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Second Quarter Update

2nd Quarter 2013

Click on the graphic for a bigger/less distorted view of the charts in this blog post

U.S. stocks sold off during the final weeks of the second quarter with large cap stocks performing worse than small caps in the correction. Weakness in foreign stock markets, notably Japan and China, also negatively impacted U.S. markets – and sent the EFA and Emerging Markets indices down significantly.

The bar chart above shows you that large cap stocks, which had been rising faster than other asset classes over the past couple of years, ended the quarter up just a bit under 3% – well off of where it was in Mid-May – with small cap stocks performing better than 4%. You can also see the damage that was done in the foreign, gold and bond markets, with the surprising result that US Treasury Bonds lost 4.21% during the quarter while Junk Bonds only fell 2.59%.

Federal Reserve comments related to the timing of the end of its bond buying stimulus drove U.S. stock prices lower and bond yields higher (which pushes down bond prices). The money printing activities of the Fed since the beginning of its Quantitative Easing programs have pushed stock prices higher and bond yields lower, all to the benefit of investors. Any threat that this easy money policy is nearing an end will be detrimental to stocks and bonds, just like June’s sneak-peak demonstrated.

From an economic standpoint, June’s reports were conflicting. Manufacturing growth slowed in May, however, car sales and durable goods orders both showed increases. Service sector employment growth slowed, yet, initial jobless claims were lower. New home sales and pending home sales both pointed to continued strength in housing even as mortgage rates rose.

In a change from the past few years, investors tended to favor the stock of smaller companies exhibiting growth characteristics over companies exhibiting value characteristics.
June Performance Chart

You can see that Large Cap Growth continues to be the worst performing asset class, but Mid and Small Cap Growth performed significantly better than Mid and Small Cap Value companies. Large Cap Growth should begin to follow its smaller cap cousins into better returns in due course.

Our stock investment methodology is a growth-based methodology, rewarding such factors as earnings growth, increasing cash flow from operations, and return on equity. These are the metrics that the owners and managers of businesses watch to make sure their companies are performing at peak levels, and it is also – over the long-term – the key to stock price out-performance.

You will always have times where a value-based and/or dividend-income methodology will outperform growth, but over a lifetime of investing, a growth-based methodology provides better results because ultimately growing earnings equate to growing stock prices. Needless to say, I am happy to see the market begin to reward growth characteristics once again, even though the Large Cap Growth class has yet to participate.

Stock performance of industry groups varied greatly during June. Top performing industries were related to the consumer – both consumer staples and particularly consumer cyclicals had good months; among the worst performing groups were the materials – gold, metals and mining, copper and aluminum – and technology, both of which tend to forecast a slowing of worldwide economic activity. The technology sector performance also explains the performance of the Large Cap Growth asset class.

From a strategic standpoint, we used the sell-off in the stock market during May and June to put a significant portion of the cash we had on-hand back into the market.

S&P 500 with 200 Day Moving Average

As the S&P 500 Index sold off to a level below the 50-day moving average near month-end June (the red line on the chart above), we used the lower prices to buy well-run companies 8% to 20% or more below recent highs reached this Spring. You will see many of these purchases in your statement this month, but many others did not settle until early July.

Today, the market has moved back to the blue band which represents a level 10% above the 200-day moving average – a typical danger zone for the stock market. Our plan now is to utilize a trailing stop-losses strategy that will protect gains in our holdings as the market tries to retake earlier highs above that blue band, automatically raise cash when we sell-off again, and then reinvest that cash at lower prices. This is the most prudent risk management strategy we can employ at this point and still participate in the market dominated by the Fed’s money-printing induced run higher.

It seems simple, but in practice it is as much art as science in determining what price level to set the trailing stops so that you do not sell on a false pull-back leaving you stuck with cash. Also, determining when to reinvest the cash back into the market during a correction, buying selected companies with solid earnings growth/returns/cash flow, so that you are not too early or too late requires the proper analysis.

We utilize technical analysis of the market to help us determine changes in the sentiment of the investing public in order to point to directional changes in the indices for buy and sell points. Regular readers of this blog are familiar with many of them but new readers can easily read prior articles to get a feel for it.

As things change in the market or as other issues arise that need explanation, I’ll be back with updates. But until then, enjoy this “Sweet” hit from the 70’s British Invasion (pun obviously intended).

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