Long overdue, the market soared Tuesday and retained its gains, closing near the highs of the week. Here are how the models look as of 8/26:
Top 20 performed quite well during the week, rallying 6.63% compared to the S&P 500 rallying by 4.75%. Just as the performance has been hurt previously by exposure to smaller companies, we got the benefit this week. It is highly likely that we will always have exposure to some smaller, less well-known names (that's actually how you make a lot of money in stocks over the long-run), but we have had a lot. Why? Low valuations for many companies with cyclical exposure as well as the potential for mergers.
I am disappointed with the performance in 2011 for this model. We had a rotten January, which was understandable after such a great finish to 2010, but the past four months have been very challenging. Last year, we got back on track after a rough summer and finished exceptionally well. I hope to see some improvement, but I am not counting on such a large margin of outperformance. While the low number of trades recently may create the appearance that I am not doing anything, let me assure you that I have been assessing each stock and trying to adapt my expectations to the changing conditions. We have a few companies that shouldn't be in the portfolio, and I have lined up several potential replacements. The high volatility of the market as well as some patience has kept me from acting so far, but we are getting closer to these "upgrades".
Conservative Growth/Balanced gained some ground too, improving 2.92% this week compared to the stock/bond index increasing 2.56%. I am glad to see that we have not only preserved capital this year (up despite challenging conditions) but that we have so far beaten our benchmark despite some inferior positioning (too much stock, not enough bonds). This strategy is benefiting from a shift to the types of stocks in which we invest (strong balance sheet, solid dividends). Depending on how much conviction I have, I may look to reduce our overall equity exposure if we get a little more strength.
Sector Selector ETF gained slightly against the S&P 500, rallying by 4.86% compared to 4.75%. We have been poorly positioned here, with high exposure to Financials. Additionally, we have little exposure to the more conservative parts of the market, like Utilities or Consumer Staples. Like CG/B, where we also have some flexibility regarding our overall market exposure, I may be looking next week to reduce exposure a bit.
Outlook
For the past few weeks, I have been struggling with a previously too optimistic forecast that had been based upon the market PE expanding slightly in 2011. Instead, we are looking at PE ratios that are actually lower despite stable to improving interest rates. The multiples are likely to work their way higher over time, but the near-term challenge is earnings. If you have no clue, join the club. My clients and other professional acquaintances, all of whom care about future earnings, are scratching their heads. The sharp drop in the market reflects a potential slowdown and may even CAUSE one, according to some, due to sapping confidence. I would argue that the worst cases I have heard (that EPS drop 20% next year) still leave stocks quite inexpensive. The math? 1177 (the current price of the S&P 500) divided by $80 (a 20% decline, roughly) yields 14.7 PE. Seems like a good deal to me, as the earnings yield (the inverse of the PE) is close to 7%, well above the long-term corporate bond rates (currently just below 5%, which is the lowest in 45 years.
I continue to suggest three potential paths ahead:
- All a Big Mistake - Rally Quickly (35% chance)
- Absorb the Damage - Rally after spending a couple of months testing the lows (50% chance)
- Ugly - New Bear Market (15% chance)
This week, we got confirmation of a rally from Investors Business Daily. I would never rely upon a single indicator, and I note the tendency for this one to give lots of false alarms, but, according to their methodology, Tuesday's high-volume advance signalled a better environment. Let's hope that they are right. Unfortunately, I am not so sure that the lights turned green. My expectation is that we could rally a bit more (back towards the unchanged spot for 2011, which would be 1257), but we are subject to a pullback from there most likely before we get back on track (this is the second scenario). This type of action would be similar to how late 1998 played out. While I am giving scenario 1 a pretty decent chance, I have to admit that the odds aren't as good as I make them out to be. So, let's keep our fingers crossed.
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Last Word
I am entertaining the idea of hosting a conference call for subscribers. If this sounds like it would interest you, please drop me an email (alan@analystforhire.com) and tell me. Feel free to share any potential topics you would like me to address.
If you are on the East Coast, please be safe (advice from a Gulf Coast resident who has been there and done that). For everyone else, have a great weekend and end to August.
Regards,
Alan Brochstein
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