The month of September was tumultuous. Equities continued to languish, driven lower by the ongoing Eurozone crisis and weakening global growth prospects. For the month, the S&P 500 fell over 7.0% and international developed markets fell by nearly 10.0%. Our domestic equity accounts, on the other hand, fell by only 3 to 4%.

The last five months should make the logic of our “value” strategy all the more clear. While our equities performed in-line with the market during the last two years of strong positive returns, they have handily outperformed the S&P 500–by nearly six percent–during recent market weakness. That’s our overarching goal: keep pace during strong years and earn our keep during flat or down markets. That is, outperform the benchmark over a full market cycle, including peaks and troughs.

A strategy that places greater focus on capital preservation works so well because math is on its side. Take two portfolios, A and B. Portfolio A rises 100% in year one and then declines by 50% in year two. Portfolio A will finish at the same level it started. Portfolio B does exactly half the returns of Portfolio A. Portfolio B rises by just 50% in year one and declines by 25% in year two. Where does it stand at the end? Portfolio B will still be up 12.5% because although it rose substantially less than Portfolio A in year one (the kind of underperformance that would get most managers fired), it fell half as much in year two and outperformed Portfolio A by 12.5% at the end of two years. Negative returns are much harder from which to recover than merely lagging the market’s strong returns during up markets. For this reason, we always manage our downside.

Portfolios outperformed their benchmarks again in September, led by outperformance in our domestic equities. Our international positions underperformed during the month–not unexpectedly–as ETF supply/demand dynamics are often altered by large market moves (in either direction) and can become detached from the tracking index’s actual performance for a time. Our fixed income underperformance, while in our opinion also transitory, was due to our positioning and not temporary market imbalances.

Our fixed income holdings are diversified outside of the Treasury market. In fact, the Barclays Aggregate has an average of eight times more exposure to the Treasury market than our current positioning. The average duration of long-term Treasuries implies potential 20% price declines if rates were to rise a mere 1% on the long end of the yield curve. There is no doubt that soft economic data and Fed intervention are for now holding down that very section, but the possible reward doesn’t justify the risk, in our opinion. Treasuries have rallied on investor fears and as such we have for now ceded ground to the bond benchmark. But as Treasury rates normalize in the years ahead, we should recapture this relative performance.

Broad equity market valuations have improved with recent market weakness, although they remain stretched by historical standards when one uses metrics that consider normalized profit margins. But we aren’t buying the domestic market; we own a basket of individual companies. As such, our domestic equity portfolios offer ample value at today’s prices. Long-term annual returns should be below the oft-quoted 10%, but adequate enough to outperform fixed income securities over the next three to five years, barring a major recession.

Economic data remains mixed. National manufacturing surveys improved from the weak readings in August while real retail sales and real personal consumption expenditures both fell last month. Employment has continued to grow, but at an uninspiring pace. Rail traffic shows modest expansion and initial claims have held in a tight range. Put simply, data is weak but not recessionary–yet. Any exogenous shock, such as a new financial crisis in Europe, could swiftly change that.