AB Analytical Services

Is December the New January for Small-Caps?

The "January Effect" is one of the very few well-studied seasonal trends that has persevered the test of time, though it has clearly lost a bit of its punch in recent years.  According to Wikipedia, it was first noted by Donald Keim, who published a paper in 1983 as a grad student at the University of Chicago, but there were other studies prior to this one that noticed peculiar excess returns for stocks in January in markets around the globe.  The basic theory is that smaller stocks fare poorly at the end of the year but rally sharply in January.  Most of the original research attributed this anomaly or inefficiency to tax-loss harvesting.  Three weeks ago I noted that Small-Caps were getting hammered relative to larger companies.  I mentioned the traditional tax-loss selling but also the sharp decline of the dollar (larger companies tend to be net exporters) and what I think is actually the most powerful dynamic:  hedge-fund repositioning.  Those comments were a bit early, but, since the beginning of December, smaller stocks have surged as you can see in the chart that I have updated below:

The S&P 500, the NASDAQ, the NYSE and the Dow Jones Industrial Average all put in new highs Friday, but the Russell 2000 needs to rally about 4% to take out what had looked like a double-top.  It will be interesting to see how it plays out, but I think that a strengthening dollar trade will help smaller companies recover some of their recent and still large relative losses since the beginning of this quarter.

I want to share my perspective that the old "January" trade may actually be moving up a bit in the calendar.  I believe that the increasing importance at the margin of hedge-funds is the underlying reason, as they typically exploit their research most effectively in smaller companies.  Given the large trend in recent years towards performance-fees, it isn't surprising that we might see some net selling by that group as we near the end of the year.  This is just a theory, but other investors may be stepping into relative weakness that exists as the year comes to an end.  The cynic in me also thinks that a lot of the cash that has been raised in this process is redeployed to result in a good mark at year-end too.  In any event, the table below, which looks at the returns over the past decade for the Russell 2000 and compares them to those of the Russell 1000, seems to demonstrate this acceleration of what used to be a January trade:

Even excluding the off-the-charts Januaries from the past two years, the trend is clear:  Small-Caps do better in December than January typically while picking up more relative performance earlier too.  Our sample size is too small to be statistically significant, and the effect isn't 100% of the time, but 7 of the past 10 years have seen better relative Decembers than Januaries.

We are already off to the races this year, and perhaps I will have to start talking about a November effect instead of a December effect next year (once everyone figures it out!).  I am not sure how it plays out.  It does seem reasonable to expect the Russell 2000 to test resistance at 640 (up 6% from here), and that could certainly happen this month.  On the other hand, maybe the double-top, which still stands in divergence to the rest of the market, will prove to be real.  In that scenario, I wouldn't be surprised to see dollar strength, suggesting perhaps that smaller companies hang in better as the market fades.

In any event, I have positioned the portfolio I manage to take advantage of improving relative outlook for Small-Caps.  The largest holding is under $4 billion, and the median market capitalization is under $600mm.  My Top 20 Model Portfolio, which is up 59.5% this year, has a median market capitalization of under $800mm with just a single stock greater than $10 billion.

Disclosure:  No stocks mentioned

Small-Cap Smackdown: Russell 2000 in Reverse

Smaller stocks have spent Q4 correcting while the rest of the market has seemingly confirmed the primary bull trend (or are we still calling this a bear-market correction?).  Since month-end, the Russell 2000 has bounced back a bit from its October thrashing, but the index is down about 3% QTD while the S&P 500 has rallied over 3.5%.  While smaller and larger stocks don't always move in lock-step, it is quite odd to see them move in opposite directions.  As you can see in the chart below, the R2000 looks a bit toppy (or is it building a base for a year-end run?):

The relationship has been fairly tame all year, with a nice run from the market low in March through September favoring smaller stocks. Since peaking in mid-September, the Russell 2000 failed once to take out that high and has now clearly lagged by giving up over 1/2 its relative advantage over the past year in a brief period.  What's going on?

I believe that three factors have been influencing the recent underperformance, including the strength of the dollar, hedge-funds locking in gains potentially  and tax-loss selling/window-dressing. 

As far as the dollar, which has recently moved sharply back to the lows of a year ago, larger companies tend to have more of their sales and earnings coming from overseas than smaller companies.  I reviewed the data over the past few years, and there is a general correlation (though the very volatile action a year ago certainly questioned the relationship). 

My theory on hedge-funds is just a hunch, but one in which I have confidence.  Most hedge-funds are up big this year.  Their incentive fee structure encourages them to reduce risk as the marking period comes to an end.  Given that they are generally long smaller stocks, where their research efforts carry more impact, it makes sense that they would be selling out smaller stocks to reduce positions. 

Finally, selling pressure from tax-loss selling and window-dressing traditionally takes a higher toll on the less liquid smaller stocks (i.e. the "January effect", one of the few seasonal trades confirmed by researchers).

I last wrote about smaller stocks making more sense than larger ones just a bit early in late January.  The call ended up being right, but for the wrong reason I suppose. In any event, the relationship is back to where it was then, and I believe that this could be an opportunity.  Specifically, in a market that is relatively overbought, there are many smaller companies that are quite oversold due to tax-loss selling and perhaps window-dressing.  The portfolio I manage has a few of these!  I have been adding to some of these names in my model portfolios as well.  Additionally, there are many stocks that are in a corrective phase but that look attractive.   

I believe that as the calendar turns, investors will be taking a closer look at laggards as well as increasing their tolerance for illiquidity that is typically associated with smaller stocks. Smaller stocks typically have slightly higher PE ratios but are valued similarly to larger ones on a debt-adjusted basis.  I guess I am looking for the January effect to work, but noting that sometimes it comes early. 

Disclosure:  No stocks mentioned 

3 Consumer Stocks That Could Fall by a Third

The long-awaited correction appears to have finally arrived.  Like a yo-yo that has climbed up sharply and is now heading back down, this fall will probably not be as sharp or as deep as many pundits would suggest.  I am going with a SPY target of 87.50 to 92 as the most likely bottom for this move.  For those that follow my work, you may recall that this happens to be the area that I initially thought would contain the rally from March.  Clearly I was too conservative.  I get to my zone using several different metrics, including Fibonacci retracements as well as charting and volume-at-a-price.   To be very successful in the last few months, one had to set aside one's fundamental views in my opinion and roll with the liquidity.  As long as interest rates aren't rising, I do believe the pullback will be orderly and contained, but the bear is back on if we can't finance our federal debt at a low cost.

Even though my expectations are that stocks in general have about 15% downside from here (two weeks or two months - who knows), I believe that many stocks have considerably more risk.  In the past few months, companies with leveraged balance sheets have roared back as the capital markets have reopened.  Many companies have addressed liquidity issues by extending their debt or issuing stock, but several others have not taken advantage of what I view as a good opportunity.  I am cautious on companies in general that have high levels of debt relative to their potential to generate free cash flow, especially in an environment of economic weakness or stagnation at best.  With that in mind, I want to share three ideas, all of which have lots of debt relative to FCF and short-interest that has come down significantly over the past several months.  None of these companies had moved to address their weak capital structures.

Weight Watchers (WTW) is a broken company in my view.  I have written about this one before, and it has had the least recovery of the three that I am discussing today.  I think the tell is that it trades at 10PE - clearly big money doesn't believe those numbers.  The problem is that if the numbers aren't right, the debt becomes a problem.  They report next week, so we shall see.  As of 6/30/09, the company had debt net of cash of about $1.5 billion.  The company's FCF is essentially its net income, so this year, last year, next year and the year after all look about the same:  $200mm.  The company repurchased so much stock that it left its equity negative.  In a harsher environment, the debt will become a burden in my opinion.  I think that this one could see an earnings miss which could drive the price back down towards the 52-week low below 17.

Collective Brands has been more than a 5-bagger off the bottom, and I don't get it.  Since April, the estimates for 2010 have increased 5% yet the stock has doubled.  I do know that shoes had a good quarter on pent-up demand, but this is a company that can ill afford a weak economy.  The company is spending significantly less in CapEx this year as it retrenches ($85mm, down $44mm), so FCF conversion will be healthy this year:  NI of approximately $70mm, D&A of approximately $140mm and thus $125mm of FCF compared to $119mm last year.  Not bad for earnings being down so much.  The problem is that total debt less cash is about $500mm.  If the FCF were sustainable, the burden wouldn't be that great, but the company is unlikely to grow if it continues to shrink.  I look for this one to test 12.

My last pick  for a potential sharp decline is Carnival Cruise Lines (CCL), which typically doesn't produce significant levels of FCF.  The stock has rebounded 100% off the lows.  I sense that this business will be challenged for years to come.  While the $8 billion in debt seems to pale in comparison to the equity and the market cap, it is important to realize that the multiple of FCF is tremendous.  I expect this one to test the 20 area again.

 

I do believe that this pullback won't be as indiscriminant as the decline earlier this year or the rally, with companies with better capital structures and less aggressive earnings ramps performing better.  As always, you can check out my disclosure to learn more about what I am thinking from that perspective.

Disclosure:  No position in any stock mentioned

Large Stocks Could Lead the Market Much Higher

A few weeks ago, I was participating in a research meeting with one of my clients.  The most bullish in the bunch, who has been that way since May, was trying to make the case that stocks are attractive.  While they typically focus on small companies, we were going through big stocks, one at a time.  Sure enough, every time we looked at one, it seemed pretty attractive on a PE basis compared to its history.  More recently, we were focused on stocks near their all-time highs, some of which happened to also make the list in the prior discussion.  As one who has been reluctant to embrace this rally as sustainable, I can't deny what is plain and clear:  Big stocks are potentially cheap and technically capable of extending their rallies.

I continue to think that the economy will be challenged for quite some time and that the earnings estimates out there are too optimistic.  But what if I am wrong?  If rates stay low and earnings recover, what is the upside?  What follows is a simple excercise.  I took the largest 20 stocks in the S&P 500.  Here they are ranked in descending market cap:

The combined market cap of the top 4% of the index represents about 1/3 of the total market cap of the index.  As you can see, the typical forward PE is 15X, though the median for the past decade has been closer to 19.  Furthermore, if one looks out two years, the current median PE is about 12 (as earnings are projected to rise substantially in the following year).

In the table below, I projected the total return for each stock by assuming that a year from now it trades at its 10yr median PE and earns its current dividend.  I then added up the total returns by their contributions and, as you can see below, got an astounding one-year return of 53%:

Again, while this is not my prediction, I do accept that PE ratios should be high when rates are low and when earnings are closer to trough than peak.  So, if companies hit the projected earnings and multiples rally to median levels, just these 20 stocks could propel the market higher by almost 18% (33% of the market up 53%).  I don't believe that smaller stocks wouldn't rally as well - the same dynamics are at work,  though perhaps to a lesser extent.

So, absent higher interest rates and/or companies failing to meet projections over the next two years, a reversion to the mean would fuel a massive rally.  I have not embraced this potential, but my eyes are certainly open to it.  The market made two horrible mistakes earlier this year:  Overestimating earnings declines and placing low multiples on trough earnings.  Surely we could be overestimating the recovery now, but the multiples are certainly not extreme in the other direction.  I found it helpful to look at these stocks one by one.  If you click the link below, you can go through the 10 largest stocks and see what the PE history and price history look like. I have included the targets that are derived from the exercise of reversion to the median.

 Download Top 10 S&P 500 Stocks

While some stocks don't seem likely to perform as well as the exercise might suggest, others appear capable of doing even better.  If the worst is behind us and better times ahead, stocks could have an even better year in 2010 than they have in 2009.

Disclosure:  Long JNJ and CVX in a model portfolio
 

A look at Q3 Equity Returns

The 3rd quarter was one that saw an obviously quite strong continuation of Q2 trends in general, but the performance wasn't as uniform as in the 2nd quarter.  As you can see in the table below, which allows us to look across capitalizations by sector, there were some stellar performers as well as some really weak areas.  I have color-coded the entries to reflect relative performance of the sector to the overall index price return, with a 5% differential for Q3 and a 7% differential for the YTD:

First, looking at the overall returns, the Mid-Caps trounced both the smaller and larger stocks once again.  Russell data confirmed this trend yet again.  On a YTD basis, the performance has been stellar.  For the quarter, "Value" beat "Growth" across capitalizations, though "Growth" maintained its clear year-to-date lead.

Looking at the S&P 500, Energy stocks did poorly and remain one of the weaker groups YTD.  Clearly, this weakness is confined to the very largest companies, as Mid-Cap and Small-Cap Energy companies flew this quarter and are among the better performing sectors in 2009 for the S&P 400 and the S&P 600.  I pointed out this opportunity earlier this year but admit to jumping off the bandwagon way too early. In any event, the weakness in the S&P 500 Energy stocks is quite misleading, as the median returns on the quarter and YTD respectively are 19% and 37.5%.  The issue is that 3 of the largest members, all integrated oil companies and representing currently over 1/2 the market cap of the sector, are still down YTD. 

Materials had a great quarter across the board, and the sector is one of the strongest thus far in 2009.  Not a single stock declined on the quarter. This sector is highly leveraged typically, and it looks like the best names this quarter and this year are the ones that performed the worst last year.

Industrials performed better for Large-Caps than the smaller companies, with 10 of the 56 names, including the very largest, General Electric (GE), up in excess of 40%.  Interestingly, the sector remains a laggard YTD, especially in Small-Caps.  I believe that there may be an opportunity in some of the smaller names and have my eyes on a few.  One factor may be the recent weakening in the dollar leading to some macro trades that have helped bigger stocks but not the smaller ones.

Consumer Discretionary, which was so hot early in the year, did a nice job in essentially keeping pace to slightly outperforming.  Some of 2008's biggest dogs continue to put up very strong returns.  It is very clear in the chart below that the bigger the fall, the higher the bounce:

Consumer Staples had a lackluster quarter, not surprisingly given the big rally.  Interestingly, the Small-Caps have been a strong performer on the year.

Healthcare was relatively weak in all market caps and remains far behind the benchmarks on a YTD basis.  I have a very high weighting towards Small-Cap Health and am hopeful that this sector becomes better appreciated for its strong balance sheets and potential growth.

Financials were the best Large-Cap sector.  While the smaller companies did well during the quarter, they remain very weak  on a YTD basis.  Representing over 17% of the total index, S&P 600 Financial stocks could be ready to play some catch-up this quarter, as they are down YTD still.

What can one say about Technology?  The sector kept pace during the quarter and remains exceptionally strong on the year.  With strong balance sheets and high international exposure, it's not surprising that the sector continues to draw a lot of focus.

Telecommunications Services, outside of the S&P 500 members, is a tiny component of the indices. 

Utilities have been poor performers across market capitalizations.  In addition to higher Treasury rates this year, there has been some concern about regulation.

Disclosure: None

Enough Already: The Rally is Over

OK.  I said it.  The Rally is over.  What a rally it was.  While it may live on a little longer, I think that its days are numbered.  It's easier to call the economy than stocks, and the economy has been experiencing a dead-cat bounce.  I have some charts that I looked at recently, and I think that the likelihood of a normal post-recession bounce is very low.  Take a look if you disagree.

Stocks, though, they are much harder to call.  This market has advanced much further than I expected, but I am starting to see some divergences.  Emerging markets and High Yield failed to make new highs in the middle of August and closed below the 10dma this past week.  The NASDAQ is looking tired - 3 "distribution" days (per Investors Business Daily) in the past 8. 

Here is what I am seeing that makes me confident that the days of this rally are numbered (besides the divergences):

• Massive collapse in short-interest
• Equity offering floodgates are about to open
• Insiders are selling
• Even the strongest companies financially aren't repurchasing

I don't know how much further this thing rides on fumes, but I expect the action late in the year to be negative.  Hedge funds, the "at the margin" players, will be looking to lock in profits (collect fees) as we sprint to the finish of this wild year.  My guess is that they will be selling, as most are up year-to-date.  They may be "underweight" but they are long.

I am sticking to my initial call of "down 15-20% for the year", though perhaps I was a bit too pessimistic.  Finishing the year down 10% would imply a return to S&P 500 to 812.  This would be a 58% retracement of the "Big Rally".  Maybe that's too aggresive, but I believe it is directionally correct.

Disclosure:  No securities mentioned

Chase Momentum at Your Own Peril

I am a huge fan of Investors Business Daily and expect that many of you are as well.  For those not familiar with the paper run by the legendary William O'Neil (Daily Graphs), it is very technically oriented compared to other business dailies (i.e. the WSJ).  While I really appreciate the work that they do regarding overall market direction, the most interesting benefit I derive is idea generation for small-cap names.  For IBD, it's all about momentum.  In rising markets, momentum works, but in sideways or down markets, it can fail miserably.

IBD publishes an index of the top 100 companies in its universe in terms of earnings and price momentum, the IBD 100.  Here is the official definition from their website:

IBD® 100 Index

The IBD 100, which runs every Monday in the IBD newspaper and can be found in the Screen Center on Investors.com, is a computer-generated ranking of leading companies trading in the U.S. Rankings are based on a combination of each company's recent profit growth record; IBD's Composite Rating, which includes key measures such as return on equity, sales growth and profit margins; and relative price performance in the last 12 months. "Quarters of rising sponsorship" counts quarters in a row in which more mutual funds have purchased a company's shares than have sold shares. A company's inclusion in the list should not be viewed as a recommendation. Many are newer, smaller and highly volatile companies that require further research due to their speculative nature.

The performance, perhaps not surprisingly, has been absolutely horrible this year.  With the S&P 500 and the Russell 2000 both hugging the flatline, the IBD 100 was down 11% YTD as of 7/13 and is down almost 52% over the past year.  While I haven't done a scientific study of what's going on precisely, yesterday's implosion of one of its 100 members, American Dairy (ADY) offers some insight:

I view the dismal performance of this index over the past year and especially as it continues more recently as a sign that the overall market is starved for real growth opportunities.  A company that seems to have traction attracts momentum investors but succumbs to the pressures of the overall economy, leading investors to head for the exits.  The cycle of jump in, pile on, jump off seems to be dogging the index and the overall market. 

So, as long as the IBD 100 continues to lag, I will be very cautious about chasing momentum and continue my strategy of buying weakness and selling strength (works very well in a sideways market).

Disclosure:  No position

2010 should be an "L" of a year

Thursday's payroll report led to some of the worst market angst we have seen since the big rally started, with the market plunging into its third consecutive weekly decline.  While the numbers didn't strike me as anything really that different from "more of the same", neither did the previous few that seemed to encourage some market participants.  I was pretty lucky to be a bear who was aware - aware that the market was quite overdone in March (and February too!).  For those who follow my views, I had expected an interim low in the market in the March/April time-frame, but at slightly higher levels that we ultimately reached.  Then again, the market stretched further to the upside than I expected when I  projected more a big rally in mid-March after having "Sponge-Bob" called the low in early March as one of the first to note the irony of the "666" low .  When looking at the markets, it's very important to remember that stocks are much more volatile than the economy:

See what I mean?  Over the past 62 years, stocks have increased a few points more than the nominal economy on an annualized basis, but the annual returns have been +/- 5-6X the median GDP growth at the extremes.  So, it doesn't seem that implausible that the stock market has round-tripped an almost 25% move as the market incorporated slowing sequential GDP decline.

We are half through the year following the worst stock markets in most of our lives.  I am sticking to my forecast that we end the year down.  My original forecast suggested that we would rally in Q2 (which we clearly did), but make a new low in Q3 before experiencing a strong Q4.  At this point, I am not that sure that the March low doesn't hold, but I do expect a move to at least 800 on the S&P 500 and wouldn't rule out significantly more damage.  Before reviewing where we are in the big picture as far as correcting the major economic imbalances as I have described for quite some time, I want to take a very long-term look at the employment situation.  I am not in the "V" but in the "L" camp.  I think that Obama's responses and the actions of the Fed could very well avert Great Depression II, but our best case is to see the economy growing by the next election in 2012.  Deleveraging has to happen, and it will take some time.

Unemployment is a symptom, not a cause.  We are "over-stored" and suffer from an abundance of goods (relative to true wealth rather than borrowing capacity).  Unfortunately, it is a symptom that feeds into a negative feedback loop.  The higher it gets, the worse the credit situation becomes.  In the chart below, you can see that this is clearly becoming the worst labor market in generations.  To answer the question in the bottom panel, we are a maturing economy.  The "good times" didn't lead to high employment growth, and the "bad times" are leading to off-the-charts reductions:

The worst part is that we continue to see the duration of unemployment extend:

It's going to get worse.  Employers are trying to retain workers by chopping wages and hours.  I will be surprised if the average wage doesn't decline year-over-year at some point in 2010.  Employers were reticent to fire in most of 2008 and certainly recognized the high inflation in prices their employees faced then.  Neither of these is the case at this point, as inflation is plunging and employers aren't shy about slashing payrolls.  As a generalist who follows many companies from varying sectors, it is clear to me that head-count reduction is the rule not the exception:

So, the tick up in unemployment and in negative payroll growth along with the cut in hours worked and the flattening in overall wages not surprisingly roiled the market.

The market is starting to focus on 2010, which is just 6 months away.  As usual, the analysts appear WAY too optimistic on earnings.  According to S&P, the S&P 500 company earnings based upon the aggregation of company consensus estimates are expected to rise a very strong 33% to $74.  This would leave them 10% shy of 2007 earnings but 50% above 2008 trough earnings.  Where can I buy some of that stuff?

As I have written before, we won't resume strong economic growth until we see:

• Housing prices stabilize
• The savings rate normalize
• Deleveraging for banks, corporations and state & local governments near completion

Housing prices have stopped accelerating in their decline, but they remain steeped in a downtrend.  I follow Case-Shiller for lack of any better metrics, and they continue to indicate that most large markets are down close to 20% year-over-year.  Until unit demand stabilizes, this won't happen.  It is worthwhile remembering that the affordability has probably never been greater - low interest rates, government incentives and lots of desperate sellers.  With so many years above the mean, I will be shocked if unit growth isn't slow for the next several years:

Folks aren't spending like they used to - funny how unemployment and contracting credit mix:

Spending is declining due to payroll slashing and the remaining workers trying to build savings.  To me, this looks like another couple of years of headwinds for the economy and tells me corporate bonds are probably the place to be relative to stocks.

The final area is deleveraging.  I don't have a pretty chart - sorry.  I think that we have only started this process.  I noted in May that the floodgates had just opened, and we have seen a ton of equity issuance since then.  All this stock for sale is quite the reversal from the massive repurchasing that was going on up until Q3-2008.  This action should help stave off Armageddon, but it will keep prices under a lid.  Look for higher interest rates and equity dilution to rob from EPS growth.

So, the bottom line is that the economy will limp along at best.  I can't yet offer a 2010 stock outlook because I don't know how the rest of the year will shape up.  I tend to discount my original forecast of a new low in the 3rd quarter, but I learned last year and earlier this year not to be surprised to the downside.  That's the risk in a deleveraging economy.  In any event, I don't expect the S&P 500 to break 1000 over the next 18 months.

Disclosure:  No stocks discussed

Q2 Stock Returns by Sector and Market Cap

What a quarter it was!  As I predicted near the beginning of the year, Q2 was the first positive one for equities since the summer of 2007.  I was obviously a bit surprised with the extent of the rally, as I had been looking for the S&P 500 to find a peak in the range of 860-920.  I expect that stocks will decline this quarter as we backfill.  My outlook hasn't really changed from the beginning of the year - still looking for "the" bottom in Q4, though it may very well be that the March lows ultimately hold.  I am not ready to share my outlook for 2010 (as it depends a lot on what happens in the next few months), but I expect a dull market at best as the economy remains pressured.  If we don't back up now, I predict it will most likely be a tough 2010.

In the chart below, I have arranged the returns of each of the economic sectors by market cap (Large-Cap, Mid-Cap, Small-Cap).  I have color-coded it so that green represents a 5% excess for the quarter relative to the underlying index and 7% for YTD.  Similarly, red represents a 5% short-fall relative to the index for the quarter and 7% for YTD:

Source:  Standard & Poors

The first thing that jumps out at me is the stark difference in the returns across market capitalizations for Energy, with S&P 500 declining 10% while S&P 600 increased 40%.  Anyone familiar with my contributions might recall my article from March 28th pointing out this opportunity.  I think that the trade has probably gone too far the other way at this point and am cautious on smaller Energy names.  The second thing that begs attention is that Technology extended its relative gains across capitalizations.  This performance is quite impressive given that the market conditions were essentially mirrors in the two quarters.  Technology is at or near the top in all capitalizations, especially so in Large-Cap.  The final general observation I care to share is that Large-Cap Staples and Health performed starkly differently than in Mid-Cap and Small-Cap.  I tend to think that this is a function of "big money" increasing its risk profile, essentially "buying beta". 

During the quarter, smaller names tended to do better than larger names generally. I have already mentioned Energy's behavior.  Interestingly, while it has lagged YTD for the S&P 500, it is one of the strongest sectors for other capitalizations.  I mentioned earlier this year that I favored the sector for its better-than-average balance sheets.  In Materials, Small-Cap surged but remains a laggard on the year.  I believe that this action reflects how cheap it got in Q1.  Industrials are the weakest area in the S&P 500 YTD despite some "catch-up" this quarter.  I continue to believe that this sector will underperform due to the stretched balance sheets of the larger companies with captive finance arms.  Consumer Discretionary was uniformly slightly stronger than the overall market.  In smaller capitalizations, it remains one of the leaders on the year thus far.  Staples are somewhat of a conundrum, with Large-Cap and Mid-Cap suffering during the quarter relative to the Small-Caps, which were able to keep pace with the index.  One advantage that the smaller names have is better growth profiles.  Also, they tend to have better relative balance sheets.  YTD, this has been a hot sector outside of the S&P 500.  Healthcare was in line outside the S&P 500, which was weighed down by a weak biotech tape.  I personally hope to see the S&P 600 return for this sector elevate relative to the market, as I have about 1/3 of my equity exposure in those types of names.  Financials were extremely strong for the S&P 500 but quite below average for the smaller capitalizations, reversing out the relative performance over the past year or so.  The sector continues to lag the overall market across all capitalizations (anyone else see the yellow flag waving?).  Additionally, it is pretty clear that smaller institutions are now struggling with deteriorating credit.  Tech - yowsa.  They win in a bear market, they win in a bull!  I mentioned early in the year that the sector has one of the strongest balance sheets generally, which helped in Q1.  Beta-grabbing helped in Q2.  My editorial comment is that this is a mean-reversion waiting to happen (I own none personally or in either of my model portfolios).  The final two sectors, which are pretty small, suffered for different reasons.  Telecomm Services is reflecting a competitive pricing environment and very leveraged balance sheets, while Utilities got hurt by the beta trade as well as the rise in long-term interest rates.

Disclosure:  No stocks mentioned

Sector Review: Energy Moves Toward the Lead

Everyone knows how well Tech is doing this year, but May was the month for Energy to make a run at leadership:

 

You may recall that I highlighted an opportunity in small-cap Energy stocks near the end of the 1st quarter, so the 54% QTD move is gratifying.  This is a sector that I had highlighted early in the year as likely to perform well due to the superior balance sheets among its constituents.  At this point, I am thinking that the larger names look a bit better.

Small-Cap Consumer Discretionary stocks were too cheap at the beginning of the year, but they are overdone to the upside now.

Financials have been strong in large-caps but not in small-cap.  Is this an opportunity?  Probably not, as the fundamental outlook for smaller banks is deteriorating with the commercial real estate market.  The relative difference is rather extreme, with S&P 500 stocks up 38% QTD but S&P 600 stocks down 10%.  Don't chase it!

Utilities may be a great contrarian play now.  With Treasury yields rising and concerns over regulation of carbon emissions, the sector has been under pressure.

Disclosure:  No stocks mentioned