Cautiously bullish about stocks for the rest of 2012

Author: Charles Sizemore

Covestor models: Sizemore Investment Letter and Tactical ETF

This year is off to a torrid start. The S&P 500 finished the first quarter up 12 percent, its best start to a year since 1998. The Nasdaq had an even better quarter, up nearly 19 percent—its best start since 1991.The more staid Dow Jones Industrial Average gained “only” 8.1 percent, but this put the index to within just 7 percent of a new all-time high.

Most European and Asian markets posted healthy gains as well. The German Dax rose a full 18 percent. Spain was a notable exception, as the only major market to see a decline.

There is good news in these numbers and bad news. The good news is obvious, of course. Stocks are enjoying one of their better rallies in memory, and the gut-wrenching volatility that defined 2011 seems more distant every day. The downside is that stocks have already come close to returning in a quarter what most money managers—including Sizemore Capital—expected them to return for the entire year.

This leaves investors to wonder what to expect for the remainder of 2012. Will the volatile opening weeks of the second quarter of 2012 be a harbinger of things to come?  Last year, also started strong before degenerating into three quarters of “risk on / risk off” volatility. Might we expect more of the same?

Sizemore Capital does not spend an inordinate amount of time pondering such questions. Instead, we concentrate our efforts on finding attractively-priced investments that offer the potential for reasonable return with only modest risk.

Still, the overall direction of the market does matter, and the vast majority of equities and other traded securities—no matter how well researched—tend to follow the direction of the broader market. And there are certainly times when it makes sense to be out of equities altogether.

We do not believe that this is one of those times.

With the European sovereign debt crisis looking to enter another rough patch, we expect the month of April to be choppy and volatile. And once all is said and done, 2012 may prove to be one of those years where it pays to “sell in May and go away.” That would have been good advice last year, even if over the longer term that maxim has had a mixed record of success.

Still, looking at the bigger picture, we continue to find ourselves cautiously bullish. While the March employment report disappointed investors and sent world markets sharply lower in early April, the economic news is for the most part improving. Unemployment is falling, even if it is doing so slowly. By many measures, it appears that the U.S. housing market is beginning to firm up (though a real recovery is still probably a few years away in most metro areas).

And perhaps most importantly, U.S. companies find themselves in the best fiscal health in recent memory. Profits are near record highs, and corporate treasuries are flush with cash—cash that they are belatedly starting to put to work with dividend hikes and share buybacks. Stocks are also relatively cheap by most measures and exceptionally cheap when compared to the returns offered on cash and most categories of bonds.

In Europe, the bond markets are rebelling against Spain’s more relaxed approach to cutting its budget deficit. But given the safeguards put in place, it is difficult to see this degenerating into a repeat of last year.  The European Central Bank has made unlimited liquidity available to Eurozone banks, which has eliminated the possibility of a “Lehman Brothers” moment in which a major bank goes through a disorderly default. Several large European banks—including UniCredit, BNP Paribas, and Société Générale—have already stated their intent to pay back their loans in the next 12 months, nearly two years ahead of schedule.

The performance of non-Spanish equity and debt markets also indicates that the concerns surrounding Spain will be contained. Sizemore Capital remains bullish on Europe in general and Spain in particular, as we believe that the attractive prices on offer on some of Europe’s finest companies more than mitigates the risk of short-term volatility.

As contrarians, it is refreshing to see continued skepticism among individual investors. American equity mutual funds continue to see weak inflows, and most investors we come into contact with are simply too paralyzed by the trauma of recent years to put their money to work. Psychological indicators (like all tools in the investment management business) are imperfect and sometimes deliver contradictory results.

Randomness and “noise” play an enormous role in short-term market moves that often swamp any useful information gleaned from sentiment indicators and anecdotal investor behavior. Still, we consider the skepticism of rank-and-file investors to be a bullish sign, all else equal.

Finally, we’d like to make a point about the sustainability of the current rally. In the April 9, 2012 issue of Barron’s, Michael Santoli commented that the S&P 500 had risen 28 percent in the past six months—a feat recorded 20 times since 1927.  Santoli noted that after such a run, the market was generally higher in the one-, three-, and six-month periods that followed.

While Sizemore Capital would never depend on this kind of data mining for serious investment decision making, we mention it to make a point: the market’s strong return over the past six months does not mean that a serious reversal is imminent—or at least this has not been the case historically.

In the first quarter of 2012, Sizemore Capital’s Tactical ETF Portfolio returned 9.1 percent vs. 12.0 percent for the S&P 500 Index. The Tactical ETF Portfolio underperformed the S&P 500 in the first quarter for two primary reasons.

First, our exposure to Spain specifically and Europe more broadly was a drag on returns, as the United States outperformed most world markets.  Germany was a noteworthy exception; our dedicated position in German stocks was a star performer for us during the quarter. Secondly, our focus on dividend-paying stocks was a drag on performance in a quarter that favored riskier and more cyclical asset classes.

Over the remainder of 2012, we would expect these two factors to be significant drivers of outperformance relative to the S&P 500. We expect Spanish and European shares to rebound sharply, and we expect dividend-paying stocks to outperform overall.

In the first quarter of 2012, the Sizemore Investment Letter Portfolio returned 11.8 percent, essentially matching the 12.0 percent for the S&P 500 Index.

The story here is much the same. The SIL Portfolio’s exposure to conservative American equities and to Spanish Telefónica (TEF) was a drag on performance, as were some of our contrarian “turnaround” investments. Our investments in “sin stocks,” luxury goods companies, and demographic-themed investments have been strong performers, however. Overall, we expect our thematic investment approach to generate market-beating returns over time.

In the first quarter of 2012, the Strategic Growth Allocation returned 7.5 percent, underperforming the S&P 500 Index. The Strategic Growth Allocation underperformed due to the fact that virtually every major asset class—including the European equities, high-dividend equities, master limited partnerships, and REITs held in the portfolio—underperformed U.S. large cap stocks.

We do not expect this trend to continue for the remainder of 2012. In fact, we would expect it to reverse strongly. Given current pricing, we would expect the other asset classes comprising the Strategic Growth Allocation to significantly outperform the S&P 500 over the next 9-12 months.