Market Review
Q1 was a sensational start to the year for stocks, but bonds and commodities struggled. The Dow Jones Industrial Average, which set an all-time high, led the way, reflecting strong investor preference for larger, more mature companies and returning 11.7%. The S&P 500, a broader measure of the market, closed at an all-time high just below its intraday peak in 2007:
There was a slight bias in favor of Small-Caps, as the S&P 600 Small-Cap Index rallied 11.81% and the Russell 2000 increased 12.39%. The sweet spot was actually medium-sized companies, as the S&P 400 Mid-Cap Index gained 13.45% and the Russell Mid-Cap grew 12.96%. One of the things that jumps out about the quarter is the variation of returns between the different economic sectors. The best returns were among Health Care, Consumer Staples and Utilities, sectors that are considered the least economically sensitive. On the other hand, the largest sector, Technology, performed quite poorly. Part of this was due to the retreat of Apple, but the weakness was widespread.
Interest rates rose very modestly during the quarter, with the 2-year Treasury essentially unchanged at 0.24% but longer maturities rising. The 5-year increased 4bps to 0.76%, while the 10-year increased 9bps to 1.85% and the 30-year jumped 14bps to 3.09%. Other parts of the market performed a bit better. Including interest, the Barclays Aggregate Bond index returned -0.12%.
Performance among commodities was essentially unchanged, with the CRB index rising less than 1%. Gold fell $80, closing near $1596. Oil was mixed, with domestic prices up a bit but brent crude, the best-known global benchmark, down $1 at $110. The pressure on commodities was likely due to the strength of the dollar, which rose about 9% against the Yen and 3% against the Euro.
Outlook
I shared a very extensive outlook at the beginning of the year. The key points:
- Bullish on stocks
- Bearish on bonds
- Cautious on oil
You may recall that I explained my 1664 year-end forecast for the S&P 500, a level that would reflect more of the same: Modest earnings growth and some PE expansion. With the close at 1569, we have already captured 60% of the price-return I expect in 2013 in just the first quarter.
In each of the past two years, my forecast proved to be too optimistic: The market rallied but less than I expected in 2012, and it was flat rather than rallying in 2011. At this point, while I am somewhat cautious for technical reasons, I wouldn't be surprised if my forecast proves modestly below the outcome.
I have shared my expectations that we could get a 5-7% pullback in the market, with likely interim peak near 1590 (just 1.3% higher). I want to caution that as hard as it is to get the big picture right, calling these zigs and zags is extremely challenging. More often than not, these pullbacks come earlier or later than I expect and have been deeper tests than I had forecast. After three straight monthly increases in the market, many stocks are overextended. Some parts of the market are overbought as well, particularly those non-cyclical sectors I cited above as leading the way. I was also concerned that the Yen was devaluing too quickly, but that trend has stabilized.
The big takeaway from my caution (and not yet negativity) is that one should be careful chasing here, as a better entry most likely lies ahead. With that said, I want to reiterate that any sort of pullback, if it materializes, is likely to be an opportunity to increase equity exposure. What encourages me is that the market has been climbing a wall of worry rather than celebrating strong earnings growth. Many point to the age of the economic recovery (four years) or the market rally as a sign that bad things are about to happen. In fact, nothing could be further from the truth. The downturn in 2008-2009 was unprecedented in both its global nature as well as its depth. It would be silly to assume that the recovery will be normal - and it hasn't!
The bears point to the risk of rising rates, and I want to conclude this outlook with a brief discussion of a couple of scenarios. I have previously mentioned that I would be extremely concerned if interest rates rose while at the same time we were experiencing weak economic growth, as this would be crippling. This is not what's going on, and there are no signs of inflation. Rather, the small rise in rates so far (and bigger one that I continue to expect) is a function of the market beginning to anticipate a less accomodative monetary policy. After four years, it's time for the training wheels to come off. The pessimists think that were it not for that monetary policy, the economy would be stuck in recession still, but this is not the case. Rates will have to rise a lot to hurt the economy. I don't expect a major move higher in any event, as I don't expect that the economy will be so strong that the Fed needs to act aggressively or that bond holders will flee en masse.
Rising interest rates, if they reflect an improving economy, are a positive, not a negative. First, an admission that rates will rise must incorporate an assumption that corporate earnings will rise, which is good for stocks. Second, we seem to have already crossed a tipping point, as investors are beginning to recognize that bonds are a one-way dead-end street. A secular move away from bonds into stocks could help support a further expansion of the PE multiple for the market, which has increased but is still fair by any measure at about 15X. The bottom-line is that stocks are already priced for higher interest rates!
Model Portfolio Performance Review
We experienced mixed performance across the three models.
Top 20
Top 20 rallied 5.8% for the quarter, but this trailed the S&P 500 rather substantially, as the market rallied by 10.61%. Most of the underperformance took place in March, when the model retreated slightly as three of our holdings suffered double-digit declines while the market advanced 3.75%. Top 20 will turn 5 at the end of May, and the performance has been spectacular, with compound growth in excess of 18% compared to 5.1% for the S&P 500, but performance has been inconsistent lately. Worse, since the end of Apil 2011, the model has given up a lot of its relative advantage. Having been responsible for managing portfolios for 20 years, I have learned that performance can deviate from quarter to quarter or even year to year. While I am disappointed with how the year has started, I remain confident in my capabilities and my processes while also realizing that I have made some errors in not only stock selection but in overall portfolio construction. With this in mind, I am sharing a much deeper analyis than I might typically do. Let's first take a look at the stocks in the model at the beginning of the year:
I used color to illustrate the performance, which is ranked from best to worst. The red stocks declined, the green ones rose more than the market, and the rest were up but less than the market. A few things jump out. First, our beginning of the year portfolio has lagged (+6.5% with dividends), but it has done better than the actual model (I hate when that happens!). Second, we have had a bunch of dogs. Third, I let the winners go too early, as the top 3 stocks on this list weren't held all quarter. Finally, while it may not be so clear because I didn't label each of the holdings with its sector, we had a lot of the "bad" sector (Technology) and very little of the "good" ones (Consumer Staples, Health and Utilities).
In terms of quantifying the poor performance, sector positioning hurt a lot. Recall that 1/3 of the portfolio was in Technology to start the year, or about 10% more than the market. We had no Utilities and no Consumer Staples. Financials outperformed, but we were underweight. The LQDT position too was a major drag given its size. Additionally, while we had a lot of Healthcare, Conmy three Small-Cap Healthcare companies (LMNX, MAKO and MASI) performed quite poorly. The rough Q1 follows a strong Q4, which can be seen in our very slight underperformance over the past six months in the table above.
During the quarter, we sold three names, all strong performers: TYPE, RAVN and ESL. While each of them rallied after we exited, I am pleased that Coinstar rallied 20% after we added it in the middle of February. Our two other adds, both in the Consumer Discretionary sector and from early March, didn't move too much. We added to HAYN early in the quarter successfully, as it rose 9%, but our adds to MASI proved to be poorly timed. Worse, I added to LQDT right before it collapsed by 28%. We trimed a few stocks during the quarter, with most of those sales proving timely, including in EZPW, TECD, SMCI, STJ and TITN. In all, this repositioning cost the portfolio, mainly due the LQDT add and the early exits I mentioned.
The portfolio currently has a somewhat different sector exposure after the repositioning, with an increase in Consumer Discretionary and a decrease in Industrials and Technology:
- Technology = 26% (+8% vs. S&P 500)
- Industrials = 25% (+15%)
- Health = 22% (+9%)
- Consumer Discretionary = 13% (+1%)
- Financials = 6% (-10%)
- Materials = 5% (+2%)
- Other = 4% (+4%)
- Consumer Staples = 0% (-11%)
- Energy = 0% (-11%)
- Utilities = 0% (-4%)
- Telecom = 0% (-3%)
Conservative Growth/Balanced
This model had a strong quarter, rallying 8.93% compared to a 6.24% gain in the benchmark of 60% stocks and 40% bonds. This 2.69% advantage was due to several factors, including an initial overweight in stocks and underweight in bonds but also good stock picking. One of the highlights of the quarter was our add of MW, which rallied 14.6%. With that said, most of the action during the quarter was trimming or eliminating positions as we reduced exposure to be 61% stocks, down from 74% at the beginning of the year. These reductions are due exclusively to my view on the underlying names and not a purposeful attempt to decrease exposure. The current holdings have a dividend yield (weighted-average) of 2.5%, which is higher than the 2.0% of the S&P 500. With our current underweight in bonds, the total income of the portfolio is currently now slightly below the yield in the bond market, but I think that risk is a reasonable one to take at this time. Over longer periods of time, the goal is to produce a 1% yield above the stock market, but that is difficult to do in this environment, so I will defer to our other goal of capital preservation! Hopefully, continued capital appreciation will offset this income deficiency. Here is how the sector exposures look (weightings are equity-only and not for the whole portfolio, which is 61% equities):
- Consumer Discretionary - 25% (+14% vs. S&P 500)
- Technology - 24% (+6%)
- Health - 18% (+6%)
- Financials - 14% (-2%)
- Industrials - 10% (equal)
- Energy - 5% (-6%)
- Consumer Staples - 3% (-8%)
- Utilities, Materials and Telecom - 0% (-10%)
Sector Selector ETF
This model increased just 4.79% in Q1, trailing the S&P 500 by 5.82%. Changes in the holdings detracted slightly, as we added to laggards that continued to lag. The biggest drag has been a very large exposure to gold miners. Frankly, while I continue to like the sector, I am losing patience. Our ETF lost 18% of its value during the quarter and fell 11% from the time we added in early February. Positively, our last add, which was large, was at lower prices, hopefully signaling an end to a very long period of divergence from gold and from stocks. Emerging markets stocks, our largest position after Small-Caps, performed very poorly as well, declining 4% on the quarter. Our large Small-Cap exposure did offset some of the drags from these two areas. The major change in the portfolio was a large increase in our exposure to Technology. This portfolio will perform best in an environment where international stocks outperform with an increased concern on inflation (or some other reason that gold miners revalue). Current market conditions suggest that I might reduce exposure to Small-Caps in the near-term, but this would be more tactical than strategic.
