Ramblings of a Portfolio Manager

Sit on it or Rotate?

What the heck happened last week? “ What?” You Say? From most investors’ perspective it was a relative calm week. Though May didn’t start off with a big rise, as we have seen in prior months, a look at the indices shows that all, on the surface, was fairly calm. The Dow pulled back a modest 1.3% but the S&P 500 fell a more severe 2.1% and the Russell 2000 dropped 3.7%. Profit taking? “Sell in May and Go Away?” Some “de risking” ahead of the halt of the Fed liquidity stream? Europe again? Yes.

Actually, the raw index data belies the real underlying damage that was done to many sectors and their constituent stocks. Of the 10 S&P sectors, only one rose during the week, and that was Healthcare, up a modest 0.03%. Selected sectors, particularly ones that have done well this year, were taken to the woodshed with Energy down 7.3%, Materials down 4.5% and Industrials down 2.5%. Financials and Technology also took it on the chin, down 2% respectively. And these are the S&P sectors, composed of large cap stocks. The movements at the small-cap end of the spectrum were even more severe—almost double across the board. Is this the long awaited “major” pullback that strategists have been espousing for months now or something more subtle yet, in its own right, more severe? We think the latter.

The week/month actually started on a high note. Over the weekend we received news that our arch enemy, Osama Bin Laden, had been killed in Pakistan and much valuable Intel had been gleaned from his computers and records. That news alone sent the morning futures into triple digits. However, by the end of Monday, all major indices were in the red with the Russell 2000 taking the biggest hit, down over 1% on the day. The Dow, which held strong for most of the day, succumbed at the end and posted a modest loss. So was this “sell in May.” Well, there was selling for sure but there was also some buying—it depended upon what sector one looks at. With Energy, Materials and Industrials taking the brunt of the hit, one could point a finger squarely at the dollar. After all, the key to these sectors all year has been a weaker dollar. In fact, the dollar did rise for most of the week and the equity markets responded with their expected inverse relationship. The temptation would be to simply dismiss the action as investors’ attempt to get ahead of the Fed’s inevitable withdrawal of liquidity from the system slated, in Ben Bernanke’s words, for several months from now. We remind investors that a simple halt to QE2 does not mean an instant withdrawal of liquidity—we, like Japan, can sit for months, years, with low rates and lots of liquidity in the system. And in some ways, the actions of certain asset classes last week bore this theory out—bonds actually rose during the week, something most portfolio managers would expect to happen in reverse once the Fed stopped buying. So what was going on last week? Did simple patriotism cause a flight to the dollar and US bonds?

From our perspective last week was a sector rotation, plain and simple, but a strong one at that. Consumer growth companies and health care, the old fall backs in a weakening economy, far outperformed the cyclical sectors of energy and materials. The fact that we got some weak data during the week (weak GDP, ADP, Service Sector PMI) only reinforces this viewpoint. Fears of Fed tightening had little to do with this—in fact, the Fed factored in little except that Bernanke made it clear we would not have a QE3 and that, combined with weak economic data, scared many investors into thoughts that that the economy couldn’t stand on its own—i.e. that we would be headed toward a double dip once QE2 came to an end. That thinking explained much. Flight to the safe haven of Treasuries and the Dollar seem to be the rule when things look weak here (confirming that the Dollar remains the world’s reserve currency) and the rotation into less cyclical sectors confirmed the trend. By the end of the week, we saw somewhat of a reversal of trend but rumors of Greece pulling out of the EU stoked more headline risk and the rebound rally lost most of its steam.

So are we headed for a double dip or, at the least, a weakening economy? As we write Goldman Sachs is cutting its GDP forecast for the rest of the year by 0.50%. Not the stuff of a double dip but not heading in the right direction either. The worrisome part is that our foreign trading partners are still struggling to reign in their own economies, something that, if they are successful, will dampen foreign demand for our exports. Again, not something good for robust GDP at home. While we still believe that QE3 is not yet on the table, the Obama administration is up for reelection in 2010 and 9% unemployment just isn’t going to get him reelected. Then again, throwing us back into recession with squabbling over debt ceilings and Social Security cuts isn’t going to retain that republican majority either. So there is impetus on Capitol Hill to get things moving. In the end, we think the Fed will once again come to the rescue and hold off on any liquidity withdrawal until at least next year. And if the data continues to come through weak, then we may see loose monetary policy deep into 2012 or later. Maybe even QE3. Are we in Japan, you ask? It’s beginning to look like it.