The market ended its fifth consecutive decline with another failed rally, closing at the lows of the week and down slightly. Here is how the models looked at quarter-end:
For the week, Top 20 declined .91%, about .5% worse than the S&P 500. Though smaller stocks fared worse in general than the S&P 500, we actually enjoyed strong performance from the majority of our smaller holdings, with 7 gains and 5 losses. On the other hand, we had three larger companies decline in excess of 3%.
Conservative Growth/Balanced moved essentially in line with the blend of the stock and bond benchmark, declining .45%.
Sector Selector ETF declined .26%, which was slightly better than the .41% decline in the S&P 500.
September and Q3 Review
TOP 20
Top 20 underperformed the S&P 500 by a little over 1%, declining 8.19% during the month compared to a 7.03% decline for the S&P 500. Performance was very mixed, with a few stocks rising but 7 stocks falling more than 14%. During the month, the Russell 2000 fell by 11.3%, indicative of weakness among smaller stocks.
For the quarter, Top 20 declined almost 18%, losing just over 4% compared to the 13.87% decline in the S&P 500. It's worth noting that the Russell 2000 declined almost 22%: Clearly our exposure to Small-Caps was the major factor behind our underperformance. Our 5 worst performers, all relatively small, fell in excess of 30%. Not one stock was able to rally, though our two large-cap Technology names fell less than 4%. We also had a small Healthcare name decline just 4%. The main challenge for the model, though, was that we were (and remain) positioned for a continued economic expansion that was questioned increasingly as the quarter progressed. The best sectors for the quarter included Utilities, which actually rose slightly, and Consumer Staples, both of which are viewed as being less sensitive economically. Our heavy exposure to Technology was one decision that proved correct, as it declined 9.2% in price, about 5% less than the market. Materials, Financials, Industrials and Energy were the worst sectors, all declining in excess of 20%. While we had minimal exposure to Materials and Energy and less-than-average exposure to Financials, our two stocks in those sectors were down more than the average for the sector. Our Industrials really dragged us down, lagging the overall sector significantly.
During the quarter, we repositioned the portfolio by adding 4 new names and another that we bought and then sold at a gain (FLIR). We sold three names that I considered "mistakes": TECUA, SKX and MFLX. We also sold out the remaining position in CHS, which was a great success, as well as SCVL. After our sale of TECUA, it collapsed, declining 23%. We had purchased FLIR on the other side, so the timing proved successful. MFLX was sold at a price that was relatively close to where it began the quarter. SKX declined from our sales, which took place primarily above 16, to 14. CHS fell 26%, while SCVL declined 25%. I mention this because as poorly positioned as we were for the market decline in terms of sector exposures and Small-Cap bias, our trading was able to add some value during the quarter.
The model remains highly exposed to Industrials at 30.5%, about 20% more exposure than the S&P 500. Technology, at 28.4%, is 9% higher than the index. Consumer Discretionary, at 14.3% and Health at 13.3% are slightly higher exposures than the S&P 500. With no holdings in Consumer Staples, we are 11.7% below the market. Our Energy exposure, at 3.9%, is about 8% below the market. Financials, at 6.8%, are about 1/2 the market exposure. This is an area I expect to increase. We have no exposure to Utilities, Materials and Telecom, but these are all small sectors with a combined 10% weight in the S&P 500. Our Emerging Market exposure is 2.8%. In terms of market-cap, 12 of our names are below $1 billion, 2 are between $1 billion and $2 billion, and the remaining 6 are in excess of $10 billion. On a valuation basis, 13 of our holdings are trading below 12.5 PE on a forward basis. The S&P 500 has a forward PE ratio of just 11.4X, and our typical stock is just slightly higher. We have several stocks trading below tangible book value, with an average of just 1.5X. Our balance sheets remain vastly superior in aggregate to the market, with the typical stock having more cash than debt.
Conservative Growth/Balanced
In September, CG/B fell 4.44%, which was 0.6% worse than the 60% stock/40% bond index. The primary explanation is that we were overweight stocks. In fact, this factor accounts for more than the difference. Our exposure to Technology offset the challenges of our stock overweight and bond underweight as well as our Small-Cap exposure (2 of our 3 Small-Caps fell in excess of 10%) and the sharp decline in our Large-Cap Financial.
For the quarter, CG/B underperformed the benchmark by almost 2%, declining 8.71% compared to 6.75% for the hybrid index. Again, the extra exposure to stocks accounted for more than the miss, but it doesn't tell the full story. Our sector exposure was helpful overall, as we had good exposure to Technology. While we had no Utilities, we did have some exposure to Consumer Staples. Unfortunately, while we sold one of our names at a profit, we also were hammered in another. On the flip-side, we had no exposure to Materials and below-average exposure to Industrials and Energy. While one of our Financials performed poorly, another performed exceptionally (down just 3%). Our Energy name did much better than the sector as well, declining 10%.
During the quarter, we sold three names as well as bought and sold another at a profit (MCHP), while adding three new names. On the purchases, we did very well with a Financial added late in the quarter, but stumbled with a Consumer Discretionary name added early in the quarter. We also added a Healthcare name. On the sales, here too we had great success. We sold CHS near the end of a long advance at an average of 15.57 (now 11.77) and CALM above 35 (now at 31.36). We also bought and sold MCHP during the quarter, gaining in excess of 7%. Despite a very tough quarter in which we were not positioned correctly, we were able to hang on to a slim gain relative to our benchmark on YTD basis.
Looking at the portfolio, it has a forward PE of just 10X, below that of the market. Again, we have very strong balance sheets, and an average P/TB of 2.2X. Our exposures to sectors are more constrained than the Top 20. Health, at 19%, is 7% above the S&P 500. Financials are now 5.7% above the S&P 500, with 19% exposure as well. Technology is our largest sector at 25%, 5.4% above the S&P 500. Consumer Discretionary at 13.6% is 3% above the market. Our largest underweight is Consumer Staples, which, at 7.6.% is 4% below the S&P 500. Utilities, at 0%, are 4% under. Industrials, at 7% are 3% under. Materials and Telecom, both at 0%, are 3.4% each under. Finally, Energy, at 8.7%, is 3% under the S&P 500. 3 of our names are below $1 billion in market cap, 1 is between $1 billion and $10 billion and the other 10 names exceed $10 billion (with four in excess of $100 billion). Finally, our weighted dividend yield is 2.9%, well above the 2.2% for the S&P 500. Our combined expected income, when including 15% cash and 10% bonds, is about 2.5%.
Sector Selector ETF
SSETF had a very rough month, declining 10.23%, which was 3.2% worse than the S&P 500. The model was helped by exposure to Technology and to Mega-Caps, but the other 6 holdings performed worse than the market. The worst sector by far was Emerging Markets, which had an 18% decline.
For the quarter, the decline was 17.2%, about 3.5% worse than the S&P 500. The dynamics were similar, with same two holdings performing very well but the rest performing quite poorly. Financials and Emerging Markets were both large components of the model and among the worst performers. We were also hurt by our exposure to Small-Cap.
Trading during the quarter proved not to be too helpful, as we repositioned towards weaker parts of the market that continued to lag. The shifts during the quarter included exits from Consumer Discretionary and reductions to Mega-Caps and Technology. The additions included adding Industrials and Small-Cap as well as adding to Financials and Emerging Markets, the latter of which proved to be poorly timed.
Our current positioning is skewed heavily towards Small-Cap now, with large additions near the lows in August. The 3 ETFs, which include a sector ETF as well that was in the initial portfolio in April, total 27% roughly. Our Mega-Cap exposure has been reduced to 11%. Emerging Markets are currently 15.6%. The other three holdings are S&P 500 sectors. The model is clearly positioned for a better market. Emerging Markets had been only slightly problematic until this month, when they were under intense pressure.
Outlook:
The near-term remains quite challenging, with concerns over Europe and now China dominating market action. Even domestically, the focus is on politics primarily. The correlation of stocks has been extremely high, with volatility so excessive on a day-to-day basis that it defies logic. It is impossible to have much confidence about a specific security's likely movement on any given day or even week. As someone who is primarily a stock analyst, I am frustrated that company fundamentals are highly irrelevant at the moment.
We have now declined 5 consecutive months without officially entering a bear market, as we continue to hold just above that 20% level. While I continue to anticipate that we will emerge from these challenging conditions, it seems less and less likely the longer we remain close to the lows. I pointed out last week that the near-term downside would seem to be about 10% from here should we break down. In terms of timing, bear markets are typically not long in duration, which suggests that a bottom, should we move to new lows, could come early in the quarter. It's worth noting that weak 3rd quarters are typically followed by positive fourth quarters. It's also worth noting that the third year of an election cycle hasn't been negative in modern history. With the potential escalation into December for the first primaries, perhaps the "hope" for "change" will lead to more optimism.
The sentiment is absolutely horrible, which, from a contrarian perspective, gives me hope. Valuation remains extremely cheap in my view. Fundamentally, extreme weakness in Emerging Markets and energy and metal prices is signalling new challenges ahead. So far, the drag from international trade was thought to have been minimal, but it appears that a major growth engine could be stalling, which is concerning. With that said, Brazil has cut its short-term rates, and China could follow. In the end, a resolution of the Euro-Crisis will vastly improve the fundamental outlook. Technically, we remain in a consolidation. The quick rally scenario didn't play out, and I am shifting my outlook to 20% worse than another 10% decline, 45% that we make a marginal new low quickly and begin to rally, and 35% that we hold the lows of August and rally. I hope that my shift proves to be pessimistic. For the models, this means that I will need to cut exposure should we move towards the lows, with the most likely scenario that I would be repositioning more aggressively shortly thereafter. Market-timing is a very difficult endeavour, and I typically try to take a longer-term view. With that said, while this is only a warning of an action I may take (if we don't begin to rally soon), I am concerned that I may be underestimating the headwinds ahead and am too optimistic on my earnings expectations. The low valuations seem to more than discount for earnings declines that might be ahead, but clearly valuation isn't drawing in buyers.
Articles:
I appreciate the continued support of our nearly 100 subscribers during these challenging times. It is disappointing to me to see subscribers endure losses, especially ones that are a bit worse than the overall market. While we remain ahead of the benchmark for CG/B and slightly behind in the Top 20 and SSETF, it would appear that 2011 will be not up to par with the exceptional performance over the prior three years. Market conditions have been challenging, but, especially in Top 20, I made several mistakes earlier this year, most of which I have addressed. I want to reassure you that I am 100% committed to providing market-beating returns, and my efforts are not diminished at all. Last year, I refused to quit despite having a massive YTD advantage over the market, and this year, I will not throw in the towel despite mediocre results thus far. Most importantly, I will not abandon my discipline in order to improve returns, as this is the worst thing any investor can do. I believe that my eclectic approach that includes several different strategies, including value, contrarian, multi-cap, growth and always a sharp focus on the balance sheet, works over the long-run, but it doesn't work all the time. Last year, when they began to work again, they worked dramatically better, as we knocked the cover off the ball after Labor Day. Clearly, my efforts in smaller stocks this year have been to no avail due to a very sharp underperformance as an asset class (R2000 is more than 9% worse than the S&P 500), but this won't always be the case. I will hopefully navigate these near-term challenges in the days ahead, perhaps using the volatility to position us even better for the longer-term. I will be scheduling a conference call for this week under separate notification in order to address any questions you might have.
Regards,
Alan Brochstein, CFA
www.InvestByModel.com
