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Don't let Wall Street's mood swings upset your investment strategy

Some investors were rattled by the recent volatility in the stock market. And it's hard to blame them. After all, one day, we're seeing record highs, and then, a few days later, we're on a losing streak  followed by a rebound. What will happen this week, next week or next month? No one really knows, but one thing is certain: Stock prices often fall (or rise) for reasons that have little to do with why you invest.

To illustrate, let's consider two of the factors that investment professionals cite as responsible for the market's series of losses in early June:

  • Falling hopes for a rate cut. Federal Reserve Chairman Ben Bernanke hinted that the Fed might not be cutting interest rates before the year ended. Because interest rate cuts often spur the economy and can boost stock prices (at least in the short term), Bernanke's statements took away some enthusiasm from investors.
  • Rising bond yields. Bond yields rose significantly; at one point during the stock market's losing streak, the yield on the 10-year Treasury note hit 5.24 percent, its highest level in five years. When yields go over the 5 percent level, some stock investors believe they can cut back on risk, and still earn a reasonable return, by investing in bonds. If many of these investors then pull back from the stock market, stock prices may fall.

As an individual investor, what should you take away from these apparent mood swings of Wall Street?

Here's lesson number one: Don't overreact to the mood swings of Wall Street. You'll waste time, money and effort by constantly trying to adjust your investment strategies in response to events such as comments by the Federal Reserve chairman or a rise in bond yields above a rather arbitrary figure.

When the market is volatile (and even when it isn't), focus on the things you can control. Here are a few suggestions:

  • Invest broadly. If you spread your dollars among a range of stocks, bonds, government securities and other vehicles, your portfolio may withstand market downturns better than if you only owned one or two types of investments.
  • Buy quality. Look for quality investments, including stocks of well-run companies with histories of paying dividends. These investments tend to hold their value better during market declines  and they usually bounce back faster when those declines run their course. (Keep in mind, though, that companies can increase, decrease or totally eliminate dividends at any time without notice.)
  • Follow an all-weather fixed-income strategy. If you are investing part of your portfolio in bonds, don't try to outguess the direction of interest rates. Instead, take an all-weather approach by building a ladder consisting of bonds of varying maturities. Once you've created your ladder, you are prepared for both rising and falling interest rates. When rates are rising, the proceeds from your maturing bonds can be used to invest in new bonds at the higher levels. When market rates are falling, you'll continue to benefit from the higher rates offered by your longer-term bonds even if the maturing bonds will be locking into the lower rates.

Above all else, keep your eyes on your goals. Your monthly investment statements may occasionally make you frown, but if you've done a good job of building a solid investment portfolio and you follow long-term strategies, you may eventually have a lot to smile about.

Jimmy Stewart is an Edward Jones financial advisor in Urbana. He can be reached at 217-328-1719 or

jimmystewart@edwardjones.com

LARGE CAPS POISED TO OUTPERFORM

Scott TapleyScott Tapley
CIBM Contributor

Small-/mid-cap stocks have outperformed their large-cap brethren for the past eight years, which brings to mind one of my favorite aphorisms. Herb Stein, former economic advisor to the Nixon Administration, used to respond to reporters' questions about economic phenomena with quips like this: Things that cannot go on forever eventually will stop.

The current run of outperformance of the little guys may be one of those things.

Some of you may be aware that for the past 80+ years, small company stocks have, on average, outperformed large company stocks by a couple of percentage points on an annualized basis, according to Ibbotson data. So, you may be wondering why you should ever be concerned about owning too much small-cap exposure. Maybe they can go on outperforming forever.

A closer look at the historical performance of small-caps versus large-caps shows significant periods of extreme outperformance that account for most of the small-cap sector's superior returns (see the table below).

Periods of small-cap outerformance in the U.S.

Period Duration % Outperformance

1932-1934 3 105%

1938-1945 8 224%

1958-1959 2 20%

1963-1968 6 152%

1974-1983 10 344%

1991-1994 4 42%

1999-? 8* 100%+

Average 5.6 146%

*Depending on the index used for measurement, small-caps eked out a narrow win against large-caps in 2005.

Source: Ibbotson

We all know that markets move in cycles, with some sectors alternating between outperformance and underperformance. Herb Stein, in a pithy follow-up to his observation quoted above, once said, Economists are very good at saying that something cannot go on forever, but not so good at saying when it will stop.

Stock analysts are no better than economists in that regard because absolute precision is, of course, impossible when attempting to navigate market inflection points. But being mindful of historical valuations and market cycles (i.e., duration and magnitude) may help you avoid being too greedy at the top and give you an opportunity to profit from a change in market leadership.

When the most recent burst of outperformance for the small-caps began in late 1999/early 2000, the average P/E (price/earnings ratio) of the average small-cap stock was about 11, while the P/E of the large-cap dominated S&P 500 index was nearly 30. In other words, a dollar of profit earned by a large company cost three times as much as a dollar of profit earned by a small company.

Right now, the P/E for the S&P 500 Index (a fair proxy for the large-cap stock universe) is about 16, and the average P/E for the small-caps (as measured by the S&P 600 Small-Cap Index) is about 24. So, using the same simplistic analysis as the prior example, small-caps are currently about 50 percent more expensive than large-caps.

This analysis is rather simplistic, because it does not take into account risk levels, growth rates, leverage differentials, etc. But the fact that the duration of the current run in small-cap stocks is nearly the longest of the past 80 years, and the fact that small-caps are about five times as expensive (relative to large-caps) as they were eight years ago, is a good indication that the small-cap outperformance ballgame is in the latter innings.

Small-/mid-cap exposure is necessary to keep your investment portfolio fully diversified, so don't eliminate all such holdings in your 401(k). However, the case can be made that now is a prudent time to reduce your small-/mid-cap exposure to, or even below, the appropriate long-term target for your individual risk tolerance and return objective.

 Scott Tapley, CFA, is a vice president/financial analyst with the Main Street Wealth Management Group. He can be reached at 217-351-6539 or scott.tapley@mainstreettrust.com.

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