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Energy Dominates First Quarter Returns

Relative Performance to S&P 500

Arthur Hill, a respected technical analyst put this chart together and I really like it. You can see very clearly that the return of the S&P 500 was dominated by energy companies. Industrials were the only other sector that showed outperformance to the broad index.

I’m a worrier – most of my friends know it. As I look at the coming quarter, I worry that we will see a correction much like we saw in the second quarter last year. Why? The end of QE2 scheduled for June will begin to be discounted by the market. Confusion will reign the day as we have never been through this before, and equity investors hate uncertainty. This leads me to think we need to raise cash, maybe 10% of portfolio allocations, in case we see a pullback.

On the flip side, though, is the fact that earnings season is upon us and we will likely see strong earnings. Growing earnings generally increase stock prices EXCEPT when we see shrinking P/E ratios – aka valuations. Certain things make investors less willing to pay for earnings, even growing earnings, things like potentially rising interest rates or slowing economic activity.

With the end of QE2, we could have both of these things. The Fed has been buying 70% of the treasury bonds issued to fund our deficits as part of QE2. If they stop, then interest rates will intuitively have to rise to entice others to buy the bonds. Also, if the monetary stimulus ends, the potential exists for the economy to slow down.

But the emerging economies are still growing and much of industrial America has transformed itself into a supply chain for Asia and South America. A slowing US economy quite possibly could have only a marginal impact on overall corporate earnings as long as the developing world continues to move forward. Reports are that China is satisfied with its results in slowing its economy and is preparing to resume imports – and Brazil is thought to have a handle on its inflation issues and will complete its cycle of interest rate increases this year, pushing its stock market higher.

The spike up in oil prices today is also worrying me – at some point we will see demand destruction and impacts on economic activity from higher oil prices that will send oil stocks and other economically sensitive stocks down. We aren’t there yet, but I’m keeping a watchful eye this issue to see if we will side step a pull back.

So, I am in a holding pattern at the moment from a fundamental standpoint waiting to see how the stock market reacts to some of this stuff. I can tell you that from a technical standpoint, one fairly reliable indicator is saying that we are likely moving higher – at least in the near-term. As you can see on the following chart, the 10-day moving average of the S&P 500 Index has crossed over to the upside of the 50-day moving average. If you look at the chart, you can see that situation is generally good for several percentage points of positive return for the broader market.

S&P 500 Index with 10-day and 50-day Moving Averages

So, at the end of the first quarter, Energy and Industrials were the big winners with other sectors underperforming. The second quarter has the potential for a pullback, but the reliable cross-over indicator above says that we could still have some room to run.

As I tell everyone, invest what you see not what you believe. I see the technicals telling me that we have some upside left, so I’ll go with that for the present. However, as we near the end of earnings season and the end of the QE2, we’ll see what the market tells us about whether we need to raise some cash.

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