Preparing For a Different Season

The stock market’s choppy move forward continues. That’s how profits are typically earned, and that pretty well describes this market advance since it bottomed in 2003. By January 2004, the broad stock market rally was over. In late 2004 and again in 2005, the energy sector generated most U.S. investment profits; the rest of the market remained pretty flat. Oil prices and energy stocks lurched forward, together. Each sell-off was eventually followed by another rally with energy and international stocks leading the way. Each sell-off was merely a pause in the energy bull market, not a signal of a new season ahead.

Until now. This rally was actually at the expense of the energy sector. A different theme must carry the rally on. The odd couple of technology and defensive stocks led the market higher, and one of these will likely be the key to the beginning of the next market phase. Which one? Only time will tell if this is the beginning of the long awaited rally in large cap, blue chip growth, or the leading edge of a more significant economic slowdown.

What is clear is that our investment models have almost completely repositioned themselves in the past six months and market sentiment has moved on. Lower interest rates are spurring on stocks. Since bonds compete with equities, lower interest rates mean less competition from bonds and (sometimes) higher prices for stocks. The risk with this thinking is that rates may be falling due to a slowing economy, which could hurt stocks. Alternatively, we may get that proverbial “soft landing” and move on to a traditional late-cycle growth stock rally.

Reduce exposure to cyclicals. Fund your liquidity portfolio (just in case). Reduce portfolio “beta,” but don’t ignore the possibility of buying high quality growth at a reasonable price. If your portfolio is standing still, you are missing some important signs along the investment highway. Stay disciplined. Be alert to opportunity. And don’t forget that old scouting motto… Be prepared.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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