In 2007 and 2008, amazing turnover has occurred in the top 10 stocks in the cap-weighted S&P 500. Comparing the top 10 list for June 30, 2008, with the list for year-end 2006, we discover that 5 of the top 10 are no longer on the list. Not surprisingly, three firms were financial institutions—Citigroup, Bank of America, and AIG. Altria Group (consumer staples) and Pfizer (health care) also faltered enough on a relative basis to drop out of the top 10. AT&T was a replacement by way of its merger with SBC Communications. The four new stocks outperformed their peers enough to climb into the top 10. Two of the additions rode the wave of "black gold" prices—the energy twins Chevron Corporation and ConocoPhillips. The other two are in information technology—Apple Computer and IBM—which has traditionally been a high-beta sector and held up well in the recent market downturn.

If a market is efficient, nothing is wrong with allocating more to recent winners. In a random walk, recent winners are just as likely to outperform as the stocks that have faltered. But a random walk is not what has occurred historically, and it didn't occur in the third quarter of 2008 either. The five new additions to the S&P 500 returned on average -17.5% for the quarter versus -8.4% for the S&P 500 as a whole and -7.9% for the average stock.[1] Large-cap U.S. stocks faced a tremendous headwind during the third quarter.

If a market is less than fully efficient, index investors will benefit from indexing strategies that break the link between price and portfolio weight. The Fundamental Index^® methodology does exactly that. It selects and weights stocks in an index on the basis of their fundamental size (as measured by sales, cash flow, book value, and dividends) and rebalances back to those weights on an annual basis. The stocks whose prices have surged well ahead of their fundamental size, their underlying economic scale, are sold and the proceeds are used to purchase stocks whose prices have cratered relative to changes in fundamental size. Intuitively, one can see that this rebalancing offsets some of the problems with holding large allocations to recent winners-which are headed for a reversal. Large-capitalization stock indices, by overallocating to these recent winners, faced a tremendous headwind during the third quarter.

Of course, this trend won't occur every quarter or, for that matter, year. We can be relatively confident, however, in the mean-reversion process repeating. Trees don't grow to the sky, and an individual stock won't outperform forever. Successful companies see their stock prices rise simultaneously with investor expectations. Human nature conditions investors to favor investments that have been profitable recently and to extrapolate recent earnings and revenue gains well into the future, which causes valuations to rise beyond the reasonable and sets the stage for mean reversion.

Looking Back And Forward

In a volatile market like today's, two approaches provide insurance against the price reversals-a disciplined, relative-value approach to asset allocation in the broad capital markets and an indexing approach that anchors on metrics of fundamental size rather than capitalization. Both are critical in the face of an uncertain and unsettling investment environment.

Trying to pick market peaks and troughs is folly. But buying investments that most investors fear has always been one of the most powerful tools in an investing tool kit. Recent years have afforded few opportunities to follow this strategy. So, we relish the opportunity to be more bullish, in many markets, than most investors. The "permabears" are, albeit selectively, exuberantly bullish. We think that the months ahead will afford the patient long-term investor some of the most promising investment opportunities in many, many years. We think that, five years hence, we will look back on the next few months as the foundation for extremely profitable investment choices.

Note

1. S&P Equal Weight Index

© Research Affiliates^®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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