Cash 35 Percent, Short Position 25 Percent
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Paul Rabbitt
Rabbitt Analytics.com |
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We maintain cash at 35 percent and have an opportunistic 25 percent short position - a very cautious stance. Our one-year forecast return for the S&P 500 is 8 percent. Most of that return should come in the final quarter. We expect a trading affair as stocks are caught drifting with solid but peaking earnings growth rates, peaking liquidity, and rising energy costs. We will play the trade-ranges.
The markets stalled last week even as crude oil declined, thereby breaking the inverse connection between stocks and oil. We have limited upside expectations and will lighten equity exposure by pruning losses quickly. In the intermediate-term, we expect stocks to weaken over the summer before firming later this year. Oil carries a speculative premium as many hedge funds have entered the trading picture. A surprise decline in oil prices would normally be a catalyst for higher stock prices.
We have over-weighted stocks in the S&P 500 and stocks with solid value themes. We have shifted somewhat by reducing small-cap exposure and moving into mid-cap (market caps between one and ten billion) stocks priced above $15/share with good liquidity, betas less than 1.0, and continuing the solid value theme.
The Earnings Reporting Season Started Last Week
As the Q1 earnings season began last week, consensus estimates called for the S&P 500 earnings growth rate to be 8.3 percent. Without energy, the growth rate will be closer to five percent.
Economic Releases Have Disappointed
Last week's economic releases tended to show rising inflation and weaker economic output. Releases included consumer sentiment (weak), retail sales (slipping) and industrial production (slowing trend). In addition, the Federal Reserve released the minutes from the Open Market Committee's March 22 meeting. This meeting had resulted in a warning about inflation. The minutes revealed the Board's governors are still in favor of the gradual rate hike policy implemented in 2004.
No Contrarian Buy-Signals
The dangerous greed that existed at the beginning of 2005 has indeed dissipated. However, it is still nowhere near the fear levels necessary to unleash a contrarian buy-signal. Three of four polls (Consensus, Inc., Market Vane, and Investors Intelligence) reflect continuing optimism. There is complacency in the options markets.
One positive sign has been an increase in mutual fund cash signaling that professional money managers are becoming more cautious. The recent increase in cash to 5.6 percent, the highest level since 2001, puts somewhat of a floor under stocks. The first environment that occurs after such an increase is a soft one for stocks. Ultimately, however, this cash must be put back to work, creating a source of buying pressure, and forcing stocks higher. Another positive sign is the public/specialist short-sales ratio, which has risen to 2.26 versus its 1.75 mean level.
Technical Picture is Weak
Technically, stocks are correcting from overbought levels. Each successive rally this year has failed at lower highs for most stocks. Internally, stocks look worrisome. Small-cap, NASDAQ and technology issues look particularly disastrous. Since January 1, the NASDAQ is down 10.5 percent. During this firm period, the main strength has flowed to energy, utilities, telecommunications, healthcare, and materials. Generally, stocks in the mid-cap area (one billion to ten billion market cap) and stocks with good value have been the best to own. Finance and small-cap stocks have lagged.
Mutual Fund Performance is Weak
The first quarter numbers for mutual funds show the average US equity fund closely tracked the S&P 500 with a loss of 2.1 percent. The only funds out-performing the market's loss were energy and natural resource or global-related.
All in all, we are not optimistic for the next few months.
Paul Rabbitt
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