Dear friends,

I’m struck less by the sadness of their situations than by the tenor of their response: people chose to defy the darkness, rather than surrender to it. From early December through early January, virtually every European culture – Celtic, Norse, Roman, druidic, Christian – created a festival of light and a season of socializing. We don’t recognize the names of many of those festivals (Modranect, Dies Natalis Solis Invicti, Saturnalia, Mithrasmas, Karachun, Yalda), though most were centered on the Winter solstice which occurred on December 25^th on the old Julian calendar.

At one level, partying on the solstice made little sense – everyone knew that two or three hard months, perhaps the hardest months, were still ahead and that no new harvest would be seen for half a year or more. And yet, when surrender was probably the easiest option, folks universally chose to focus on the eventual good instead of the immediate hardship. An admirable decision perhaps?

And also a profitable one. While everyone bandies about Warren Buffett’s famous aphorism ("be fearful when others are greedy, and greedy when others are fearful"), there’s a rather less known observation from another fine investor. Shelby Cullom Davis was a New York investment banker, philanthropist and Ambassador to Switzerland, but also father of Shelby M.C. Davis (who founded the Davis and Selected funds) and grandfather of Chris Davis who co-manages Selected American Shares (SLASX). The elder Mr. Davis famously turned $100,000 in 1947 into $800 million by the time of his death in 1994. His aphorism was this: "Bear markets are when you make all your money. You just don’t know it at the time."

That advice makes some considerable sense regardless of what you’re investing in. Here are two simple examples derived from my day job as professor. My employer, Augustana College, has decided to do something remarkable: we’re hiring faculty. Hundreds of other colleges and universities, including many of the wealthiest and most renowned, faced with the gravest economic threat in living memory, have frozen their hiring in order to conserve resources. But not us. We concluded that this may represent a once-in-a-lifetime opportunity to hire folks who in any other year would have been drawn to Harvard or Dartmouth, Williams or Cornell. Because hiring a great faculty member pays dividends for 40 years or more, we decided the only rational course was to buck the bear market and invest boldly.

At the same time, my academic department has launched a major in Multimedia Journalism which will be one of the first in the nation designed from the ground up to accommodate the brave new world of interactive media, blogging, Twittering and ‘tubing. Given that conventional journalism is in the midst of the worst crisis in its history – publications are closing weekly, layoffs are universal, news budgets are collapsing and venerable institutions like The Tribune Company are in bankruptcy – you could be forgiven for concluding that we’re lunatics. We’d beg to differ: unless you believe that people no longer want access to current, reliable information about their lives, their world and their fortunes, journalism has a future. The best way to profit from that future is to invest now – in the darkest times – in the staff and programs that will allow us to grapple with, and prepare our students to shape, that future.

All of which is to say that neither the world of zero-yield Treasuries nor money markets paying a negative 3% (in inflation-adjusted terms) represents a serious option for long-term investors, regardless of how safe the decision appears in the midst of the storm.

One way that folks have chosen to defy the market’s darkness is by engaging the service of market wizards. These are folks who promise to rotate, allocate, derivate, strategize, opportunize, short or otherwise work magic upon your portfolio. Roy’s adventures with one such bunch -- market-timers whose actual performance was breathtakingly worse than their advertised record -- was documented in a series of stories over the course of a year. Over the next several months, we’ll be looking at the track record of related funds which have made similar promises to see if anything consistently works.

We’ll start this month with sector rotation funds. The premise is simple: there’s always a bull market somewhere, managers merely need to be willing to "let the trend be their friend." Rather than working with long-term macroeconomic themes ("the graying of America" or "a warming world"), sector rotation funds use mathematical algorithms to automatically move money out of decaying sectors and into rising ones. Back in February, market technician Michael Ashbaugh trumpeted the good news: "Sector rotation may drive [the] next market upturn." His Marketwatch story (published 2/4/08) was adorned with seven complex price charts with "shoulders" and "necklines" all neatly circled.

The marketing literature for the Claymore/Zacks Sector Rotation EFT (XRO) is pretty typical of the genre:

Simple: get out before the plane crashes! Four funds have placed "rotation" in their names:

There’s also reportedly an XTF Sector Rotation ETF but I can’t track down any useful information about the danged thing.

So how are our sector rotators doing? I measured them against the simplest possible benchmark: Vanguard Total Stock Market index (VTSMX). VTSMX is the ultimate "stand in the middle of the road and take your hits" fund that seeks to replicate, without bias toward size or valuation, the entire U.S. market. It is, at the very least, cheap: 0.15% when you buy the fund and 0.07% if you buy the ETF version.

I measured the sector rotators two different ways: total 2008 return versus the total market and win or loss in each of the past eight quarters against the market. Here’s the scorecard:

Bottom line: every sector rotation fund underperformed a simple buy-and-hold-it-all strategy in 2008. On average, the funds outperformed the market half the time and underperformed half the time. On the other hand, the funds’ all did outperform the market in 2007. On the other, other hand, the only two funds around in 2006 (Rydex and MFS) substantially trailed the market. But they did lead it in 2005. Which is to say, if you’re looking for performance consistently better than the market’s, you won’t find it in the short record offered by sector rotation funds.

But maybe things will look bright next month, when we look at the work of "the tactical allocation" wizards!

On December 22^nd, "Ralph" launched a spirited discussion on FundAlarm’s Discussion Board with this announcement:

Ralph’s entirely-sensible observation echoed many of the critics of active management: almost no one has enough actual talent to win over the market in the long-term. His option was Vanguard STAR (VGSTX), a fund-of-funds that typically has 60% of its assets in stocks and 40% in bonds. STAR has three distinctions worth noting: (1) its underlying funds are chosen from among Vanguard’s best actively managed funds; (2) it offers Vanguard’s lowest investment minimum -- $1000; and (3) its 0.32% expense ratio puts many index funds to shame.

While STAR is a consistently excellent performer – Morningstar awards it four stars for the 3-, 5- and 10-year periods – you might want to note two other potential off-ramps from the rat race. Fidelity Four-in-One Index (FFNOX) is another four-star performer that simply holds about 55% of assets in Fidelity Spartan 500 Index, 15% in Fidelity Spartan Extended Market Index, 15% in Fidelity Spartan International Index and 15% in Fidelity U.S. Bond Index. It has a 0.08% expense ratio but a $10,000 investment minimum. Investors with smaller pocketbooks might consider AARP Moderate (AAMDX), which holds 50% in a bond index, 40% in a US stock index and 10% in an international stock index. While the fund charges more than the others -- 0.50% annually -- its investment minimum is the lowest around: $100 for a one-time investment, or $25 with an automatic investing plan. The fund is not yet rated by Morningstar.

Marketwatch’s Peter Brimelow recently reported on the newsletters which were the "Ten Worst Performers of 2008" (12/23/2008 ). "The Terrible Ten" includes two newsletters published by mutual fund managers. Louis Navellier's Emerging Growth newsletter clocked a loss of 57.6% through the end of November while Jim Oberweis’s Oberweis Report cost its investors 63.4%. Oddly, though, the flagship funds for both of the managers outperformed their newsletter recommendations by about five percentage points over that same time period. The gap is even larger given that the funds bear expenses that the newsletters’ hypothetical portfolios do not.

Which leads you to wonder: do these guys take their own advice? Or, take it with a grain of salt?

Briefly noted:

Baron International Growth is now open to business. It will be a diversified fund that invests in developed and developing countries, with emerging markets exposure capped at 30%. It "expects to focus on small- and mid-sized growth companies with market capitalizations of $10 billion or less." As with all the Baron funds, they look for companies whose stock has the "potential to increase in value 100% within four to five subsequent years."

As of December 15^th, Wasatch officially relaunched the very fine 1st Source funds as Wasatch-1^st Source funds. The management teams, disciplines and expenses remain intact.

On the particularly bleak morning of the Winter solstice, I was rudely awakened just after 6:00 a.m. (well before dawn) by the Quad-Cities' local stock shill ("investmentgurumarketwizard" Jim Victor, Senior vice president for wealth [sic] management at Citigroup - Smith Barney in Davenport, a major local booster and market ... uh, optimist) who announced "the one month anniversary of the New Bull Market in stocks." I don't know if the guru actually believed this (in which case he might be an honest journalist, but a bad investor) or if he thought that encouraging investor confidence was so important that he didn't care about the truth of what he was saying (in which case he was a dishonest journalist, but perhaps doing the job of a loyal Citigroup employee). Neither alternative offers much hope that we've learned anything yet.

We should note that FundAlarm lost one important funding option in the past month: Amazon shut down its Honor System, by which individuals could contribute to worthy recipients of their choice. The only way for FundAlarm to access the Honor System’s replacement is to become a 501(c)(3) (i.e., non-profit) organization, which would be a long, relatively expensive, and surprisingly tricky proposition. Fortunately, Amazon hasn't discontinued its Associates Program, which is what pays FundAlarm a percentage of your Amazon purchase each time you buy an item through FundAlarm's Amazon link . One option for those of you with book-buying (or DVD-, Blu-ray-, television- or grocery-buying) friends is share the FundAlarm link with them.