After four straight days of rallying, with the market moving to the mid-point of the range since the market peaked on 5/2, things look a lot better at the close of the quarter than they did just a week ago. Here is how we look:
Top 20 has returned to a marginal advantage over the S&P 500. For the month, the model lost 2%, 0.33% more than the S&P 500. For the quarter, it lost almost 3% compared to a 0.1% return for the S&P 500. The model had a horrible May, and I have addressed those issues previously. While smaller stocks, where we have some exposure, did worse than the overall market (especially the really small ones, where we are highly exposed), the fact is that we have had too many turnarounds or value-plays that aren't panning out, at least yet. During Q3, we had too many losers, with 3 names falling more than 20%. Historically, the model has bounced back sharply from weak months or quarters relative to the market. In fact, we have underperformed exactly one quarter in each of the years since we launched in 2008.
Looking at how we are structured currently, we have recently increased our exposure to "growth" after being a bit too exposed to "value". Of the 20 names we own, just 3 are in the S&P 500. Our median name has a market cap of $1 billion compared to the S&P 500 at over $11 billion. We have our highest weightings in Industrials followed by Technology. We are also slightly more exposed to the Consumer Discretionary sector than the market. We are most underweight Financials and Energy. Our overall exposure to less cyclical sectors, like Health, Utilities, Consumer Staples and Telecommunication Services, is quite low, which hurt performance during May and June. Our holdings are based on picking stocks, not sectors, but I do monitor our exposures for risk control. As an aside, I would like to own more Financials - it's a challenging area for me personally to pick stocks. We continue to have stronger balance sheets than the overall market - just 3 names have more debt than cash. Our valuations are slightly higher than the market with our recent additions of two growth companies.
Conservative Growth/Balanced returned -0.5% in June, .67% above its benchmark of 60% stocks and 40% bonds. For the quarter, it gained 1.96% compared to a .94% increase in its index. We reduced our exposure to bonds during the quarter and were underweight the entire time, which hurt performance modestly. While we had a few names pull back sharply, we avoided any substantial losses. Some of our Mega-Caps performed quite well, and we had more exposure to non-cyclical names here too (it is "conservative"). I am very pleased with the performance in light of the tough conditions during the quarter.
We currently hold 13 stocks, only two of which have more debt than cash. 8 are in the S&P 500, and we have a median market cap of $29 billion, which is well above the S&P 500. Our dividend yield is 2.4% compared to 1.8%. Here our sector exposures are much more balanced. We are overweight Technology, Consumer Discretionary, Consumer Staples, Financials and Healthcare, while we are underweight Energy, Industrials, Materials, Utilities and Telecom Services. Our median forward PE is 13.5, with 4 names below 10X
Sector Selector ETF, which launched at the end of April, is still down slightly since the launch, but it outperformed the S&P 500 during June, declining 1.52% compared to 1.67%. We changed our exposure slightly during the quarter (selling Utilities and Healthcare, adding "MicroCap"). The model was helped during the month and quarter by its large exposure to emerging markets, which was encouraging given that the dollar strengthened. Our biggest exposures are to Mega-Caps, Technology, Financials and Emerging Markets, while our other three holdings are Micro-Caps, Small-Cap Industrials and Consumer Discretionary.
Outlook
While the recent recovery has been encouraging, I don't think we quite yet have the green light - hopefully soon. In April, I noted that we were ahead of the pace I had expected (a 20% increase in the S&P 500 in 2011), but now we are a little behind, even with the rally. What I feared most this year hasn't happened (higher rates), while what seems to have hurt the most (higher commodity prices) appears to be reversing (the CRB Index is now up just 2% YTD after falling sharply during the quarter).
I continue to expect that we will see 1500 on the S&P 500, a forecast I shared publicly in October initially. My basis for the bullish forecast was that the prolonged period of low interest rates and an improving economy would lead to a slight expansion in PE ratios. In simple terms, I was looking for modest earnings growth and a move from 13 PE to 15 PE. The earnings growth has materialized, but the PE expansion continues to be somewhat elusive.
When I think about the markets, I tend to break out my observations into three categories: Fundamental, Technical and Valuation. None of these seems to be an impediment to better stock prices.
I believe that the fundamentals remain fairly positive. It's important to remember that there are always obstacles, and we face our fair share today (primarily structural debt issues, but also restrictive monetary policies in certain emerging markets). My overall view is that we are pretty early in the economic cycle with substantial slack in the system. My outlook tends to be influenced heavily by the comments I hear from the hundreds of companies I follow across a wide variety of industries. I am not wildly optimistic on this front and expect just moderate growth due to the structural debt issues. As far as companies, earnings estimates continue to rise. The 2012 S&P 500 consensus has increased from $104 to $112 in the past six months, suggesting 17% growth in 2011 and 14% next year. The key challenge beyond the structural debt issues is our employment situation, which is improving albeit quite slowly. I expect low interest rates to persist, which is a long-term stimulus. The spike in energy and other commodities has acted as a short-term tax on our economy. To the extent commodities remain behaved going forward and employment improves, we could see economic growth move to more normal robust post-recession type of expansion. Muddling along is the most likely scenario, and it's not such a bad one, just not as good as it could be.
The technicals seem favorable. We had a very deep correction from which we were emerging last year when I first shared my bullish forecast. Now, we appear to be emerging from a more normal type of correction (at least so far, with a pullback of 9%). Many companies are trading at all-time highs. In general, the market charts are positive - rising moving averages, not too many overbought or extended stocks.
It is valuation that stands out the most. While it wouldn't surprise me to see the 2012 S&P 500 earnings estimate decline to $108 over the next six months, this will still be higher than the $100 I was expecting when I first shared my forecast (15 PE on $100 is 1500 for the S&P 500). At 1320, we are currently trading at 12.5PE on a forward basis. The market remains as cheap as it was when I first began looking for 1500 by the end of 2011. Assuming 108 (rather than 112) for 2012, my 1500 target is now less than 14PE. I look at the earnings yield, which is the PE of the market inverted. The current earnings yield (1 divided by 12.5) is a stunning 8%, which is higher than junk bonds by far. People used to compare it to the 10-year Treasury, which yields just 3% roughly, but a better comparison is long-term corporate bonds, which yield close to 6%. Stocks are quite the bargain. Rising dividends and a robust M&A environment support optimism. My view is that as time passes, investors will ultimately forget about the carnage of 2008 and bid stocks to a more sustainable level compared to other assets.
So, my outlook, which isn't always positive, remains so for now. It definitely biases my stock selection, but only to some degree. "Double-dips", or recessions following closely behind a prior recession, are quite rare. The last one was due to excessively high interest rates. For now, while I remain concerned about several factors, I remain constructive on stocks after weighing fundamentals, technicals and valuation.
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This note is all you will hear from me today. Have a fantastic 4th of July!
Alan Brochstein, CFA
