Once again, summer is proving to be challenging for stocks. When the major indices went "red" for 2011, the floor fell from under, leading to one of the worst days and worst weeks since 2008. We entered an official "correction", which, by my definition, is a decline of 10-20%. The correction last summer was almost 20%. The models were all down sharply, mainly with the market:
Top 20 fell about .8% more than the S&P 500. Given the dramatically worse performance of smaller stocks compared to larger ones, I was somewhat relieved that we didn't lag even more. While we were pounded on our biotech holding, it was fortunately our smallest position. While the overall market fell over 7%, we actually had one stock rise and several fall just slightly. Unfortunately, there were several double-digit decliners as well. The model is down marginally year-to-date despite some very poor security selection, some of which has been addressed. At this point, I am looking at a couple of names that have fallen sharply but are likely to perform well if the economy weakens.
Conservative Growth/Balanced tracked its benchmark of 60% stocks and 40% bonds, declining less than 4%. The model retains a decent advantage over the index despite poor positioning with respect to its allocation to stocks near the maximum of 75% and bonds near the minimum at 12% . At this point, I am not looking to cut exposure, but that may change shortly. Our stocks did better than the market. In fact, not a single name was down as much as the S&P 500, as our "conservative" stocks perhaps benefited from some rotation.
Sector Selector ETF,which had finally moved into the green (barely), was burdened by its exposure to Emerging Markets and to Financials. The model has tracked the S&P 500 since the launch at the peak of the market in late April despite being constructed very incorrectly in hindsight. The exposure to Financials has been disastrous, though that error has been offset by large exposure to the largest stocks as well as to Technology. I am likely to make some changes here, though perhaps not Monday, as I believe that we can likely reallocate from our better performing ETFs to some degree.
Lessons Learned
In Top 20, we had a big disaster this week (our biotech stock) and nearly averted another one (the stock we sold yesterday declined 20% today). On the biotech stock, which was highly speculative in the first place, I should have eliminated the stock at a small loss a few months ago when it was clear to me that the story was being delayed. The only redeeming aspect is that the position was small at the inception, and we never added to it as it declined. The lessons, then, are to keep risky positions small (we did) but take the loss when the story isn't playing out as expected.
On the last-minute sale that averted another huge hit, I want to share some thinking as well. This was a stock that the story changed, but I paid attention, fortunately. One of the original reasons to buy the very cheap stock (relative to asset value and earnings potential) was new management. The stock did very well after we bought it in early 2010. Earlier this year, when the CEO suddenly departed, the stock plunged. There is a sub-lesson here, because we were successful in not selling but rather buying more of the stock initially. We were then able to cut the position dramatically in size after it rallied. It wasn't an accident that we sold yesterday - I expected that the earnings today would likely be ugly, and I knew that there was probably nothing the new CEO (former CFO) could say that would make investors feel good. The lesson? Sell when the story changes, especially if the overall market environment or economic outlook is changing. While I don't feel good at all about our overall experience, I am grateful that we were able to prudently extricate ourselves from a bad decision. I would point also to ORN, which is now almost 50% below where we sold it late last year after yet another horrible earnings report.
I make mistakes - we all do. My goal is to minimize our losses when that is the case. It runs against human nature to admit we are wrong, and we thus tend to hold onto losers. It's essential not to let the emotions rule in these cases. Unfortunately, we have some other "mistakes" that I continue to work to rectify. The massive volatility in the market may make it easier for me - it's not too hard to find potential replacements.
Outlook
Clearly, my expectations of 1500 on the S&P 500 by year-end are looking unlikely (it would require a 25% rally, which is even greater than the 21% rally into December from August last year). Stranger things have happened, but it seems like a stretch. It would be foolish of me to cling to that prediction at this point just because it was what I had been thinking. With that said, I haven't yet formally revised it.
Honestly, I struggle with my expectations. As I shared with subscribers to My Own Analyst this week, Valuation is great, Fundamentals are tentatively ok, but Technicals are challenging. My call for 1500 was based upon some slight valuation improvement (13 PE to 15 PE for the whole market), predicated on stable low bond yields and an ok but not great economy that allowed corporate earnings to grow about 7%. The simple truth is that stocks could stay cheaper longer than I have been expecting. The increase in merger activity this year reflects good valuations relative to borrowing costs, so I expect valuations will likely rise over time - just not as fast as I had expected perhaps. Stocks proved to be a great value in late 2008, but they were an even greater one a few months later. Valuation is helpful but not a guarantee in the short-term.
The economic outlook I have embraced is "muddle along", and I still think we are doing just that. Following a major credit crunch, it's not surprising given all the deleveraging that we are struggling. It has been the case, and it will likely remain the case, though the cynic in me thinks that our politicians will do whatever they can to improve appearances in about a year when the elections are heating up. Still, and this is what has me worried, the tighter liquidity conditions (i.e. commercial paper demand dropping) can lead to even more challenges than our fragile economy can handle. Weak stock prices beget weaker confidence and then weaker spending by consumers and businesses, creating a self-fulfilling prophesy (been there, done that, right?). So, while I think the economy hasn't changed, I am actually less confident this summer than I was last summer about our ability to avoid dipping back into recession. Usually, a double-dip is caused by rising interest rates (not the case these days), but this isn't a "usual" time. Listening to dozens of calls this week and last, I know that I am not alone in my concerns.
So, that leaves me with the Technicals. There was a lot of damage done this week, with our YTD gains wiped out. The thing about Technicals is that they can change very quickly. I imagine a potential recovery will not happen overnight, but a move back into the green in the next few months might beget more strength. I am just not ready to try to predict that. We saw how crazy the market can get last year (Flash Crash), and I can see how stocks become pieces of paper to discard rather than claims on the future profits of a corporation and become disconnected from reality. At this point, we are in a correction. I had suggested to clients that 1175 might be in the cards after we broke 1257 (where the market ended the year), and it took all of two days to get there. I hope that these levels set today hold, but it's mere speculation at this point. The intermediate-trend has turned negative, and I will be respectful of Technicals.
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The market won't be going down for the next two days, so have a nice weekend!
Alan Brochstein
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