With continued turmoil in the world that includes escalating energy prices, rising interest rates, higher inflation, and geopolitical risks around the globe, we believe assuming a defensive stance is the prudent thing to do.
A defensive stance is nothing more than reallocating assets within investment portfolios by reducing equity positions, and increasing exposure to income investments like bonds, certificates of deposit, and cash.
There will come a time when these conservative assets will be reduced, and reallocated back to the stock market, but this will not take place until the stock market corrects, and creates attractive bargains.
As we look at the recent earnings reports for the top sectors in the S&P 500, we find that the best earnings are within a very narrow group of sectors. Investors only reward stocks within the sectors with the best earnings. This is why you will see some stocks rise substantially while others languish.
For example, earnings for the second quarter are being reported now. It is estimated that earnings for the S&P 500 will rise in the neighborhood of 14%. On the surface this sounds pretty good. But when you breakdown each sectors contribution to the 14% increase, you get a totally different picture.
Only 3 sectors of the S&P 500 are contributing to earnings of 15% or more. They are;
Energy + 38%
Materials +17%
Financials + 15%
The stocks in these sectors have been the best performers.
Only 2 sectors of the S&P have reported earnings of 10% or more. They are;
Utilities +12%
Industrials +11%
The stocks in these sectors tend to perform in-line with the market averages, but have not outperformed.
Lastly, 5 sectors have substantially underperformed the market, and the stocks in these sectors have languished. They are;
Technology +9%
Telecom +8%
Cyclicals +6%
Staples +4%
Healthcare +3%
Are point in this exercise is to show how narrow the stock market has become. A well diversified portfolio in the 10 sectors of the S&P have returned mediocre results, while a portfolio over weighted in the top 3 sectors (Energy, Materials, Financials) have beaten the market averages by a substantial margin.
The risk tendencies among investors sometimes lead them to overweight portfolios to stocks in the best sectors to achieve maximum results. This is exactly what happened in 1999-2000 when technology stocks were running wild, and when the party came to an end, investor portfolios were crushed.
Hopefully, investors learned a lesson after the heyday of technology.
Presently, we have advised clients to be no more than 50% invested in the stock market, keeping the remaining 50% in cash (money market, cd痴), and a proper allocation to bonds.
With the 50% (depending on the risk tolerance of each investor) allocated to the stock market, we would be diversified among the sectors with the best earnings growth.
For value investors, buying into stocks and sectors whose earnings are temporarily depressed is a good strategy also. But, what a value investor knows without being told is this, a stock or a sector that is temporarily out of favor may take a year or more to return any results.
We believe investors need to realize that for the foreseeable future, Realistic Expectations for well diversified portfolios are in the ballpark of 6-8%. This assumes a 50% stock and 50% fixed income mix.
Of course, if you are currently overweight in the top 3 sectors we mentioned above, your return will be higher, but so will be the risks. Overweighting only 50% of your equity assets to the top 3 sectors can yield you better returns with half the risk.
Since the other 50% of your equity assets are already on the sidelines (money markets & cd痴), I would not be opposed to an investor using the remaining 50% to overweight in the best sectors.
Here are the 2006 YTD returns for the market averages;
Dow Jones Industrial Average +3.43%
S&P 500 +1.16%
NASDAQ -6.66%
Given all of the turmoil we highlighted above, a cd or bond yielding 5-6% looks pretty attractive in comparison to the 2006 YTD returns of the market indexes.
