Shadow Stock Portfolio Update and the Disappointing Election-Year Market

    by James B. Cloonan

    Shadow Stock Portfolio Update And The Disappointing Election Year Market Splash image

    As of the end of May, micro-cap stocks continue to lag the market and the Model Shadow Stock Portfolio reflects that trend, with a weak three months. Year-to-date, the portfolio is down 12.2%, compared to a loss of 3.9% for the Vanguard S&P 500 Index fund (VFINX).

    Although micro-cap stocks had a poor three months, small-cap stocks had a relatively strong showing and the Vanguard Small Cap Index fund (NAESX) now is up for the year, with a return of 0.7%.

    I can’t remember the last time that small caps were the strongest size sector and micro caps were weakest. Mid-cap and large-cap returns were in between.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 5/31/08)

    Figure 1 shows cumulative returns for various periods for the portfolio, and the entire history of the Model Shadow Stock Portfolio is provided in Table 1.

    The last time that the portfolio lagged the overall market for this long a time period was in the 1998–1999 period, a time when value stocks in general did poorly relative to growth stocks.

    In the past, two years in a row is the longest that the portfolio has underperformed the S&P 500, and we are not at that two-year lag stage yet.


       About the Model Shadow Stock Portfolio

    The Model Shadow Stock Portfolio provides guidance for investing in the promising micro-cap value sector of the market. It reflects AAII Founder James B. Cloonan’s investing philosophy, which holds that:

    • The best stocks for individual investors are not the same stocks that are best for institutions, and
    • Success comes more from concern for the overall portfolio than for individual stocks.

    The Model Shadow Stock Portfolio is an actual portfolio with real dollars invested. Updates on portfolio activity are provided both in the AAII Journal in this column, and on our Web site at

    Quarterly Portfolio Activity

    Table 2 highlights the activity in the portfolio for the three months ending May 31, 2008.

    Transactions were carried out during the last week of May and Table 3 shows the current holdings and their status as of June 6, 2008.

    Table 2. Second-Quarter 2008 Transactions
    BlueLinx Holdings Inc. (BXC) negative earnings
    Building Materials Holdings Corp. (BLG) negative earnings
    Marlin Business Services Corp. (MRLN)  
    Saga Communications (SGA)  


    The sales were:

    • BlueLinx Holdings Inc. (BXC), and
    • Building Materials Holding Corp. (BLG).


    The purchases were:

    • Marlin Business Services Corp. (MRLN), and
    • Saga Communications (SGA).

    We made no changes to the rules and no adjustments to the qualifying levels for capitalization size or the price-to-book ratio.


    The Coming Year

    As an election year, 2008 is still disappointing from a stock market point of view—even though Congress is spending liberally.

    Volatility—low for several years—is returning to long-term historical levels, and based on recent days it may be headed even higher.

    The Federal Reserve is being pulled in both directions—higher rates vs. lower rates—because of the balanced threats of recession (which dictates lower rates) and inflation (which dictates higher rates).

    On top of the usual problems, we have the price volatility of oil. I recently saw a survey of “experts” predicting the price of oil at $75, $140, $150, and $200 over the next year. Perhaps we will have all those prices.

    A Coming Recession?

    There have been strong arguments that a significant recession will ensue.

    However, if you accept this as a possibility or probability, it is still necessary to predict whether it will be a traditional recession or an inflationary recession if you want to make portfolio adjustments.

    While I find it difficult to predict the future and believe in a long-term portfolio approach, with maybe a little tweaking, many investors have already made or intend to make adjustments to their portfolios.

    But in the current environment, if you want to adjust your asset allocation you need to make an additional judgment concerning the type of recession the country is facing. That’s because in a traditional recession, stocks should go down and bonds should go up. If, however, we have an inflationary recession, then stocks may stay flat or even go up a bit, and bonds (as well as income stocks) will go down.

    It’s never easy.

    Even though the majority of respected gurus—including Warren Buffett—are predicting a significant recession, there is at least some probability of a different scenario that should be considered before making major changes in your asset allocation. It is possible that many of our major economic problems will lessen over the next year, or improvement will be anticipated.

    In an election year without a returning president, it is to almost everyone’s benefit to say how bad it is and how much we need change—regardless of whether that is, in fact, true.

    But imagine a different scenario:

    • The mortgage problems wash out;
    • Oil production from shale at $75 a barrel or from offshore at $40 being predicted and the first production steps underway;
    • Plug-in and fuel cell hybrids begin production, foretelling significant reduction in oil demand;
    • Politicians decide not to raise taxes;
    • More accurate analysis showing that Social Security is not in trouble but likely over funded;
    • Hostilities in the Middle East scale back...

    While I’m not predicting these occurrences, there is at least some probability of an emerging bull market in the not too distant future. Just to put this into perspective, I am writing this on a day the market is down about 3%, so I have to be a long-term believer.

    The bottom line is that it may be wise to stick with your long-term asset allocation or make minimal adjustments.

    Or at least realize that there is a probability of an inflationary recession or a deflationary recession with at least some probability of a quick and strong recovery. Remember that the stock market is a leading indicator and can move up or down months before actual economic events occur.

    We will next update the Model Shadow Stock Portfolio in the October AAII Journal; in the meantime, you can follow it at

→ James B. Cloonan