Invest By Model

Away from the Edge of the Cliff

In what was a dramatic reversal of the frightening action during the thin Thanksgiving week, stocks staged a massive rally this week:

Top 20 rallied 8.5% this week, edging out the S&P 500 by over 1%.  Still, the model is trailing this quarter by a disappointing 4.5%.  With four weeks left in the year, I continue to evaluate a few names that have been among our worst performers for potential sale (as well as a few others too).  As always, my goal is to deliver market-beating performance over a one-year horizon, and that has certainly not been the case this year (really since late April).  Any decisions I make regarding the portfolio will be consistent with that goal and not driven by short-term considerations.  Just as I didn't stop trading in late 2010 (as better opportunities presented themselves), I won't trade excessively in an attempt to salvage this year.  Some much smarter investors than me have struggled this year as well, reminding me that the road to success is often filled with potholes.

Conservative Growth/Balanced advanced almost 5%, edging out the 60/40 balanced index by about 0.7%.  While typically the model will lag a sharply rallying market, it has held up this quarter, matching its benchmark.  We reduced equity exposure this week and are currently at 70%, which is still quite overweight but now below the 75% maximum. 

Sector Selector ETF had an exceptional week, rallying 9.1%, which was 1.6% better than the S&P 500.  The model is still lagging since we launched right at the top of the market, but it is ahead by 2% so far in Q4.  We have an overweight in Financials that has been a drag, but I continue to believe that the risk/reward to that position is favorable.

Market Outlook

I had mentioned a week ago how precarious the rally had become, expressing my concern for an even tiny retreat from the weak close.  It was a whole new game this week, with three gaps up.  As I had noted, there has been a pattern of strong closes in all of the down months since the market peaked.  They came close to turning November green, but it proved to be a very slight decline for the S&P 500 and the Small-Cap Russell 2000. 

From my perspective, the rally from early October is intact.  While normally I would expect that we end the year strongly given what I see technically, I have become conditioned to temper my enthusiasm.  Unfortunately, we must continue to contend with risks of financial contagion and global recessions while Europe confronts its fiscal challenges.

Bottom-line:  We have a coiled spring waiting to explode once we have "clarity" on Europe. 

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Final Observation

For those who subscribe to CG/B, you know that I am not a fan of bonds here.  Today, I want to specifically call out Treasuries, which I believe are extremely risky.  The 10-year Treasury yields just 2%.  If one buys it, holds it to maturity and reinvests the semi-annual coupons, the "total return" over the next 10 years will be about 21%.  Almost all of this could be lost in a year if rates were to rise by 2% to 4%.  Having witnessed what happened recently in Italy and Spain, where the rates shot up above 7%, I worry about what might happen if demand for Treasuries fell because of an absence of buyers (since over 1/2 the buying comes from foreigners).  More likely, an improving economy could drive rates higher. 

In CG/B, we are using dividend-paying stocks and cash rather than hold bonds (which also include corporate bonds and mortgages).  In fact, of the bonds we own (the minimum), none are issued by the Treasury.  Depending on your risk profile and your investment horizon, I would recommend replacing all long-dated Treasuries with shorter Treasuries or alternatives.  I have written about BDCs, which yield 9% or more and could see higher total returns since many trade below tangible book value.  One can allocate a little there, a little to REITs (smaller ones seem to offer more value), a little to MLPs (be cognizant of tax-related issues), a little to Utilities (though many are fully priced), some high quality corporates (or munis), perhaps some low quality corporates (JNK or HYG), some dividend-paying stocks with strong balance sheets and reasonable growth prospects, a small amount to emerging market debt (through an ETF), and perhaps some to floating-rate corporate debt (again, though a fund or an ETF - I am working on this one). 

The most likely scenarios are that longer-dated Treasury bonds will prove to be inferior, with low or even negative returns.  Pension funds and professional investors have to own them - you do not.

Regards,

 

Alan Brochstein, CFA

www.InvestByModel.com

November Performance

Despite strong improvement in the last three days, all of the models lost ground in November:

Top 20 lost 4.5% during the month, with 11 stocks declining more than the 0.22% decline in the S&P 500.  While several stocks increased by more than 3% (all on the smaller side in terms of market cap), the performance was dominated by seven stocks that declined by 8% or more (all on the smaller side).  One stock in particular dropped 27% as a rival was unable to generate a takeover bid after trying to sell itself and as fears of potential government cutbacks in the future apparently scared a large holder of the stock.  I expect this stock could recover by 20% or more over the next two months from extremely oversold levels that have left it at an extraordinary value.  One of our stocks, a recent purchase, declined on a bad earnings report and diminished outlook.  The stock had already lost 25% of its value before we purchased it in what proved to be poor timing.  Tax-loss selling may also be a factor in some of these steep declines.  While I am very frustrated by the performance, I know how quickly things can change (as the past few days demonstrate).

Conservative Growth/Balanced lost 1.1%, underperforming the stock/bond index by about .9%.  The performance here was marred by two double-digit decliners, both of which reported disappointing quarters.  More stocks increased than fell during the month.  Despite the rough month, the model remains ahead of its benchmark for the quarter by almost 1% and is back above the benchmark for 2011 after having slipped below last week.

Sector Selector ETF lost about 1.5% and trailed the S&P 500 by 1.3% during the month.  While the model would have lagged without the heavy exposure to Financials, it was hurt by the 5% loss in that sector.  Despite the weak performance, the model is ahead of the market so far in Q4 by 1.7%.