Ramblings of a Portfolio Manager

Santa Claus smiled upon the US equity markets in December, delivering solid gains with much reduced volatility versus prior months. In this market environment, the Kettle Creek fund generated a strong positive return for the month as the high correlations among individual stocks, seen for most of the year, unwound allowing those with stronger intermediate-term fundamentals to outperform.

While 2010 can be characterized as the year investors in the US equity markets spent most of their time looking abroad and worrying, fretting over everything from debt defaults in Europe to inflation in China and military tensions in the Koreas--to name a few--December will be remembered as a welcome respite from global concerns, a month when investors turned their focus to the improved political landscape and strengthening economy at home. It was almost as if investors looked at the troubles overseas and decided, for a month anyhow, to adopt Alfred E. Newman's philosophy of “what, me worry?”

This isn’t to say that there was nothing happening in the global landscape to cause concern to investors at home. Ireland, one of the “I”s in the now infamous PIIGS (the second “I” having been recently added over concerns for Italy), continued to be thrust to the forefront as yet another over-leveraged, slow growth, entitlement-addicted European country in need of a bailout from the IMF and EU while Portugal, the “P,” loomed ever larger on the horizon as the next domino, followed potentially by Spain, the big “S.” China also continued as a global macro concern but for opposite reasons. In an effort to tame inflation in December the PBOC hiked bank reserve requirements for the third time in two months, followed by a Christmas day surprise of a 25 basis point hike in its discount rate. Suddenly, the same investors who have been calling the stated growth rates in Chinese GDP “falsely inflated” began to worry that the PBOC’s attempts to reign in the inflation generated by those “lies” would overshoot, slowing the “engine” of global economic growth too far and thrusting the world back into recession. And even while the mid-term elections in November improved the political backdrop at home, in December we were reminded that the bureaucrats are alive and well in Washington as the SEC launched a massive insider trading probe with some high-profile hedge-fund arrests while their counterparts on the other side of the hill at the newly created Consumer Financial Protection Bureau continued to attempt to weaken domestic financial institutions this time by drastically cutting debit card swipe fees charged by credit card companies.

Still, in December, investors believed that much of these concerns had already been discounted in the equity markets and a few early Christmas presents in their stockings helped them think more positively on
equities. On the European front, the IMF and EU moved much more rapidly than in prior situations to
staunch the bleeding in Ireland. Serious talk of a bailout fund to deal proactively with future crises ensued and China began buying up distressed bonds of many European countries (eschewing our own overpriced debt instruments), emerging as a potential financial backstop in future European debt dilemmas, particularly should Spain look to begin sliding into the same morass. As for China, while inflation fears persisted, a weaker-than expected PMI brought comfort to some that the tapping on the brakes efforts were beginning to work. Here at home our own PMI, Consumer Confidence, Industrial Production and Unemployment Claims numbers all came in better than expected and on the political front the Obama Administration rolled over on the Bush tax cuts, extending them another two years for all income brackets while unexpectedly tacking on a Social Security tax cut for all, an extension of unemployment benefits, more generous estate tax provisions and, best of all, a one-year 2% payroll tax cut with a 100% writeoff on capital investments for business. All of this positive news on the domestic economy caused many economists to lift their GDP forecasts for 2011 through 2012 by 50 to 150 basis points, something the markets had not been expecting.

With little new negative news and a spate of good political and economic data the US equity markets responded positively. The VIX dropped to at 3 year low, while Treasury yields began to climb despite the Fed’s efforts on QE2. The dollar climbed as well as did oil prices on expectations of economic strength. Suddenly, talk of a double-dip recession, rife over the summer, turned to hand-wringing over if the Fed would even complete QE2 and when they would start withdrawing liquidity ala the PBOC. In this market environment the Kettle Creek Small Cap Fund performed well as we have been exposed to the cyclical
sectors of the US equity markets all year long in the belief that the domestic economy would continue to strengthen, despite the turmoil in Europe. While this thesis hurt us during the downdrafts of May and August, when the talks of a European contagion were at their zenith, our discipline to stick with the thesis paid off in December. The strongest performing sectors in the fund were Financials, which were helped by the steepening yield curve, and Industrials and Materials, both of which got a boost from the improving economic data even in the face of a slightly rising dollar. Weaker sectors included Technology, to which we have been reducing our exposure, and Consumer Discretionary, which saw some profit taking after a nice run-up into Christmas.

We haven’t changed our outlook on the US equity markets, which continues to be favorable for 2011 and into 2012. We are a little concerned about the decline in Short Interest along with a recent bump in investor confidence—both signal that much of the good news in the Economy may be already discounted in investors’ minds and stock prices in the near term. We also have our eye on interest rates and energy prices with concern that the recent climb in both might begin to choke our nascent recovery. We expect, however, that the news flow domestically will continue to be positive and, though it will drive Treasury prices even lower thus further raising rates, will produce a net outflow from US bond funds and into US equity funds—something that hasn’t happened for over three years but the beginnings of which are just becoming manifest. That would signify an asset allocation shift among institutions as well as a return of the individual investor to the US equity markets. Given the relative size of the US bond market to the equity markets, such a cash flow reversal can produce sizeable stock price gains over the next several years.