Sticking to a System in Bad Times Pays Off

2008 may have been a year most investors would like to forget, but I'm sticking to my annual tradition of assessing Common Sense's performance.

The worst year in financial markets since the Great Depression, 2008 was aberrational in almost every measurable way. There was only one recommendation that consistently made money, which was to sell everything and buy U.S. Treasurys. That's the most defensive posture imaginable, and I don't know anyone who was suggesting such a radical, one-dimensional strategy a year ago. Back then, Common Sense recommended defensive plays. It warned against financial stocks as well as inflated commodities and emerging markets. Through the first eight months of the year Common Sense was faring pretty well. Then markets went off a cliff in a cascade of crises, upending many of my earlier recommendations, even defensive ones.

I concede that I neither saw the magnitude of the financial crisis we were headed into nor was able to assess to what degree the market already reflected those rapidly deteriorating economic conditions. I don't purport to be an investment professional or an economist, though I note that few of them were any more discerning. Despite my disciplined system and some insights during the year that proved to be accurate, my net worth at the start of 2009 is lower than it was a year ago. I assume that to be true of anyone whose major investment is in the stock market.

Just about any stocks I recommended in the first half of the year looked foolish by October. Agriculture stocks like Monsanto (MON) and Deere (DE) made sense when I recommended them in February, and kept rising for months before collapsing along with commodities prices. (I still own both stocks, now far below their 52-week highs.) I repeatedly recommended (and bought) Google (GOOG), a stock I still own and a company I believe in, which now trades at less than half its 52-week high. During the course of the year I suggested tiptoeing into financials once I thought things couldn't get any worse. They did get worse. But in this I was hardly alone. Given that virtually every stock went down in 2008, nearly all buy recommendations turned out to be, at the least, premature.

I've often said, however, that the key to investing is getting the big themes right. I've never recommended using leverage, which was vindicated in 2008, when leverage ruined some investors. My call in May to take some oil money off the table and, especially, my July analysis that oil and commodities were in a bubble contributed to some of my biggest gains of the year. Those were not easy calls to make, given the commodities mania that swept up so many investors. It reminded me once again how hard -- but important -- it can be to swim against the tide. Now, with commodities out of favor, it seems a good time to be re-building positions.

Some good news about 2008 was that, in addition to stocks, just about every asset class sold off, creating some remarkable bargains. I signaled especially attractive opportunities in municipal bonds and investment-grade corporate bonds. It's too soon to know how those will fare, but they have rallied in recent weeks.

Not since the collapse of the technology bubble has the market crossed so many Common Sense buying thresholds. I follow a disciplined system of buying stocks whenever the Nasdaq Composite drops 10% (buying lower) and selling on rises of 25% (selling higher). In recent low-volatility years there have typically been one or two of these occasions annually, and the system has worked well. In 2008, there were multiple drops of 10% in the Nasdaq without any intervening 25% rallies. The first was in January followed by a dizzying rush of further drops this fall. I signaled each of these in my weekly columns, and steadfastly followed my system by buying more on five occasions. Fortunately I had built up some cash from the sale of my oil and commodity positions as well as savings.

Needless to say, most of these purchases are still underwater. But it may come as a surprise to those conditioned by bad news to note that the last of these -- executed when the Nasdaq was at 1375 -- is now showing a substantial gain with the Nasdaq over 1600. Indeed, the index is near a new selling threshold of 1645, which is a 25% rise from the closing low of 1316 reached on Nov. 20. The S&P has already rallied about 25% from its closing low, also on Nov. 20, so it's actually time to start thinking about taking some profits. For people who have been smugly sitting on cash since November, they've just missed a major rally.

I know some readers lost faith in my system and stopped buying as the market continued its relentless decline. I readily understand this, since the repeated process of buying and then watching the market drop further is powerful conditioning not to engage in such a strategy. It feels terrible. But it's exactly when you feel like abandoning the system -- when the market is at its lowest -- that you must summon the discipline to keep going. I learned this lesson during the 2000-02 drop. And investors must never give in to the herd instinct to sell when everyone else is. That is a prescription for selling low and buying high, the antithesis of Common Sense.

Of course this has been a difficult and often unpleasant year in the markets. But nothing about 2008 has shaken my conviction that investors must take intelligent risks in order to be rewarded, and that long term, stocks represent the best investment alternative. We know that markets go down, creating buying opportunities, as well as up. At the moment, my portfolio has stabilized and has recently shown some significant gains. Time is an investor's best friend, and any year-end review is a snapshot of a short period. It will take at least another year, and perhaps more, to fully assess how the Common Sense system fared in 2008. But if history -- even including the Great Depression -- is any guide, patient, long-term investors will be rewarded.