No Pain, No Gain – Taking the Long View on the Dollar and Commodities

“Long ago, Ben Graham taught me that price is what you pay; value is what you get. Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down” – Warren Buffett

We pointed out in our recent quarterly commentary that a major countertrend movement was brewing in both the dollar and commodity patch. In other words, the primary trends for the dollar (up) and commodities (down) might have hit a point where their respective gains and losses were overdone in the short-term, but we have a firm conviction that the strong dollar and weak commodity thesis should continue to dominate the backdrop in the long-term.

We're heading for a pause in the market

Is the Market Heading for a Pause?

First quarter market performance was as whippy and volatile as the weather. Unusually cold temperatures in the U.S. not only froze much of the country’s population, but it also wreaked havoc on the quality of economic data, and kept markets on edge regarding how investors should be positioned. Geopolitical issues also rose from the ashes as various emerging markets had currency issues and Russia showed poor sportsmanship and invaded the Ukraine shortly after the conclusion of the Olympic Games.

By the end of the quarter, the markets showed mixed results, with U.S. stock and bond markets logging roughly equal returns, and international markets showing large variations depending on country and region. Commodities appeared to benefit the most from the weather and geopolitical environment, and they bounced to a very strong quarterly return.

What I Like Most About This Rally

Back in the second quarter our theme was “consolidation and continuation”, meaning we were looking for a market correction that would lead into a continuation of the bull market (See April 20, 2012 “Looking Ahead to Second Quarter”).   Well, the correction we were looking for clearly unfolded, taking the S&P 500 down about 10% between April and June.   More recently, the market has rallied 11% off the June bottom, and it is now beginning to feel like the continuation phase that we were expecting is taking hold.  After an eleven percent run from June, we are forced to reassess expectations for the market going forward so we can position our client portfolios accordingly.

Discretionary Stocks Continue to Impress

Since the stock market made its recent high on April 2nd (in the S&P 500), there has been a noticeable shift in sector performance. As they often do during periods of market indigestion, defensive sectors such as Health Care, Consumer Staples, and Utilities have been outperforming. Meanwhile, the cyclical sectors of the market that had previously been leading are now underperforming. The notable exception among cyclicals is the Consumer Discretionary sector, which not only continues to outperform the broad market even during this correction, but is the best performing sector this year by a decent margin.

Getting Ready for a Consolidation

What a ride this year has been in the markets. Volatility has been sucked out like water through an unplugged drain, any bad news has been quickly absorbed and discarded, and equities keep gliding to the upside. During this Bull Run, the market has climbed an enormous wall of worry, and has found a way to look more constructive along the way (for example, the S&P 500 broke out of the 2010/2011 range, most global markets recaptured positive trends, and the much maligned financial sector is participating in the current uptrend).

Following the Beta Trail

In our Inside the Investment Committee presentation, I mentioned the great start to the year for high beta, domestic cyclical stocks (“high beta” refers to the volatility of the stock compared to the S&P 500). Small cap, semiconductors, miners, and energy stocks have more volatility when compared to the S&P 500 and therefore a higher beta. These areas tend to outperform when the economy is improving, which is why they’re called cyclical stocks — they ebb and flow with the economic cycle. This is exactly what we saw from the October bottom through January.