The Last Shall Be First

10/13/2009 1:00 pm EST

Focus: MARKETS

Janet Brown

Editor, NoLoad Fund*X

Janet Brown, editor of NoLoad Fund*X, says the biggest losers from the bear market have been some of the biggest winners in the rally. But can it continue?

The powerful rally continued into September, capping a strong quarterly advance. For the second consecutive quarter, stocks of all types soared. Small caps led in the third quarter, with the Russell 2000 up 19%, compared [with] gains of nearly 16% for the large-cap Standard & Poor’s 500 index, the Dow Jones Industrial Average, and the more tech-oriented Nasdaq Composite index.

After the best back-to-back quarterly gains since 1987, major indices are up 50% from their March lows, yet remain 30% below their all-time highs in October 2007. The powerful rally off the 12-year lows in March was widespread. Global stock markets posted their best quarter in 20 years, with the Dow Jones Global Index, excluding the US, up 19%.

Ned Davis reports that 39 of 42 global market benchmarks have risen at least 15% above their 200-day moving averages. European markets were particularly strong, as well as emerging markets, particularly Latin America.

Foreign fund performance benefited from the dollar’s losing streak, [which] began when stocks started rallying in March and picked up steam recently. As economies around the world chugged back to life, investors moved into riskier investments in search of higher returns.

For the quarter, the dollar lost 4% of its value against the euro and nearly 7% against the Japanese yen. Currencies of major commodity-producing nations soared against the dollar. But a weak dollar hurts European and Asian exports and eventually policy makers will attempt to keep their exports competitive. Both Asia and Germany, Europe’s biggest economy, remain highly dependent on exports for growth.

As investors moved back into riskier investments, many of the biggest decliners during the credit crisis posted the largest gains last quarter. Recently financials were the best performing sector, followed by industrial materials and consumer discretionary, which includes the much-battered auto industry. Small caps as a group led large caps off the bottom. Growth outperformed value last month, but for the quarter and year, value is ahead.

Even after seven months of big gains, many investors remain understandably cautious. Stock investors typically earn higher investment returns after periods of sharp losses, but the most extreme drop of our lifetimes has left many investors shell-shocked.

Looking at all the previous 20-year periods to date, the average return from stocks equals the best return that bonds ever produced in any 20-year period. Bonds, for all their ability to buffer a portfolio, have not offered much protection against eroding purchasing power in the long term. For that, you need stocks.

But the price we pay for higher long-term returns is market volatility, and recent volatility has been so extraordinarily high that many investors have withdrawn. Perfectly understandable, considering two devastating back-to-back bear markets and a negative ten-year total return for stocks.

The worst time to abandon an investment discipline is often when the news is most pessimistic. If a balanced allocation [between stocks and bonds] enables investors to stay with their long-term strategy, it will be successful in the end.

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