Invest By Model

June Swoon Follows MAYhem

The market entered official "correction" territory, with the S&P 500 trading more than 10% below the intraday high reached in the first trading session of the quarter on April 2nd, closing at the lows of the day and slightly below the 1280 level I had suggested might be support.  Here is how the models looked one day into the new month:

In case you missed it, I posted a review of May on the blog.  As a reminder, you can always access the blog easily by logging in and clicking on "blog".  While I email quarterly reviews and weekly commentary, I always share end-of-month reviews as well as trade descriptions on the blog.  If you use Twitter, you can follow me for notification of updates to the blog.

Top 20 had a terrible day to cap a terrible week.  While the model is still up YTD, we are now slightly lagging the S&P 500.  We are well ahead of the Russell 2000 index of Small-Caps, which is up 0.07%.  For the week, the model dropped 4.5%, losing about 1.5% more than the S&P 500.  This week marked the four-year anniversary of Top 20, and, while we are in a rough patch at the moment, it's worth recalling the history of strong performance the model has enjoyed.  The S&P 500 is up a total of 1.63% since our launch (including dividends), while Top 20 is up 84%.  We don't win every single quarter (this data is available on the website under the performance tab, where we break it down by quarter and by year), and we tend to do a bit worse than the market when the market is weak, but we almost always make up for it when the market recovers, as it ultimately does.  We also tend to do better when the market is at its worst, like in 2008 (due to our focus on strong balance sheets).  While I have suggested that finding wildly mispriced (cheap) securities was a lot easier in 2009 than in 2010 and even the first part of 2011, I am quite confident about the potential of the stocks in the model currently.

Conservative Growth/Balanced declined 2.38% this week, which was almost 1% worse than the stock/bond blend.  The bulk of this poor relative performance was due to being overweight stocks and underweight bonds.

Sector Selector ETF had an interesting week, declining "only" 2.54% and beating the market by about 0.4%. This strong relative performance came today, as the precious metals ETF soared.  I had been a little early adding down in the hole to this one, but I believe that it offers a nice diversification potential as well as capital gains opportunity.  We are up 12% on the last purchase, but the first two buys are still below cost.  With the big jump up as the stock market has melted, I am inclined to consider taking some profits on the recent addition in the coming days, especially if it can advance a bit as the rest of the rest of the market tests the lower end of the 1250-1280 zone of support.

 

Outlook

Between my update this morning and what I shared last week, I really don't have much to add.  Let me just repeat what I said last week first and then I will try:

I don't have much of an update this weekend.  While it was encouraging to see the market bounce and get back towards the 1320-1350 zone that I had expected to be support for the S&P 500, we closed below it.  At this point, we are still in correction with no signal yet that the low is in.  I shared some levels that might be tested, including the possibility of a slight breach of the 2011 closing price of 1257.6.  Longer-term, I remain constructive, but, in the short-term, we are contending with some volatility related to Europe once again.  It's always hard to tell "what's priced in" , and the challenges to the global financial system are certainly out-of-the-ordinary, but we emerged from the 2010 and 2011 by printing new post-2008 highs both times.  The 2012 correction has been less severe (so far) and hasn't been nearly as volatile as the prior two years.  After two very strong quarters (Q4 and Q1), it's not at all out of the ordinary to retrace a bit.  We should get some news out of Europe in mid-June regarding the potential for a Greek exit from the Euro.  Until then, I expect that we could base between 1250-1280 and 1370.

So, here we are, at the high end of that zone.  I have no crystal ball, but I do have some tools that I can use.  They are telling me to remain patient before conveying that the lows are in, as the market isn't oversold enough to warrant a reversal in and of itself.  With that said, the bad news of today and this week (not just U.S. employment weakness, but also data out of China and India) could be a catalyst for coordinated activity by global central banks.  The problem is that haven't we "been there, done that"?  There are some big events ahead in June:  Supreme Court ruling on Obamacare, Greek elections (6/17), and a European leader's summit (6/22).  I do know that markets turn on a dime, and the big move in gold today may be a precursor to coordinated action.  As I mentioned this morning on the month-end review, perhaps it could inspire our inept political leaders in Washington to address the "fiscal cliff" sooner rather than later.  Markets hate uncertainty, and, as of now, we are on auto-pilot to fly into a potential double-dip recession if we push through the scheduled spending cuts and tax hikes.  

While the market doesn't feel quite as bad as it did at the lows in October, we finally have had several big down moves, though nothing like what transpired after July of last year into October or in the previous year following the May flash-crash.  I still see tremendous value in stocks and horrible value in government bonds.  My economic outlook has been for "muddle along", and that's what we have.  I tried to be cautious at the end of March, but I really didn't anticipate the extent of the contraction, especially among the smaller stocks that I tend to favor.   5-7% has turned into 10-12%.  After two back-to-back spectacular quarters, Q2 has retraced about 41% of the move in the S&P 500.  The 1250 level is approximately the halfway mark, which I suspect should contain this correction.  Hopefully, we are close to the end of the move. 

 

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Enjoy the weekend...

 

Alan Brochstein, CFA

www.InvestByModel.com

Correction Intensifies in May

Like the prior two years, this was a tough May. The macro issues overwhelmed the market, with a worsening political and economic situation in Europe deteriorating.  A surprise loss out of JPM and a horribly executed IPO for Facebook didn't help matters.  The value of the dollar soared against the euro and broke a key level of .80 to the euro, leading to a terrible pricing environment for commodities, with oil plunging and gold declining.  The CRB index is down about 11% in 2012, highlighting deflationary pressure.  Interest rates plunged to generational lows, with the 10-year very near 1.5% as the month ended.  The month of May saw very little difference in the performance between smaller and larger stocks, but sector performance varied greatly.  Consumer Staples and Utilities were down just marginally, while Telecomm Services actually rose.  On the other hand, Energy fell double-digit, while Financials, Materials and Technology all declined by almost 8% or more.

If a month of "mayhem" wasn't bad enough, it looks like we are starting the new month with a "June swoon" following very weak jobs data.  As I type (it's about 9AM EST), the market is set to eclipse the lows of May by just a bit.  I have been looking at this correction as having the potential to test 1280 on the S&P 500, and perhaps even go slightly negative on the year to 1250.  At that low level, the retracement from 1422 would be 12%, still much better than the 20% moves in the prior two years.  Fiscal and monetary policy responses are somewhat challenging to envision at this point, but there are some potentially positive changes in response to the weakening employment situation.  The one that stands out to me is a more pro-growth political response from the Democrats, perhaps even an early addressing of the "fiscal cliff" at the end of 2012 when many taxes become reinstated and automatic spending cuts are scheduled to kick in.  While much of the focus has been on Europe, this is actually a bigger issue and not out of our hands.  Favorably,  we do remain above support, this looks like a correction still and the market is now somewhat oversold.  If the technical situation worsens, we will need to make some changes to the structure of the portfolios.

May was rough for all of the models.  Here is how we looked at month-end:

Top 20 is still ahead of the market so far in 2012, but it gave up 2.09% compared to the S&P 500, falling 8.09%.  For the quarter, it has dropped over 12% and trails by about 5.5%.  Looking at the performance on the month, we had two stocks fall more than 20% and another 9 fall by 10-20%.  While one rallied 32%, only a handful or so were able to perform better than the 6% decline in the S&P 500.  The weakest stocks were in the sectors I highlighted as the weakest:  Materials, Energy, Financials and Technology.   

Conservative Growth/Balanced declined 6.5% during the month, which was over 3.2% worse than the blend of stocks and bonds.  QTD, the 7.09% loss is 3.95% worse than its benchmark.  In addition to being underweight bonds, which had a 0.9% return during the month, and overweight stocks, some of our stocks performed poorly.  The stock/bond allocation accounted for about 1/3 of the performance short-fall.  5 stocks declined more than 10% (3 from Technology and 1 from Financials), while one Consumer Discretionary name actually rallied.  

Sector Selector ETF fell 7.98%, which was 2.47% worse than the S&P 500.  For the quarter, the 9.89% decline has trailed the market by 3.78%.  We were very poorly positioned here, with exposure to 3 of the 4 weakest sectors as well as Emerging Markets.  Interestingly, our precious metals ETF, to which we added during the month, was the best performer, ending slightly ahead of the market (the only ETF to do so).  

Clearly, I am disappointed by the near-term market action as well as the results.  I manage these models for the long-term focusing on a one-year horizon.  While I felt at the end of March that there was some risk in the market, we have done a bit worse than the 5-7% correction I anticipated.  I don't think that the rally that began in 2009 or the economic recovery are over, but I am cognizant of the many risks our economy faces.  Hopefully, the weak start to June puts us closer to the end of this correction.

 

Bounce Week

Stocks bounced, holding the lows from the previous week.  Here is how the models looked as of Friday:

Top 20 lagged, rallying 1.44% and trailing the S&P 500 by .44%.  The past couple of weeks, the model has tracked the market in an uncharacteristic manner - holding in during the big downturn in the prior week but rallying less this past week.  Additionally, Small-Caps had a pretty decent week, which usually would have helped.  Looking at the stocks, nothing really stood out, though there was considerable variation.  While the S&P 500 rallied 1.88%, we had 8 stocks decline (the worst was just 1.5%).   This is a bit strange quite frankly.  We had several stocks perform quite well, with 5 stocks rallying above 3%.   This has been a very tough quarter for the model, but it is maintaining a lead over the S&P 500 in 2012.

Conservative Growth/Balanced rallied 0.41% during the week, trailing its benchmark by 0.68%.  Encouragingly, our best stock was one of the ones to which we added early in the week.  Still, of the 15 stocks in the model, 13 increased less than the market.  The model's performance in Q2 (and especially May) has been weak, with the QTD return differential more than offsetting the strong Q1.

Sector Selector ETF posted a good week, rallying 2.19% compared to 1.88% for the S&P 500.  In contrast to last week's uniformly weak performances by the ETFs in the model, we saw reversal of negative momentum in one of the larger holdings (Small-Cap) and in one of the more beaten-down ones (Precious Metals).  The strengthening dollar has been a challenge for the model this month.

 

Outlook

 I don't have much of an update this weekend.  While it was encouraging to see the market bounce and get back towards the 1320-1350 zone that I had expected to be support for the S&P 500, we closed below it.  At this point, we are still in correction with no signal yet that the low is in.  I shared some levels that might be tested, including the possibility of a slight breach of the 2011 closing price of 1257.6.  Longer-term, I remain constructive, but, in the short-term, we are contending with some volatility related to Europe once again.  It's always hard to tell "what's priced in" , and the challenges to the global financial system are certainly out-of-the-ordinary, but we emerged from the 2010 and 2011 by printing new post-2008 highs both times.  The 2012 correction has been less severe (so far) and hasn't been nearly as volatile as the prior two years.  After two very strong quarters (Q4 and Q1), it's not at all out of the ordinary to retrace a bit.  We should get some news out of Europe in mid-June regarding the potential for a Greek exit from the Euro.  Until then, I expect that we could base between 1250-1280 and 1370.

 

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Have a nice long weekend!

 

Regards,

 

Alan Brochstein, CFA

www.InvestByModel.com

Trades in Top 20 and CG/B

In Top 20, we are sharply reducing a relatively new position.  This company's fundamentals may be worse than I had been forecasting, and I have reduced my target substantially.  The stock held in relatively well last week but is at risk for a potential 10% decline in my view, and I feel it's necessary to cut exposure despite the poor performance since we initially added in late January.  It's too risky to hold as our largest position given my changing views.  We are redeploying the proceeds into two names that have pulled back sharply since we recently trimmed them.  In both cases, the two names, which will now be about average in position size (while the one we are selling will be slightly below average), offer higher returns to my one-year target.  As far as the remaining piece, I have several other potential replacements I am considering.

In CG/B, we are reducing a retailer that has performed well of late.  It offers about 37% to my one-year target, and the position size seems too big given other opportunities.  We are redeploying the proceeds into a Technology name and another Consumer Discretionary name.  The Tech company, which is below where we trimmed in in October, offers 67% to my one-year target and will now be the largest position.  The Consumer Discretionary name offers 41%.

The Worst Week of the Year

The consolidation deepened this week, leaving all of the models down sharply as the market fell each day:

 

Top 20 moved with the market roughly, losing 4.44%, slightly worse than the 4.33% decline for the S&P 500.  So far this quarter, the model has lost 12.36%, about 4.5% worse than the S&P 500.  In May, the model has dropped 8.35% compared to the 7.26% decline in the S&P 500.  Performance this week was very mixed.  We had a few stocks up slightly or unchanged, but a few that were hammered, especially the energy company that we had reduced recently but also one other double-digit decliner.  Considering the relative weakness in smaller stocks, the model held up fairly well.

Conservative Growth/Balanced fell 2.15%, which was about .4% better than the index of stocks and bonds.  For the month, the model has fallen 6.12% compared to 4.24% for its benchmark.  The relatively good performance this week was due to the performance of two of the retailers in the model that happened to rise after earnings reports.  

Sector Selector ETF had another rough week, declining 5.3%, about 1% worse than the S&P 500.  So far this quarter, it has dropped 11.33%, 3.5% worse than the market.  The challenge this week was primarily continued weakness in Financials and Emerging Markets.  The precious metals-related ETF that we increased early in the week (a bit too early) was the best performer.  I maintain confidence in the structure of this portfolio over the long-term, but the performance has not been acceptable to me.   

 

Market Outlook

As seems to often be the case, the market has fallen a bit more than I had expected.  In advance of the peak, I had suggested a pull back of about 5-7%, suggesting a low of about 1320 on the S&P 500.  So far, the low has been 1292, or a decline of 9% (130 points from the 1422 intraday peak on 4/2).   All of the technical indicators that had me somewhat cautious near-term as we approached the end of Q1 have corrected.  At this point, the YTD rally is still intact, but the third straight year of extreme dislocation rearing its head in Europe remains a big challenge.  Certain barometers are concerning market participants, including the strength of the dollar, extreme weakness in commodities and a retreat in the value of high-yield bonds.  To be clear, none of these has moved to levels that makes me rethink my basic thesis (slow growth, improving valuation), but it suggests that the consolidation that began in early April is perhaps not fully played out.  The "Facebook Fizzle" , a relatively tepid response to a very hyped initial public offering, certainly isn't adding to anyone's confidence.  Today was an options expiration too, which can magnify market moves.  

My 2012 projection of reaching 1600 represented an aggressive 27% gain, or almost 30% with dividends.  Through Q1, we were well ahead of that pace (12.6% instead of 7.5%), but now we are certainly behind (3.76%, while on a linear basis we should be closer to 11.5%).  It's hard to believe, but just two weeks ago, we made a new post-2008 high on the Dow Jones and were very near the 4/2/12 peak on the S&P 500.  My point is that the market moves around a lot.  Today feels horrible, perhaps the inverse of as good as it felt at the end of Q1.  It's important not to get sucked into the emotions of the market, or you end up buying high and selling low, a sure recipe for long-term failure in investing.  I tried to sound a cautious alarm when things were heating up, but I surely underestimated how much the market could swing back.  Keeping things in perspective, we have retraced about 38% of the rally from early October to early April - this is quite normal.  A fair question is:  When should I get nervous?  Let's mark that as S&P 500 retracing more than half the rally - that would be 1248 (another 3.6%).  At that level, the correction would amount to 12.2%. 

Will we actually get there?   I actually would expect not, but it's possible.  That would pull the market to down year to-date on a price basis (but about unchanged with dividends).  In 2010 and in 2011, we had the market pull back almost 20%, so this would be less of a correction but still quite substantial.  Before 1250 area, I do see some support at 1280. 

 

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Have a good weekend...

 

Regards,

 

Alan Brochstein, CFA

www.InvestByModel.com

 

Trade for Conservative Growth/Balanced Model Portfolio

With the pullback in stocks and the collection of dividends, we are under the 75% max exposure to stocks, allowing me some room to add.  The stock we are adding offers 38% to my one-year target and a 3.1% dividend yield.  The company looks attractive relative to peers, and I think the fact that it is purely domestic is a nice feature in this market that seems to be concerned about all things international.  This buy gets the position more appropriately sized, as it was our smallest position before today.  We had trimmed the stock in late January, and it has declined over 6%.

Sector Selector Trades

We are cutting exposure to a small-cap ETF that has actually rallied a bit more than the S&P 500 this year in order to fund our purchase of a precious metals-related ETF.  The ETF we are buying is very oversold at this point.  From a technical perspective, the action this past Wednesday suggests to me that the recent downtrend may be ending.  I was premature in adding this exposure to the model in Q1, but the sector offers the potential for both appreciation as well as diversification.  

The Week That Felt Horrible But Wasn't

For all the angst this week, which included concerns over Europe flaring up and a large one-time loss at JP Morgan, the markets were just slightly lower.  Here is how we look:

 

Top 20 had a lot of volatility among the constituents, with earnings reports driving the action.  We took a few big hits.   For the week, we declined  a little over 2%, which was about 1% worse than the market.  So far this quarter, we have lost 8.3%, which is 4.6% worse than the S&P 500.  For the year, we are up 10%, but it's disappointing to give up almost half of our Q1 gains.

Conservative Growth/Balanced also had a rough week, hurt by an earnings report as well.  For the week, we declined 1.7%, which was about 1% worse than the 60/40 stock/bond index.  So far this quarter, we have lost 4.7%, which is about 3% worse than its benchmark.  For the year, the return of 5% is now trailing the benchmark by about 0.9%.

Sector Selector ETF lost about 1.6% this week, underperforming by about 0.5%.  The weakness in Financials as well as continued poor action in Emerging Markets and Gold Miners weighed heavily.  For the quarter, the model is down 6.4%, about 2.7% worse than the market.  For the year so far, the 7.3% return is now a little over 1% behind the S&P 500.  

 

Market Outlook

It seemed like the shallow correction had ended, but the market actually extended it slightly this week, with the S&P 500 trading to a low of 1343 on Wednesday, 1% below the 1357 low in early April.  I am not too concerned, though it's not yet clear that 1343 will prove to be the ultimate low.  Recall that I was forecasting a 5-7% decline from the peak, and 1343 represents 5.5%.

I continue to believe that the pattern of the last two years will not be repeated, meaning NO SUMMER SWOON.  As much angst as there was this week, consider that at the lows we were down less than 2%.  Next week, Facebook (FB) will finally price, perhaps improving the psychology a bit.  While the quarter has been a real dog so far, especially for the models, it's important to put it into the context of the big rally from October through March.

 

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Have a great weekend, and Happy Mother's Day to our moms out there!

 

Regards,

 

Alan Brochstein, CFA

www.InvestByModel.com

 

Top 20 Trade

Going into today, the two positions we are trading were equal in size, both at about 5% of the model.  The small trade today reflects that the stock we are selling is now somewhat overbought and offers about 40% to my one-year target, while the stock we are selling is somewhat oversold and offers over 60% to my target, which I revised slightly lower.

Trades in Top 20

We had some excess cash from the sale last week.  Two stocks that were well below average in terms of position size were recent trims that fell sharply after our sale.  The small adds today leave both those positions still below average size despite the above-average returns.  The large financial saw its estimates actually rise slightly for 2012 and 2013 earnings following its Q2 report, while the small Technology stock, which beat in Q1 but guided a little light for Q2, saw its estimates maintained at prior levels.  My current targets on these stocks are 51% and 73% respectively.