Portfolio Selection for 2012

To say that this was an interesting year is certainly an understatement. To briefly restate the well-known issues, the lackluster US economic recovery, lack of direction from Washington, Arab spring, increasingly aggressive stance against Iran, Greek debt and Euro troubles, are just to list a few. We should probably refer to the “interesting” year as what the Chinese culture refers to “interesting”, meaning it is challenging or troublesome.

With high volatility and high correlations, it has certainly been difficult market to invest in. For the stock pickers especially it is virtually impossible to make good investments right now. Government interventions is turning out to be the key market driver, as opposed to inherent company valuations. The market is simply not trading on fundamentals.

The situation has not improved in the past couple of months. Many predicted a strong end of the year rally, or just some rally, but that that has not (at least as of today) turned out to be. The S&P 500 is up 0.24% for the month and down at 0.61% for the year.

Many have asked my thoughts on the next year and our firm’s expectations where the market is going. A short and straight answer is that we do not have a crystal ball to peek into the future, so there are no predictions. What I can share is what our quantitative process “Sector Scoring and Allocation Methodology” (“SectorSAM” for short) is telling us.

The “SectorSAM” analysis shows that the Financial (XLF), Technology (XLK), and Materials (XLB) sectors are undervalued and should be our portfolio holdings for the next 3-9 months. Here are the reasons why.

The Financial sector (XLF) has been the worst performing sector for the year, it is 19.23% down relative to the S&P 500. It behaved in similar fashion as the Healthcare sector did last year. It is primarily driven in the US, by the companies still digesting the impact of the Dodd-Frank act. Still a weak banking sector, albeit recovering slowly. The news from Europe, as it pertains to Greek debt and the crisis of Euro as a currency, as well as to the European economic union are either bad or really bad. We all heard of the “BRIC” countries, which stands for the growing emerging markets economies in Brazil, Russia, India, and China. As much as I don’t like it, some people have coined a new term “PIGS”, which is a rather unflattering term that refers to the four weak European countries Portugal, Italy, Greece and Spain. It is no wonder the Financial sector did so poorly this year.

So that brings me to the Long position in XLF for next year. The Financial sector is due for a long term rebound. Although Dodd-Frank is an expensive piece of work, most companies have either already digested or priced in the cost of compliance. The Euro crisis will get resolved, period, no doubt about it. There is too much at stake for the European union not get it done. Of course, there will be more drama, more gyrations, more negotiations, but it will get resolved and the Euro as a currency will not fold. It will get further devalued, but it will stay as the European currency. European countries might subdivide into “two speed” economies, but they will stay commercially and politically integrated and Greece and others will not drop out of the European economic union – too big to fail!

Other things that point to the rebound of the Financial sector here in the US are low interest rates and strengthening financial institutions. Historically, low interest rates allow economy to grow (need to control for inflation of course) and bring about rising stock market. The financial institutions are operating at optimal efficiency now, with costs well down and earnings (slowly) on the rise. All taken into account, I believe the Financial sector is ready for next year’s gain.

The second Long pick is the Technology sector (XLK). After the downturn in 2008, all companies cut expenses drastically, through layoffs and lower or minimal capital expenditures. The expenses also affected periodic investments into technology and infrastructure. So now, three years later, the technology moved fast forward (Windows 7 is out, iPhone is in its fourth generation already, etc.), while the internal infrastructure has become obsolete and it hit the replacement period. Now that the economy and the markets have stabilized, i.e. there is no expectation of serious downturn, it is time for the companies to start increasing its spending into technology and infrastructure, hence the Technology sector should benefit.

The third Long pick is the Materials sector. As mentioned before, the US economy and the markets have stabilized and we are all expecting a recovery, not necessarily a large uptick, but recovery nonetheless. In a typical recovery environment, the Materials sector is one of the first sectors that can and will benefit from improved economic situation. I do want to point out that, although our analysis shows a rising Materials sector, we do not believe that the current recovery is strong enough to lift and continue to expand the Materials sector for a sustainable (longer than 3-6 months) period.

These are our thoughts and positions and we hope and expect, based on our analysis, that they will bring good results to prudent, risk averse investors in the upcoming 2012.

At the time of publication Gurvich and Rockledge clients had long positions in XLB, XLF, XLK.