Invest By Model

Finding Something in 2011's Nothing: 2011 Review, 2012 Outlook

The year that just ended was particularly challenging for investors.  Still early in our recovery after the huge shock to the financial system in 2008/2009, the U.S. economy continued to improve, but the growth was rather unimpressive.  For the second year in a row, the consensus of a double-dip emerged in the summer, only this year, it seemed more likely given the multiple shocks to the system, including a natural tragedy in Japan, which is still the second largest economy in the world, a game of "fiscal chicken" in Washington, D.C., and a financial crisis in Europe. 

For all the cross-currents, U.S. companies performed admirably.  S&P 500 earnings are on track to grow 17% in 2011 and are expected to grow another 10% in 2012, both considerably higher than forecast a year ago.  Of course, with stocks unchanged in price for the year, this means that they got a lot cheaper.  Smaller stocks somewhat lagged  larger ones.  The best sectors for the full year were Utilities, Consumer Staples and Healthcare (low "beta"), while the worst ones included Financials and Materials.  Clearly, this was the year of the dividend. 

While our stocks needed every bit of their strong Q4 performance just to get back to where they started, they stood out in a world of weak equity prices.   Here in North America, Mexico and Canada both fell about 10%.  Europe's  big winner was Ireland, which managed a small gain.  They have done the austerity already.  Germany and France fell over 15%, while others fell more.  The UK was down about 6%.  Japan fell 17%.  Australia too.  Emerging Markets were horrible, with all of the BRICs falling in excess of 17%. 

Interest rates around the world plunged.  Here, despite the downgrade by S&P, our ten-year Treasury rates ended at multi-generational lows, falling from a "low" 3.3% to an "insane" 1.9%.  Safe-haven Gold had a nice year (up 10%), extending its streak of positive annual returns, but it struggled in Q4.  Commodity prices were generally weaker, though oil rose about 10%.  Our currency eroded very modestly relative to the Yen while improving very modestly relative to the Euro.

While the key focus for all economic forecasters this year has to be the prospects for Europe, the problems there are well documented and widely known.  This was the year where we all learned about European politics.  Just like we had (and continue to have) lots of naysayers and doomsday forecasters here a few years ago (and still), the pundits lean very negatively when assessing the outlook there.  Truthfully, none of us knows how this will play out.  The problems of high debt can be resolved in a number of ways - restructuring and growth come to mind.  The key is to avoid chaos, and there is signficant potential for orderly resolution.  Italy, for instance, is actually in better fiscal shape than the U.S.  Still, they are being squeezed by the bond markets now.  The recent global initiative (three-year credit facility) helps, but it doesn't go far enough.  I expect that Europe will figure out a way to keep kicking the proverbial can down the road.  The calls for the demise of the Euro, which I made back in 2008 myself, don't carry a lot of credibility in my view.

Surely, global GDP will see a drag from what will likely be a recession in Europe due to austerity measures.  Still, we need to remember our post-2001 economy, when the U.S. consumer kept spending  even though we were in a big-R recession.  From what I have read, the typical European consumer isn't constrained like their governments.  One of the benefits of a slowing Europe is the sea-change in Emerging Market monetary policies, which have moved from restrictive to easy in the last few months.  The growth stories for these economies aren't built on just exports but rather real demand from the rise of their own middle classes.  I think that this is a real trend that will persist.

I step back from trying to forecast every single country's GDP or even ours.  I think it's reasonable to expect that growth will continue to be sub-par but positive for us.  No U.S. recession, but no boom either.  For those concerned about Europe, I urge them to take a look at the stock markets - they are all still comfortably above the lows set in Q3 (which was BEFORE our lows).  If Europe will drag us down, won't Europe drag down Europe too?  To the extent Europe turns out to be in less trouble than everyone seems to think, the risk could be very strong U.S. GDP.  Of course, we have our own fiscal drag, but, if I am right about an improving employment situation during the year, this may prove to be surmountable.

I have shared my specific U.S. equity forecast:  1600 on the S&P 500 (+27%), based on just 14PE and using 2013 earnings that are below the current consensus.  While last year, I didn't expect Small-Cap to do better than Large-Cap (after years of doing so), I think that they will perform a bit better this year if I am right about the better stock market.  Sadly, retail investors tend to be followers, selling low and buying high.  If I am correct about the improved tone, they will be chasing performance, which should stem the big tide of outflows from small stocks we endured in 2011.  Additionally, I expect the M&A environment to remain strong, which should help smaller companies.  I would expect non-US equities to do at least as well if not better than our stocks, especially Emerging Markets, which are very inexpensive and likely to show better growth.  I don't have a strong view about commodities, but I guess I am moderately negative, at least for the first part of the year.  Oil seems a bit inflated - I wouldn't be surprised to see supply pressures push it back towards $80.  Gold is unlikely to fare well if my constructive equity outlook  proves true. 

With low valuations but challenged fundamentals, I put extra credence in the charts, which look positive to me.  The trends I see are a long-term bull that started in early 2009 that has now been tested twice.  The 2011 lows proved to be higher than 2010's.  More recently, we reestablished the bull trend in October in my view and tested it later in the quarter.  This third leg up is still relatively early in my view. The last peak in the market was in 2007, when the S&P 500 touched 1576. While 1600 may seem like miles away, it would represent just a 1.6% increase in five years despite EPS that will likely be 20% higher than the prior peak. My guess is that this sounds quite ridiculous to most people, which is encouraging to this contrarian.

Top 20 Review and Structure

Top 20 lost about 3% in 2011, while the S&P 500 gained a little over 2.1%.  The Russell 2000, which is the index for smaller stocks, lost over 4%.  Certainly my focus on smaller stocks, where I feel like my research is more likely to pay long-term dividends, hurt returns, but I made some terrible picks.  Unlike 2010, when it was very difficult to do better than the initial portfolio, trades this year helped.  The beginning-of-the-year model lost over 10%.  We were able to exit the two worst performers (TECUA and SKX) at what proved to be good exits (despite taking losses).  While some of the stocks we sold kept rallying, we did book gains in HAYN, CHS and CPRT early in the year.  We also punted AMAT and STJ at a nice profit. SYNO, of course, was the highlight of the year.   Sticking with CSCO proved to be a good decision in retrospect, and we made some nice pick-ups of INTC, DORM, SHFL, SCVL, FLIR (twice), SMCI and AKAM .  On the other hand, SVNT was a complete disaster.  Fortunately, we never added to the position, which was kept small initially due to the nature of biotechs.    We booked losses in MFLX, PLXS, SKX and TECUA, but the latter three sales proved timely.  The purchases of DGI and DRIV proved to be way too early, and MPR (April) and IIVI (June) were poorly timed. Same with the repurchase of STJ in July.  Some of our current holdings, to which I added on weakness, have weakened further.  In all, though, despite having way too many problem stocks and totally missing how sharply we would correct in Q3 (when most of our damage took place), I was pleased that our ultimate performance proved significantly better than the initial portfolio from year-end. 

Looking at just Q4 briefly, we ended up marginally lagging the S&P 500, which was disappointing not only because it was the third consecutive quarter but also because I should have done better.  Our smaller stocks should have boosted returns.  Premature exits from SHFL and LOW proved costly as did hanging onto SVNT.  DGI and DRIV performed absolutely horrible, and STJ and CRK were disappointing as well.  We had exposure to a lot of smaller Industrials, and they performed poorly in aggregate, with just one name beating the S&P 500 while the other five lagged.  Thankfully, SYNO worked as did a few other stocks.

As I look at the model today, the weighted expected price return over the next year (based on my targets for each stock and the how much we hold of each in the model) is over 60%.  Perhaps this is too optimistic, but I think it points to signficant potential upside relative to the market.  We have a lot of smaller companies, with 9 below $1 billion market cap.  Another 5 are $1-2 billion.  2 stocks are in the $10 billion range, while 2 are "Mega-Caps".  The last stock (the ETF) has a large-cap constituency.

Looking at sectors, here is how we stack up:

• Industrials = 36% (+ 26% vs. S&P 500)
• Technology = 26% (+ 7% vs. S&P 500)
• Financials = 13% (even vs. S&P 500)
• Consumer Discretionary = 9% (-2% vs. S&P 500)
• Health = 7% (-5% vs. S&P 500)
• Energy = 6% (-6% vs. S&P 500)
• Other = 3% (+ 3% vs. S&P 500)

We have no Consumer Staples (12% of S&P 500), no Utilities (4% of S&P 500), no Materials (4% of S&P 500) and no Telecomm Services (3% of S&P 500).  Clearly, I don't attempt to match the composition of the S&P 500.  If the economy proves to be sharply weaker than expected, the structure of the portfolio could prove risky given a higher overall beta (1.2X). 

On the other hand, the model has a more conservative capital structure than the S&P 500.  Just 5 of the stocks have more debt than cash.  Our very worst name with respect to debt isn't too much worse than the average for the S&P 500. 

Valuations stand out as being reasonably cheap.  5 of the stocks trade below 1.5X tangible book value (two are below).  With the exception of one, all of the stocks have positive tangible book value.  The weighted EV/EBITDA multiple is just 7X.  2/3 of the names trade below 13PE (even cheaper if adjusted for cash).

While I feel like the balance is better than it was a year ago, the portfolio has a value bias.  The one other attribute worth noting is some exposure to the U.S. government.  While several of the names have some exposure, I view three of the names as having significant revenues generated from defense spending.  I also believe that at least half of the stocks are potential acquisition candidates.

As a reminder, my long-term goal with the model is to significantly outperform the S&P 500.  It won't happen every quarter and, unfortunately as 2011 proved, not every year. We launched in 2008 and were able to beat the market by over 6% (from late May) in a crazy market.  In 2009, we totally blew away the market, rallying 69%, which was more than 42% better than the S&P 500.  2010 continued the glory, with a 52% return compared to 15% for the S&P 500 (almost 37% better).  To be fair, it was a good year for Small-Caps, which did about 12% better than the S&P 500.  I tempered expectations a year ago because I didn't want people to think I was some sort of miracle-worker, suggesting that 12-20% ahead of the market was my aggressive long-term goal. In reality, consistently beating the market by just 3-5% would be exceptional.  Thus, while the longer-term track-record of the model is spectacular despite the rough times since the market peaked in April (17.8% annualized return compared to a slight decline for the S&P 500), I would hope that the future performance won't see such protracted periods of poor performance as the model endured this year.

Conservative Growth/Balanced Review and Structure

Unlike Top 20, CG/B was able to beat its benchmark.  Using quarterly rebalancing, the gains were modest, as the model returned a little over 5% compared to the blend of the S&P 500 (60%) and the Barclays Aggregate Bond Index (40%), a relative advantage of just 0.17%.  Excluding rebalancing, the model performed better, as the stocks (up 2.11%) and the bonds (up 7.85%) in aggregate rose just 4.4%.  That's the beauty of rebalancing, as quarterly adjustments led to higher returns, primarily due to the extreme move in Q3 (bonds rallied sharply, stocks sank).

Like Top 20, though, our initial portfolio proved to be a relative loser, with the stocks in the model at year-end 2010 declining a little over 2% in 2011.  We were able to use market volatility to make some good sells as well as good buys along the way.  My bullish outlook on stocks for the year and bearish outlook for bonds proved wrong and certainly cost the model somewhat, but we were able to overcome those structural challenges with some active trading.  Some of the trades that stood out during the year included AFL, MCHP and CSL, where we established positions and quickly sold at profits.  We also had a timely sale of AMAT in early February, though I prematurely added it back in April.  INTC stood out in terms of new buys during the year, while WAG proved to be a poor decision.  We had excellent sales of several stocks during the year, including FLO (ultimately), LOW, CVX, BCR, CHS and OMI.  Sales later in the year in CALM and LOW proved premature.   While the year was disappointing with just a slight beat, I am pleased with the absolute return in a tough year, especially considering how wrong I was on the big picture in Q3.  I was especially pleased that the model was able to keep up in Q4 given how challenging it can be to match a very strong equity market with "conservative" stocks.

Unlike Top 20, CG/B is positioned much more in line with the market.  We do have an exceptional underweight in bonds, though, with just 11% of the portfolio invested in the asset class.  Additionally, we have no government (or corporate) exposure - it's all in mortgages, which offer more yield and less interest-rate risk (absent a really big spike in rates, in which case the interest-rate exposure increases).  We are also overweight stocks currently, just under the 75% maximum.  Almost 15% is invested in cash, as I expect bond returns will likely be negative.

Looking at the stocks, Health represents 23% (+11% vs. S&P 500), while Technology is 20% (+1%).  Financials at 18% (+5%) and Consumer Discretionary (+5%) are the next largest exposures.  Rounding it out are Energy at 9% (-3%), Consumer Staples at 7% (-5%) and Industrials at 7% (-4%).  We have no exposure to Utilities (4% of S&P 500), Materials (4%) or Telecomm Services (3%).  These exposures are dramatically different from Top 20 (or SSETF), but so is the mandate.  This model isn't about maximizing returns but rather generating income, reasonable capital appreciation and protecting from loss of capital.  The "beta of the stocks is slightly lower than the market.

I do think that the stocks in the model are very reasonably valued. Forward PE ratios of 11.7 are below the 12.4X for the S&P 500.  Our dividend yields are 2.8% compared to 2.1%.  EV/EBITDA is low at <6X.  The very highest P/TB ratio is 6.6X, with an average of 2.6X.  Balance sheets are much stronger than the overall market, with the very worst debt to capital ratio at 21%, which is below the average for the S&P 500.  9 of the 14 names have more cash than debt.  Finally, the portfolio as it sits now has an interesting dynamic:  The weighted 2011 return was -8.6% - we aren't sitting in a bunch of inflated stocks.  The very best performer over the past year is up less than 17%.

Like last year, I expect bonds to be a drag.  In fact, while I had hoped for zero return in 2011, this year I don't expect even that much.  Officially, I expect bond returns to be about -4%.  As far as the stocks, my targets suggest the potential for 46% return.  More realistically, in the context of my 27% expected return for stocks in general, I would hope (with a 70-75% equity exposure), to experience a 30% return.  Again, it's very difficult to keep up with a strong market with "conservative" stocks.  The weighted return, then, might realistically be closer to 20% in the scenario I describe, compared to the index at about 14.5%.  As a reminder, the model lost 6% in 2008 (from late July) compared to a 15% decline in the stock/bond index.  In 2009, the model returned over 24% (6% better than the index), while improving to almost 27% in 2010 (14.7% better than the index).  Our annualized return since inception has been 13.8%, which is 8.7% better than the index of stocks and bonds.  So, after an "off" year of 5% in 2011 in which we essentially tracked the benchmark, I am hopeful that 2011 might look more like 2009 and 2010. 

Sector Selector ETF Review and Outlook

I could not have picked a worse time to start SSETF, with the launch taking place just days before the high for the year in late April.  While I was optimistic about the returns over the balance of the year, I was somewhat cautious at the time of the launch and structured the portfolio with atypically large exposure to Mega-Caps and very little to Small-Caps.  I also included some low-beta sectors - Health and even Utilities.  The really big bets were Financials and Emerging Markets, and those exposures proved very costly.  From 4/29, the S&P 500 fell 8%, but Financials have declined 21% and Emerging Markets by 24%.  This explains more than 100% of the underperformance in the model. 

The current portfolio has evolved significantly, as we reduced a large Mega-Cap exposure and replaced it with a large Small-Cap position, while also adding to our losing bets.  I continue to have confidence in both the Emerging Markets exposure as well as Financials, but I will be quick to abandon them should the recovery in stocks begin to fade.  Our model is definitely set up bullishly, as the beta is 1.23X.  On a weighted basis, our ETFs we currently hold were down 11% in 2011 - we will benefit from mean-reversion should it play out. 

As I mentioned at the launch, my expectations for being able to beat the market with ETFs are MUCH more tempered than with stocks.  I would hope to do so by 2-4% in a year, so 2011 was a big dent in the record I hope to build (at -3.8% compared to the S&P 500).  It definitely wasn't my market (especially in Q3, when we endured 87% of the relative underperformance), but we did manage to recover somewhat in Q4 as we added significant Small-Cap exposure but continued to struggle with other parts of the portfolio.  So, as disappointing as the performance has been since our launch in late April, I remain optimistic that 2012 could more than make up for the rough start.  Emerging Markets had a terrible year, but they are very volatile.  They continue to lead our stocks over longer periods of time despite the poor recent performance, offer more growth potential and are valued at lower PE ratios.  Financials, on the other hand, haven't shown good performance relative to the market in over 5 years and stand out for their valuation and extreme investor apathy.  Aggressive, yes, but these look to be smart contrarian bets to me.  Small-Cap is a bigger bet (1/3 of the portfolio spread out in three different ETFs), but it won't likely play as important a role in the future performance as the other two that I have described.  Our two other ETFs are S&P 500 sector ETFs. 

Less than Zero (Just Barely)

It was about as close to zero return as it could get, with the S&P 500 closing the week (and day) down slightly, adding a little drama on the last day of a year that had already had WAY too much drama.  A year ago, the market had closed at 1257.64.  Today? 1257.60.  It doesn't get any closer!  Of course, with dividends, the S&P 500 was able to post a gain.  Here's how the models look as of this evening:

 

Top 20 lost about 0.5% during the very quiet week, slightly less than the S&P 500.  Unfortunately, while we closed the year with a strong month (up 2.9% compared to the 1% rise in the S&P 500), the model modestly underperformed the market over the last three months, rallying about 11% compared to the 11.8% return by the S&P 500.  For the year, the model lost a little over 3%, while the S&P 500 gained a little over 2%.  One of the big challenges this year was the persistent weakness of smaller stocks, as the Russell 2000 Small-Cap Index declined over 4%. 

Conservative Growth/Balanced also lost about 0.5% during the week, but this was worse than its index (60% stock/40% bond).  Our stocks declined slightly more than the S&P 500, and we are overweight.  On the other hand, we are signifcantly underweight bonds, and they rallied during the week.  For the month, the model underperformed its benchmark by about 0.7%.  For the quarter, the model lagged by about 0.1%.  For the full year, the model ended up essentially tracking the index, returning a little over 5%.

Sector Selector ETF matched the S&P 500 this week and underperformed by about 1.4% in December as Emerging Markets lagged sharply.  For the quarter, SSETF grew 12%, slightly ahead of the S&P 500.  We launched SSETF right at the peak of the market in late April, and the model was never positioned very well during the year.  The bulk of the 3.8% underperformance took place in August and September.  Over the past few months, we were able to restructure the model such that it is substantively different from how it looked at the launch, with an even more aggressive posture that I believe properly reflects the better valuations.

Market Outlook

When I discuss each of the models later this weekend, I will integrate my outlook.  I haven't changed my view, which I have discussed extensively over the past few weeks.  I continue to view the market as very inexpensive from a valuation perspective that seems to more than compensate for some challenging macro factors.  Fundamentals seem modestly positive - our economy remains in a recovery from a very deep recession and shows no signs of excess.  We have way too much slack - plenty of firepower to grow the economy, if only we can better use our resources.  High unemployment is really our biggest challenge, and improvement in the labor markets, which is slowly underway, is the single most important factor in my view (except, of course, for what's going on in Europe!). 

I was very bearish in 2007 despite "cheap" stocks - the economic expansion was too mature.  We also hadn't experienced a pullback of more than 10% since the early 2003 lows.  Today, I find the technicals much more encouraging.  We have now had two very deep corrections to the rally that began in 2009.  Skepticism abounds.  I know that my optimism proved unwarranted in 2011, but I view the market as insanely inexpensive today as I viewed it expensive in 1999.  Of course, it rallied in 1999, but, in retrospect, it was expensive, especially the larger companies. 

The technical set-up today is quite apparent in my view:  The long-term up trend from 2009 is intact.  The 2nd correction ended in early October, and we have been consolidating the bullish break from the lows subsequently.   I expect that 2012 will look very different from the past two years, which were remarkably similar in many respects.  2010 and 2011 saw late-April peaks followed by the lows of the year in the last four months.  2010 bottomed at Labor Day, while 2011 bottomed about a month later.  Q4 was strong for both years.  The biggest difference, of course, is that we closed at new highs in 2010, while we struggled at the flat-line in 2011.  I expect a strong start to the year and a strong finish presumably.  We might stall out somewhere in the middle, but I don't expect a 20% pullback like we endured the past two years.

2012 is an election year, which will provide a lot of focus.  I find it very difficult to integrate the political outlook this year, one way or the other.  On the one hand, I can see optimism regarding Obama potentially ceding the White House, but I can also see Obama making a potential "bold move" to try to cement reelection.  In any event, while I don't mean to minimize the potential impact, I do think it's very unclear. 

So, to repeat my previous outlook:  I think we could have a big rally this year.  I shared a view that 1600 on the S&P 500 (up 27% from the 1257.60 close) is achievable, based on modest earnings growth and some PE expansion.  My target is based upon the market trading at 14 PE a year from now.  For this outlook to work, we will most likely see improvement in our employment outlook and more optimism about the downside risk from the European financial challenges.  In this scenario, longer-dated Treasury rates are likely to climb, with some pressure on other interest-rates as well. 

As this year proved, though, I have no crystal ball.  The first four months tracked my forecast very well despite the shock of the Japanese earthquake and tsunami.  Even as late as early July, we seemed on track.  My 2010 forecast proved highly accurate, but the market did much better than I expected in 2009.  I share my views because they do influence portfolio construction, especially for CG/B and SSETF but also Top 20.

Articles (all on Seeking Alpha)

• Small-Caps Should Rally in January
• Potential Bounce Candidates
  • Consumer
  • Health
  • Technology
  • Financials
  • Industrials/Energy/Materials

Final Thoughts

While I didn't achieve my goals with the models in 2011, I am optimistic that 2012 will prove to be significantly more fruitful.  I know that not only was I not alone in my struggles this particularly challenging year, but that I continued to make the necessary effort and to stay true to my discipline.  One of the biggest challenges all of us have is stay with our methods when they are clearly not working.  I made a lot of mistakes, especially not having a better respect for the rapidly changing market in late July and early August.  It could have been worse.  In both Top 20 and in CG/B, the results for the year were aided by changes made to the models during the year (more on this in my full review).  So, with a little humility and a lot of disappointment, I also want to express my gratitude to all of my subscribers.  May 2012 be a great year for us investing but, more importantly, a happy, healthy one for you and your families.

Regards,

 

Alan Brochstein, CFA

www.InvestByModel.com

 

 

 

Top 20 Trades - Last of the Year

We are trimming two positions that performed well in December and adding to two that didn't.  The two partial sales we are making are simply reversing purchases from earlier this month.  On the additions, one stock has been a tremendous disappointment, while the other suffered a reversal during the year but is ending up about unchanged.  Both of the buys offer about 75% return over the next year to my target, while the sales are 43% and 53% respectively.  Both of the purchases are moderately oversold as well.

Small Trade in SSETF

We are getting rid of the last part of the Mega-Cap Exposure and also trimming some Industrial, investing all of the proceeds into Technology.  With the recent drop in ORCL, GOOG looking like a breakout, AAPL coming back to life, AMZN declining sharply and some other component moves, I wanted to move the portfolio a bit more towards the sector.  On 2012 Consensus, Technology trades at a slightly lower PE than Industrials.  When one looks at the valuation after incorporating cash and debt, Tech looks even better.  In a real downside scenario, Tech should win.  I think also in the base case Tech will fare slightly better - smaller tickets than Industrials for the most part.  In a reflation trade, though, Industrials will likely appreciate more.  I feel like our large exposure to Emerging Markets and Financials as well as Small-Caps balances out that scenario.  Tech should beat Mega-Caps in the bullish scenario as  well. 

Strong Week for Top 20

Stocks were strong in the second-to-last week, with the S&P 500 moving back into the green just barely for what has been ultimately not a very exciting year for investors.  Here is how we look in all of the models:

 

Top 20 put up another good week, aided by our newest purchase, AKAM, soaring after it made a strategic acquisition to eliminate a competitive threat.  I was also pleased to see IIVI respond well to negative news (updated guidance).  Working against us was the fact that larger stocks led the way this week.  For the week,the  model rose 4.17%, slightly besting the S&P 500's 3.79% return.  After a decent October relative to the market but a bad November, the model is ahead of the market by 1.86% this month.  With the recovery, it is still 0.9% behind the S&P 500 for the quarter.

Conservative Growth/Balanced rallied by 2.46% this week, which was 0.42% ahead of the 60/40 Stock/Bond index.  While the model is lagging slightly in December, it remains ahead of the benchmark for the quarter slightly as well as the year.  The performance this week can be attributed to the fact that we are overweight stocks and underweight bonds, with stocks rising and bonds falling this weak. 

Sector Selector ETF gave up some ground, trailing the market by 0.65% this week.  This adds to the underperformance for the month, with the model lagging the S&P 500 by 1.4% in December.  So far this quarter, it remains slightly ahead of the benchmark.  Small-Caps and Emerging Markets were the reasons for the poor performance this week.  On the other hand, our largest position is in Financials, and they look like they may finally be ending their underperformance.  This week was very strong.  Unfortunately, I have been too early on the sector - same with Emerging Markets.  I do expect to have a few trades to execute on Tuesday.

Market Outlook

The market got off to an ugly start but surged Tuesday as market participants began to better understand the recent global liquidity program announced earlier this month.  Short-term government bond rates plunged in Europe as a consequence.  The move was good enough to trigger an indicator I watch, the Investor's Business Daily outlook, which turned positive.  The trigger was the "confirmation" of the move off the low set in late November.  It took a very long 17 trading sessions to achieve the signal, which is a function of a large rally on increased volume.

The year is ending, and trading could be volatile over the next four trading sessions due to light volumes.  One thing I expect to see is continued strength in some of the beaten-down names, especially in small-cap.  In general, with pretty bad performance by professional investment managers this year, I think that we could see some real gaming with smaller stocks in general, as fund managers push up the prices at year-end to boost the performance.   I know that I threw out a 1340 forecast a few weeks ago for year-end.  While that's possible, I don't think we see it. 

Not surprisingly, this is a time of year that people love to share their one-year outlooks.  I usually set my outlook well before December, which I shared previously (looking for a big move up to 1600 on the S&P 500).  What I am hearing from my clients and in the media is that 2012 will start slow and finish strong.  While I tend to be somewhat nervous about the crowd's outlook (it never seems to play out as expected), I have to say that 2012 did play out as expected (not much change). I proved to be the outlier with an aggressive forecast (1500) that was on track until April but then quickly began to look foolish.

My value-add is not in calling the market, but in finding good stocks.  Still, I think it's important to understand the big picture.  My view is very similar to a year ago - stocks are extremely cheap relative to alternative investments due to poor sentiment following the once-in-a-generation slaughter for the second time in one decade.  As I consider the fundamentals, I wasn't that excited last year, and I remain in the camp of "slow growth".  We got slow growth this year, but due to natural disasters and the European financial challenges, fears about the future were even greater than last year.

Remember 2010?  2011ended up looking almost the same.  In both years, the market marched to new highs in late April.  In both years, growth slowdown fears led to horrible summers.  In 2010, we bottomed at Labor Day, when the market made it's low for the calendar year.  In 2011, we bottomed a month later.  The rally at the end of 2010 was powerful, eclipsing the April highs.  This year, while we ended up having a very strong Q4, we were unable to recover the previous highs.

Going back to the "slow start but finish strong" consensus that I see emerging (the bears would say slow start but slow finish, so everyone agrees on slow start), I think we get a fast start and strong finish.  The difference this year will be the lack of the summer swoon of the past two years.  Most likely, this will require Europe remaining at least stable, which includes a mild recession as austerity measures kick in.

As I have been saying, we do face many fundamental challenges, but our companies continue to plug along and our consumers seem to be past the extreme retrenchment following the 2008 Financial Crisis.  We certainly aren't hitting on all cylinders, but there are signs of improvement in key housing and auto industries.  I think the wild-card for the year will be the employment outlook, which is slowly improving.  Keep in mind that growth solves a lot of the problems our economy faces.  Getting people back to work, if it continues, is the best thing that could happen. 

Of course, we have the elections with which to contend.  My view here is that elections create uncertainty, so I can see how no matter what happens, we will see more optimism afterwards.  The last time we elected a President, we were in the middle of a huge shock.  While things aren't great, most people are better off today or feel better today than they did in late 2008.  With a little more improvement, this perception will be even more magnified.  Obama is likely to benefit from this improvement.  I expect that he will be reelected. 

Stocks are really, really inexpensive.  Earnings are higher than a year ago and likely to continue to rise.  Prices are on average the same.  Interest rates are lower.  Add that up, and stock are a bargain by any measure.  I expect that we will see a lot of M&A as the new year begins, and this will be a major factor I consider when adding new names to the Top 20.  Other themes I am pursuing is the concept of buying stocks that have record earnings but not record prices - there are lots, and we do own some.

Cheap valuations and challenging fundamentals leave many thinking that we are in a deadlock - no reason to buy stocks.  I see this point, so I turn to the technicals:  What is the price action telling us?  My view remains that stocks began a new bull market in 2009 and have been tested now twice.  We began a new intermediate uptrend in October and have spent the past two months consolidating it, including a very deep test in November.  We had two consecutive declining quarters (Q2 and Q3) followed by a what will be a winning quarter.  Slightly higher prices, in my view, will draw in a lot of buying, and we aren't far from those levels.

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Final Thoughts

As the year-end approaches, I want to see if there is continued interest in conference calls.  We held our first one at the end of July to discuss the market conditions and then again in early October as part of a process to hold quarterly discussions. 

I am not so sure that the interest runs very deep.  If you have a strong desire for the live call, let me know.  Alternatively, I now have some good software that allows me to create an audio file.  I am happy to field questions in advance by email and incorporate them into my presentation.  Another option would be to collect questions by email and to provide written responses.

Please let me know your thoughts.  No matter what, you can count on me to continue to keep you up-to-date with my weekly commentary and trade updates. I also have been sharing a more thorough portfolio review on the blog on a quarterly basis.  My goal is to make sure that subscribers are confident that they understand my thinking when it comes to running the models, so please share your preferences.

Finally, if you are interested in a more interactive experience, My Own Analyst may be for you.  Many of the subscribers also subscribe to Invest By Model, and they value the frequent discussions about the names in the models.  MOA subscribers also have access to recommendations on names outside the models, especially those on my watchlist.  If you are interested and would like to learn more, please read the brochure.  I am offering a free look until year-end - just email me if you would like access or have any questions.

 

Merry Christmas!

 

Alan Brochstein, CFA

www.InvestByModel.com

Disappointment, But No Damage

European stocks were quite weak this week, dragging down U.S. stocks, but the recovery that began in early October appears to remain intact.  Here are how the models look as of this evening:

 

Top 20 caught a break - didn't we deserve it?  SYNO's 50% surge helped a lot, as we would have given up a little ground otherwise.  Stocks in the model were all over the place, with two stocks besides SYNO positive but 8 down by more than 5%.  We fell 1.3%, while the S&P 500 fell 2.8%.  Beyond SYNO, we had several stocks rally but a few plunge.  So far this quarter, we are lagging by 1.2%, but we are ahead of the S&P 500 this month by 1.4%.

Conservative Growth/Balanced had a challenging week.  Our stocks lagged a bit, and bonds rallied (we are underweight) while stocks fell (we are overweight).  For the week, we declined 2.3%, while the stock/bond index fell 1.5%.  So far this quarter, we are now about 0.25% behind the benchmark, though we maintain a marginal advantage for the full year. 

Sector Selector ETF lagged a bit this week, hurt by the exposure to Financials and Emerging Markets.  For the week, we declined 3.8%, while the S&P 500 fell 2.8%.  So far this quarter, we are substantially ahead of the S&P 500 (9.3% vs 8.4%).

Market Outlook

Gold collapsed this week as the dollar rallied slightly against major currencies, declining the first four days of the week before finding its footing today. Interest rates remain depressed here and in Germany.  Taken together, we can assume that expectations are becoming somewhat more negative about economic outlooks following last week's Euro summit.  Recall, there was no money-printing or leveraged bond-buying bazooka fired, leaving investors feeling, for now, that European bond rates may remain elevated.  My take is that this is more of the same.  The European Central Bank and the Germans don't want to play their cards now.  First, they want to extract progress on more tightly aligning the EMU fiscally.

While we are down slightly this month and this year, the U.S. market is the best among major economies.  I have been hopeful that investors will soon begin to accept that there are big concerns but that they appear to be more than priced in, but it's hard to get confident about the very near-term.  Today was the quadruple options expiration, and there is unlikely to be a lot of volume over the next 9 trading sessions to end the year.  I do expect that some beaten-down stocks may attract some investor attention, but this type of thing sometimes happens after the calendar turns. 

My technical view is that the market endured a sharp correction.  This is definitional though, as technically we may have hit a bear market while Europe and many other markets certainly triggered the official "bear market" with declines in excess of 20%.  Our market is clearly in a rally mode since early October.  Further, we had a big test a few weeks ago and are now comfortably (well, not exactly "comfortably" but still somewhat) above the lows set in late November.  While this may not be apparent, this type of formation prevails around the world.  Yes, Europe, the epicenter of financial woes, put its lows in early October, rallied, retraced and is above the late November lows too.  I believe it is important to watch the European stocks (and the currency).  Their stocks are down more than ours, but they are showing a similar pattern of a good low having been set earlier this quarter.  Further, for all the concerns about Europe, the Euro has declined only 2% this year relative to the dollar. 

Tying it altogether, I have no change in my views.  Stocks are very cheap, reflective of fundamental challenges that are quite prevalent but also well known.  I think sentiment is almost as bad as it was in early 2009.  I view the technicals as favorable.  I was too optimistic this year for sure, as I had expected the market multiple to move to 15X from 13X on $100 projected 2012 EPS.  The 2012 projected EPS are indeed $100 a year later (actually $107), but the multiple currently is closer to 11.5.  As I look out, we could see some big and seemingly unexpected improvement in the employment outlook.  Already, initial claims have dropped sharply.  The potential changing of the guard (or the reaffirmation, if I am correct, with Obama somehow pulling off reelection) could prove to be a catalyst for sentiment too.  My forward outlook entails an expansion of the PE to 14X but on projected 2013 EPS of $110.  This works out to 1600.  My expectation is that the current 2012 estimate of $107 is probably too aggressive, and we will need to contend with that in the first couple of months of the year as companies report Q4 but also project 2012 outlooks.  My guess is that lower earnings are priced in - that's why we are down from April by over 10% still.

One final thought on my outlook is that smaller companies should continue to attract potential M&A activity.  As long as the headwinds are going to keep blowing, which is likely, larger companies, starved for growth, will continue to try to buy it.  A second big driver for smaller stocks will be improved investor sentiment.  Small stocks suffered in 2011 as soon as the market turned in early May and liquidity began drying up.  It's not always that market direction dictates the relationship between big and small stocks, but that is the dynamic these days.

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Regards,

 

Alan Brochstein,CFA

www.InvestByModel.com

Trades in All Three Models

In CG/B, we are adding to two Healthcare names, using some of the cash we have raised recently to take advantage of the dip in prices this week.

In SSETF, we are adding modestly to our Financial exposure.  This trade leaves the model about 8% above the S&P 500 in terms of exposure. 

The acquisition of SYNO has allowed us to redeploy over 7% of the portfolio.  We are adding to three names and establishing a new position.  The adds all offer 60% or more to my one-year target, and I consider each of them a possible acquisition candidate.  In each case, the stock is now above average in size.  The new buy is a name that we traded successfully in 2009.  After we sold it, it proceeded to double before round-tripping.  In any event, this Technology company offers about 47% to my one-year target, which is still well below the high a year ago.  I believe that the growth prospects are strong for this unique company and find the valuation compelling.  Keeping with the theme, I include this company as a potential acquisition candidate as well.

For taxable investors, you might choose to defer the sale of SYNO in order to capture a long-term gain potentially or to defer the recognition of the gain until 2012.  I have reviewed the proxy that was filed yesterday.  BAX approached SYNO.  Clearly, they are serious, and I would expect that they will close the deal, but they have the right to terminate if they find an "adverse material effect" or there is a regulatory constraint.  The latter is almost impossible, but the former is always a small risk.  There is always a small chance another bidder could emerge, in which case SYNO would have to pay about $10mm (<$1 per share).  Given that the stock is trading about 1% below the $28 bid for a deal that settles in about 3 months, I would suggest that the current price reflects very little risk of the deal not closing and maybe a small potential for a higher bid.  My best guess is that the deal closes at $28 in March, which gives you the chance to delay sale if that fits your needs.

Synovis Life Technologies Acquired

This morning, Top 20 Model Portfolio member SYNO announced that it will be acquired by Baxter (BAX) at $28, with closing expected in Q1.  Long-time subscribers will recall that we first added this name in July 2009, so this has been a terrific opportunity that played out over a longer-time frame.  We will most likely be selling the stock tomorrow, and I think that 27.77 (where it  currently trades minutes after the open) is a fine place to sell.

I want to take a moment to highlight several aspects of the 29-month investment in this company, as I believe there are many lessons we can learn.  It also demonstrates how Top 20 is supposed to work, though it wasn't perfect in any sense.  I deeply regret now, with perfect hindsight, trimming the name just last week.  Before proceeding, here is a chart of the price from the time we bought through yesterday:

My first observation is that sometimes things take time to develop and to play out.  I was a bit early initially on SYNO, as we paid 15.34 on 7/14/09 after it dropped from 20 when it announced an acquisition.  We continued to add over the next 5 months, paying as low as 11.92 in November 2009.  At the end of 2009, our average cost was  14.02.  At the time of initial purchase, I set a one-year target of 24.  Until today, the initial position lagged the overall market, though the other purchases all proved to be "better than the market" through yesterday (and certainly after today).

My second observation is that trading can add a lot of value.  We had three sales, ranging from 12/22/10 until the more recent one last week.  The first trade obviously generated a LT gain, and the other two generated a mix of LT and ST gains.  We were able to make purchases below our sales prices following the first two sales as well.  While my most recent optimization proved costly, I remain committed to allocating more capital to stocks that look more attractive.  In 2011, trading has added to our return, even including having a smaller SYNO stake than at year-end.

SYNO was a Small-Cap, maybe even a Micro-Cap.  There were very few analysts covering the name when we first bought it, and liquidity has never been great.  I had the opportunity to visit with the CEO and CFO in their office in June 2010, was one of the few questioners on their quarterly conference calls and had a continual dialogue with management.  In fact, the CFO called me this morning to make sure I was aware of the transaction.  While I paid attention to the charts obviously, this was a fundamental story that I embraced and followed closely.   From the onset (after a dilutive acquisition), I believed that the market was making a big mistake in how it valued the company.  This is the type of situation where good work can pay off, even if it takes longer than expected. 

As difficult as this year has been for me with the Top 20 Model Portfolio, I am encouraged by how SYNO played out.  This is what Top 20 is all about - finding relatively unknown stocks that have great upside relative to the risk assumed, making the investment and trading it around.  We had suffered a drought of acquisitions this year after getting our fair share in 2009-2010.  As I shared earlier this year, I didn't expect smaller companies to outperform larger ones but I felt like a large allocation was important given the likelihood of accelerated M&A in a slow economy.  Sadly, only SYNO has proven me right, but we have others that I believe could be acquisition targets as well.  Predicting the timing, though, is next to impossible.

 

 

Rally Extends

The week started and ended well, with the high set on a gap-up Monday morning followed by a test on Thursday and then a nice recovery on Friday, leaving the market up modestly after the huge gain in the prior week.  Here is how the models looked at the close:

 

Top 20 had a good week, but we still have lots of wood to chop after a rotten November.  For the week, the model rallied almost 2.5%, which was 1.5% better than the market.  It leaves the model still lagging the S&P 500 so far this quarter by almost 3%, which is quite disappointing.  Historically, the model has performed better in rallying markets.  We continue to have several names that are under pressure from tax-loss selling in my view, but there are signs that this is lifting.  As I mentioned last week, there is still one beaten down name in the model that I am trying to embrace more, but I am questioning my confidence.  Otherwise, I like the portfolio.  I have seen how quickly the model can rally, and I feel like it is loaded up with stocks with tremendous potential.  We have been through a very tough patch that coincided with the market becoming more defensive in late April.

Conservative Growth/Balanced advanced 1.4% this week, beating its stock and bond index by 0.7%.  It remains ahead of the benchmark for this quarter.  Typically, the model lags in a big rally, but it has defied history.  Fortunately, we have been overweight stocks, which has helped and accounts for more than all of the difference.  The model has outperformed in 2011, but it hasn't done as well as I had hoped.  We recently reduced our exposure, and I am looking at several potential additions.  By my calculations, the lowest expected return over the next year for any security in the model is more than 30%.

Sector Selector ETF tied the S&P 500 this week, rising about 0.9%.   So far this quarter, the model has recovered half of the under-performance from May to September, rising 13.5% compared to 11.5% for the S&P 500.  The model was poorly positioned from the onset, but I believe it is set to benefit from a recovery in Financials and continued leadership by Small-Caps.

Outlook

This week may have marked the end of the pause to the rally that started in early October.  What was most impressive was that we closed up despite no "bazookas" out of the European Central Bank (ECB) or the International Monetary Fund (IMF).  Market pundits have been rightly concerned with sharply rising bond yields for Italy and Spain, but the expectation that they could come down only with intervention proved to be wrong.  The pundits and many market participants have been arguing too that Europe's Monetary Union could die, threatening the very existence of the Euro as a currency.  Instead, European leaders re-embraced the Euro and pledged to work on fiscal alignment.  So, European problems will likely linger, but it is rapidly becoming clear that the imminent threat to the global financial system is highly exaggerated.

In the very near-term, with just three weeks to go, I wouldn't be surprised to see some improvement as the market is gamed higher.  I expect the month to finish strong - so far we are up about 1%.   I could be way too optimistic again this year with my even higher target (1600) for year-end 2012, but I am sticking to my view, which is based on 14 PE (down from the 15PE I used for my 1500 target this year).  My forecast failed this year  because PE multiples slipped rather than expanding slightly as I had expected.  Next year, with a Presidential election that could reinvigorate calls for "hope and change" in a somewhat different and ironic twist to the campaign theme from four years ago, and an economy that looks a bit more resilient than this year's (which was hit by tsunamis, floods, financial contagion fears and the threat of government shut-down), we could move to an all-time high in the Dow Jones Industrial Average (14,200 is just 16.5% away.  It's easy to get lulled into complacency and fear, but I see a nice alignment of technicals, valuation and fundamentals here.  No doubt, we have some headwinds, like federal spending and a still-challenged mortgage finance market that is holding back the housing market, but a little growth in the economy can go a long way to addressing the challenges. 

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Regards,

 

Alan Brochstein, CFA

www.InvestByModel.com

Top 20 Trades for Monday

We have 3 buys and 3 sells for Monday, including the elimination of one name, two trims, two adds and a new purchase.  The net effect on the portfolio will be to raise the overall expected return modestly as we shift out of Healthcare slightly and Industrials to a greater degree towards Technology modestly and Consumer Discretionary to a greater degree.

Starting with the sell, it is, sadly, not my very worst investment in the Top 20 over the past 3 1/2 years, but pretty darn close.  I had initially sized the position small due to the risks I described at the time of purchase and fortunately never added to the position.  The investment was made at a time when the model was performing exceptionally well.  While it proved to be a mistake, I think the error wasn't in the purchase (as bad an idea as that proved) but rather in not selling it when I realized the story had changed significantly.  Even recently, I had hung on not because I thought the long-term outlook was good but rather it violated two technical rules I use to avoid selling stupidly.  It still does, but the position is so small that even if it rallied 50% it wouldn't have a material impact on the portfolio.  I truly apologize to subscribers for this one.

The two trims are quite different from one another, with one a loss and the other just taking some reasonable profits.  Why am I trimming these positions, which were among our largest holdings?  Starting with the "loser", it offers 52% to my one-year target, which is below average.  It is also slightly overbought.  It is a "value" stock lacking a catalyst, and it seems like we have enough of those.  The trim gets it to a size that is more in line with the opportunity as I see it.  The other stock reports in mid-December its year-end.  It offers 54% to my target, and the reduced size more appropriately reflects the opportunity.  I continue to like the company's long-term prospects, but I have to admit to being a bit fearful about the near-term prospects.

Our new buy isn't a new name.  It's trading well below where we sold it this summer (32+) and even below where we had purchased it about 11 months ago.  My target suggests about 58% upside.  The company just reported a slightly disappointing quarter.  It rallied last week but is still a bit oversold.  The Chairman of the Board owns 25% of the company and, having just sold his NFL franchise, may focus his efforts here on "extracting value".  This is a company I have followed from almost 5 years and in which I have confidence in management.

We are adding to a Healthcare name that was pounded on Friday amidst rumors of more potential headwinds for the Medical Device industry.  I may have to adjust my target slightly lower as we learn more about the actual pending changes with respect to Medicare, but, for now, I believe that the company offers 70% upside over the next year.  Like the biotech we are selling, it is oversold and is also overextended (a technical term I use to describe when a trend has persisted too long without any correction).  The other name is trading right where we bought it three months ago - it has traded a little lower and then a lot higher.  To my target, it offers 75%.

2009 and 2010 were years in which I could do almost no wrong in Top 20, but 2011 has proven to be more challenging than I had expected.  Relative value and contrarian entries paid off handsomely last year but have been a recipe for pain this year.  Value, in general, has underperformed, and I have done a poor job of adding "growthier" names.  We have one name that has really disappointed me greatly (one I added as "growth"), and I will need to make a decision regarding my confidence in their future.  As it stands now, it offers 72% to a target I have reduced significantly since the initial buy earlier this year.  The position is a little over 3% of the portfolio.  We have several other names that have performed poorly, but I have confidence in their long-term prospects.  I continue to look closely at a handful of new potential names to add as well.