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Sep 30 2009
The Markets are Back Up
Dave Young
Third Quarter 2009 will be remembered as one of the most eventful periods in market history. One year has passed since the weekend that shook the foundations of Wall Street and the global financial system. Lehman Brothers collapsed, Merrill Lynch vanished as an independent entity, and AIG was taken over by the U.S. government. Almost two years have passed since the Dow Industrials hit its all time peak of 14,164.

In this article I will summarize where we have been this year, where we are today, the prospects for the period ahead, and some lessons from the last year's financial collapse.

PORTFOLIO UPDATE

Both of our portfolios did extremely well third quarter and year-to-date. Stock trounced bonds, small cap and mid cap stocks outperformed large caps, and emerging markets outperformed all asset classes. Fortunately, that is where our models positioned us, and is why our portfolios outperformed their benchmarks.

Our conservative portfolio, Managed Income, is up 11.93% year-to-date, more than doubling the 5.72% for its benchmark, the Barclays Bond Index. Our growth portfolio, Top Flight, is up 27.7%, year-to-date, versus 19.3% for its benchmark, the S&P 500. Since January 2007, Top Flight is down only one percent versus the S&P 500, which is down 21 percent during the same period. Since its inception in January 1998, Top Flight has gained 337% versus only 33% for the S&P 500 index.

WHERE WE HAVE BEEN

If you watched television or listened to the radio six months ago in early March, it felt like the world might be coming to an end. Talk of a “return to the Great Depression” dominated the media. Politicians also did their best to scare everyone to death. President Obama gave a speech that mentioned depression and catastrophe 24 times. Fear was rampant as a result of the media hype and political meddling. Stocks responded to these nightmarish scenarios by hitting the lowest levels in 12 years, with many financial stocks losing 90% of their value.

In an effort to stem the overwhelming tide of fear, we created a presentation called, “Is The World Ending?” In short, we did not believe it was the end. We believed the entire situation had evolved into unwarranted panic and fear, and we advised clients to become fully invested.

As we expected, the March lows were the market bottom. Since then, the economy has moved back from the precipice. Since the March lows, the U.S. market has gained 50%, retracing a good portion of the losses since last fall. Many of the international markets have come back even stronger, with the emerging markets leading the way.

FIVE LESSONS LEARNED FROM THE PAST 12 MONTHS:

The investment strategy that Wall Street and mutual fund companies constantly promote called “buy and hold,” has been a complete failure over the past 12 years. It has generated negative returns when adjusted for inflation.

Market forecasts by “experts” provide no benefit. Most forecasters completely missed this decline. The majority also missed the recent rebound.
Setting your risk tolerance properly before investing is critical to success. You must be comfortable with the amount of volatility in your portfolio or you are likely panic and sell at the wrong time. Once again, hoards of investors bailed out at the market bottom and then missed the entire rally.
When building your retirement plan, hope for the best but plan for the worst. Expect the unexpected.

Follow a disciplined, proactive investment strategy. Remove emotion from your investment process. In the investment world, decisions based on emotion are usually wrong.

WHERE WE ARE TODAY

Two years ago, the market was characterized by rampant optimism. The Dow Industrials hit a new high in October 2007, and concerns were set aside as minor annoyances. By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere.

Today, the market is somewhere between those two extremes, and most investors can be characterized as extremely nervous. Generally speaking, a certain level of anxiety is positive. An excess of either optimism or pessimism gets investors in trouble. The good news is, there are still excellent opportunities for investors who are prepared for short-term volatility.

I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. Most say they still find very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.

Six months ago our models positioned us in the areas of the market that do best after a “waterfall decline.” Currently, we are invested in those areas of the market that do best after a recession ends.

GOING FORWARD

In August, BusinessWeek ran a cover story called “The case for optimism.” The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism looking forward.

Powerful forces under the surface will drive economic growth, and that growth will drive stock prices. Examples include the positive impact of technology, the recovering U.S. housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.

Leading indicators show that the recession likely ended in June. Our indicators also showed that the end of June was the turning point, and have only strengthened since. We believe this recovery is real. Contrary to what the pessimists say, it appears to be very sustainable.

The FED is in easing mode. Usually they keep interest rates low until 20-30 months after the end of a recession. The low interest rates should power the economic turnaround. We don’t expect rates to move up until unemployment starts declining, and that is at least 18 months out. We are not concerned about inflation at the moment, but it is one of the factors we will be watching.

The markets are back into a positive, upward trend. All 42 of the global markets we track are above their 40-week moving average, which is very bullish. That’s what markets do. They go down, and then they go back up. Then they repeat the cycle. It’s pretty basic, but it’s the way it’s always been. We will continue to run our models and adjust our portfolios accordingly. The biggest wild card is to what extent politicians jump in and slow down or disrupt the cycle. Their actions won’t kill the recovery, but the debt they are piling on will likely slow it down.

In 1907, U.S. financier J. Pierpoint Morgan single-handedly averted a banking panic among U.S. investors. Later in life, someone asked him his best guess as to the direction of markets. His answer: “They will go up, and they will go down.”

One hundred years later, that’s still the best answer for a short-term market forecast. No one can predict market movements in the immediate period ahead. At Paragon, we will continue to follow our models and adjust our portfolios to whatever the market throws at us. No one likes volatility, but for most of us it’s the necessary price to arrive at our ultimate destination.

Please make sure to take advantage of the updates we provide on our blog moneymanagerslive.com. As always, feel free to contact us at any time if you have concerns or would like to meet.