Monday, January 25, 2010

The Great Rotation

For those who give a lot of weight to the “January effect,” and believe that the first few weeks of stock market performance in any year is a good barometer of what to expect for the remainder of the year, last week sets up a major disappointment brewing in 2010. The S&P 500 Index with dividends reinvested closed the week down -1.99% from the beginning of the year and the most cyclical sectors of the market were further in negative territory. Semiconductors have had the most auspicious start to the year closing the week down -8.65% since January 1.

The investment team continues to examine our base case that the broad market can grind higher through the first half of the year based on the proposition that the economy is expanding and stocks should outperform. Our stated range for the S&P 500 to the upside remains at 1,200 - 1,300, even though we acknowledge that the stock market is, and has been, due for a correction within this cyclical bull market. Last week’s market performance can certainly be viewed in the light of a long-expected correction that, if recent history is any guide, will turn around long before the broad market reaches its 200-day moving average.

Nevertheless, we are prepared to begin rotating the portfolio out of the more volatile and cyclical sectors of the market and into more defensive sectors if and when the market moves higher. Last week we began the process with sales of our energy services position, a trim of metals and mining, and the sale of our remaining ETF positions in high-yield bonds in favor of a more conservative high-yield bond fund. We expect that this rotation could result in significant changes in U.S. sector allocations throughout the first part of the year. In-house we call it “the Great Rotation.” Of course, there is the possibility that last week was the beginning of a new cyclical bear market that will take the broad market down towards the lows set last March. If that is the case, we are satisfied that our current portfolio construction will defend a significant market decline should it appear from here.