Market Skepticism Can Lead to Strong Portfolio

My friends and clients get on me at times for being too pessimistic about the market, but it’s that worrying nature that prevents me from having drawdowns in my clients’ accounts.

So, exactly what am I talking about?

When I look at the market I am simply amazed at what it’s doing. The market is advancing in fits and starts on mediocre volume (which isn’t unusual these days), while declining days come on big volume and seem to scare everyone half to death even when the S&P is only down five points or so. When I start to arrange the informational puzzle pieces I don’t really like what I see. I’m sure people will howl at me and call me names for saying this. That’s fine -- there are always two sides to a market -- but I’ve also been doing my job very well this year as my primary strategy is beating the S&P handily so far.

So, what do I see?
 

• Lots of companies are beating EPS but still missing revenue estimates, meaning they are still making it work by maintaining lean operations... a.k.a. no new real hiring.
  
  
• In transportation, I'm seeing mixed earnings in trucking, but rails have been strong.
  
  
• Strong price increases across the board with companies involved with soft commodities. For example Procter & Gamble (PG), Colgate (CL), Kimberly Clark (KMB), Kellogg (K), General Mills (GIS), and more. This doesn’t count restaurants everywhere raising prices because of rising grain, beef, chicken, corn, and sugar prices. (See also The Future of Food Prices.)
  
  
• Technology is doing well. This is the one thing the US still does better than anyone else in the world.
  
  
• Manufacturing is still doing poorly.
  
  
• The general public is struggling mightily. The number of people on food stamps is hitting new records, states across the country are teetering on the edge of bankruptcy, the state of unemployment is not improving (anyone that knows how headline unemployment is calculated knows this), and the ultimate sign is how one million people applied for 62,000 part time jobs at McDonald’s (MCD).
  
  
• Government policies and actions are hurting us more than anything or anyone else. The legislative risk in the US has never been higher than it is now. Unfortunately, that risk is one of complete and utter uncertainty. That uncertainty makes investing much more unpredictable. The government is in near lockdown while Congress battles over cutting pennies from the biggest budget deficit ever. Will we balance the budget or get a balanced budget agreement? Will we raise the debt ceiling? Will we raise taxes? Will we raise taxes other than the income tax? Will Obamacare clear legal hurdles? Will the dollar fall through the bottom of the floor? This is just a smattering of what’s out there and they are all relatively short term issues that are still causing problems.

To close this particular list, market leadership is supportive of these issues:
 

• Financials: Goldman Sachs (GS), Bank of America (BAC), JPMorgan (JPM), and Wells Fargo (WFC) look sick. JPM is doing the best of this group, but it’s more or less flat on the year, while the other three are taking a dive.
  
  
• Energy: Schlumberger (SLB), ExxonMobil (XOM), Chesapeake Energy (CHK), and Valero (VLO) -- Energy is so large and diverse that it’s tough to list enough to be broad, but this sector is clearly soaring. With energy demand remaining high, this isn’t likely to change much... even if the US economy continues to slow.
  
  
• Tech: Apple (AAPL), Cisco (CSCO), F5 Networks (FFIV), Akamai Technologies (AKAM), and more are not doing well. AAPL has floundered and its leadership is squarely in question. Other technology stocks have been all over the board, but many larger companies are having a tough time.
  
  
• Consumer: Walmart (WMT), Target (TGT), Costco (COST), and SPDR S&P Retail (XRT) -- The XRT is very strong, but traditional leadership with WMT and TGT are doing very poorly.
  
  
• Agriculture and metals are also soaring.

That puzzle does not add up to the S&P hitting new highs to me, though I imagine that “forces” will get it to 1400. I’ve preached caution and attentiveness to readers for some time now and that stance hasn’t changed. I still feel like we are playing musical chairs and the longer the lunacy continues the more difficulty we will have in a correction... which could be right around the corner with the alleged ending of QE2. With most targets for the S&P around 1400-1450, I would consider portfolio hedges around that level. For my primary strategy, I am buying some longer term puts on volatile positions while bolstering the portfolio’s income generation with some high quality bonds (if I can get them for a decent price), master limited partnerships like Linn Energy (LINE), Plains AllAmerican (PAA), Natural Resource Partners (NRP), and Enerplus Resources (ERF), and defensive dividend paying equities like AstraZeneca (AZN), Sanofi-Aventis (SNF), GlaxoSmithkline (GSK), (which I wrote about on March 21st), and Vodafone (VOD). Positions like these reduce portfolio beta while providing a stream of income that helps reduce portfolio volatility even more. This setup really helps smooth out a bumpy road while giving some participation on the upside.

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