“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness...” -Charles Dickens

October 8, 2012

The above seems to us an apt description of  the first 3 quarters of  2012 for the U. S. markets. It has been a year defined by a dichotomy. A Tale of Two Markets, if you will: the U.S. markets rife with uncertainty that can’t possibly climb higher…and the U.S. markets that do just that.

In Q3, the market continued to rally, albeit with low volume, as the central banks acted as catalysts, and a “calm before the storm” mentality produced nervous chuckles on Wall Street.  What’s so funny? Not much. Because not much has changed.

Domestic economic growth remains sub-par and recent numbers point to more of the same. European economies are continuing to struggle as politicians attempt to craft a workable fiscal integration, and Chinese economic growth is slowing at a more rapid rate than previously thought. Geopolitical risks remain high. Sovereign debt issues continue.  The Fiscal Cliff keeps getting steeper.  Election concerns continue.

Yet, emerging from the shadows of these well-documented set of risks, two men armed with major announcements determined to make the markets continue to edge higher.

The first, ECB President Mario Draghi, who on Sept 6th delivered on market expectations to begin the outright purchases of Eurozone sovereign debt. While funds have yet to be deployed and the details are somewhat murky, the policy announcement has had the desired effect in reducing yields in problem countries and reinforcing the ECB’s commitment to the future of the Euro.

The second  our own Ben Bernanke, whose mid-Sept announcement of QE3, promised to keep policy rates at 0% for at least another three years and provided a flood of liquidity (real or perceived) into the system. This forced investors into riskier asset classes, driving the market higher despite contracting earnings.

Yes, you read right. Since Q3 began, earnings expectations have swung from a +3% year over year view to -2.3%, yet the S&P 500 has managed to rally 6.5% over this period.  The market is near highs instead of  in corrective mode where perhaps it should be.

On a somewhat more positive premise, the economy remains in low-growth mode, and signs of an imminent recession have not emerged. Auto sales remain strong, and retail sales have rebounded from a mid-summer slowdown. The housing market continues to improve and jobs are being created, albeit at a painfully slow rate.

So plods on one of the most unloved S&P 500 rallies in quite some time, fraught with risk, devoid of trends, and, seemingly, hell-bent on leaving active managers scratching their heads.  Most active, risk averse investors, like us, are underperforming YTD.

As of this date, we have again increased our holdings in several sectors.    Virtually all of our new holdings pay somewhat generous dividends.  We are no longer holding significant MLP positions other than in the Income accounts.

“The Winter of Our Discontent”

So the question is…how have we reacted, and what are we doing to capitalize? As is our custom at L&S, we have been managing the risk in today’s market nonstop, looking for the sectors that are driving the growth, and investing in those sectors, IF AND ONLY IF, our data points tell us that the sectors are risk appropriate.

Indeed, risk is everywhere.  While the renegade investor thinks the greatest risk is missing out on this run, even if it is fed-led, fundamentals be damned, we believe the greatest risk is following the herd and getting caught in a correction. The concept of being a passive investor and simply buying an index or buying certain sectors and forgetting about it is an anathema to us.  BUT that would have worked very well this year. However, we sleep better, and hope you do, with our approach.

You have hired us to analyze and determine the most appropriate risk adjusted investments to hold in your portfolio. While we think we might all agree that it has been frustrating to not participate in the year to date S&P returns, we never for a second considered wavering from our plan to manage risk and preserve assets. Rather than ride the rogue wave that is today’s S&P, against our principles and in lieu of our process, we are focusing on the preservation of capital and a positive risk adjusted return. This is what we promised and do, and this is what we will continue to do while minimizing risk as we see it.