly concerned. Looking at the big picture, Top Flight has beaten the S&P 500 over the past three, five, seven, 10 and 12 year time frames (see complete track record and disclosures on Paragon's website, www.paragonwealth.com).

This seesaw market has been very confusing for most investors. On Main Street, there has been an overwhelming negative sentiment, but on Wall Street, corporate profits are exceptional, and the Dow has rallied from 6500 to 11000.

Why the contrast? Main Street is bombarded by the media negative spin day after day. Politicians on both sides try to gain advantage by further exacerbating the negative. Some TV talking heads take it to a whole new level of gloom by pushing their own version of impending world doom.

From foreclosures, to a possible double dip recession, to unemployment, to European problems, to political insanity, to the deficit, etc.; the list of problems is endless. I can understand why people are depressed and scared to invest right now.

These issues are very real and difficult, especially to those who are directly affected by them. However, it seems that they are often blown out of proportion. They don't affect everyone, and they aren't insurmountable. For example, when everything was great in 2007, there was an unemployment rate of 4.6 percent. Currently, the rate is about 9.6 percent. We have gone from the best of times to the worst of times and only five percent more of the population is unemployed. Further, on a positive note, 90 percent of people are still employed and earning income.

What about the BP oil spill? That was supposed to be the beginning of an insurmountable Armageddon for the Gulf Coast. I haven't heard much about it lately.

Last I saw sea microbes were unexpectedly solving the problem. Or swine flu? I remember something about the government spending billions to save us because it might end life as we knew it. Didn't happen...

When we factor these spotlight media issues into our investment strategies, we call them "Big Scary's." The abbreviated acronym is "B.S." That is because they usually have a big media impact and occasionally a short-term investment impact, but rarely a long-term effect. Part of our job is to determine which "B.S." is meaningful and which is just noise.

Contrary to popular opinion, I think there are still reasons to be positive. If you look at the data, there have been a few instances in the past 100 years where the market has gone down over a 10 year period of time, like it has this time.

Every single time the market has lost ground over a 10 year period, performance the following decade performance has been positive. According to Ned Davis Research, on average, stocks gained 157 percent in the following decade. The decade with the lowest performance (98 percent) was Jan. 1, 1939, to Dec. 31, 1948. The highest (289 percent) was March 1, 1941, to Feb. 28, 1951.

Negative performance for two back to back 10 year periods would be unprecedented. Not to say it is impossible, but it would be unprecedented. It is also noteworthy that investor sentiment following each of the previous 10 year periods of underperformance was horrible... much like it is now.

Paragon Wealth Management a registered investment advisor that is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from other sources Paragon believes this to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.