Charting a Course for Rest of 2013

05/01/2013 8:15 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

With the market seeming to defy gravity, investors are caught between betting on a pullback or hoping the rally will run on. More prudent is a small-ball strategy capable of delivering decent returns with a modicum of risk, writes MoneyShow’s Jim Jubak, also of Jubak's Picks.

Selling on valuation has felt like a mug's game for the last six months or more.

The question now is, is this about to change? The last significant drop in the US stock market came in late spring/early summer of 2012. Wall Street is clearly worried about a replay of that drop and it's not overstating the case to call the current market jittery.

Are we about to see a drop that's large enough in volume and long enough in duration so that selling on valuation will finally pay off? Or is this just enough head fake from a market that will keep going up until global central banks take the punch bowl away?

If you're sitting on cash, do you keep sitting on it, looking for drop? If you don't have much cash should you be raising it hand over fist?

I wish I could give you one of those big dramatic "Sell everything" or "Buy everything" calls that make the headlines and sell lots of newsletter subscriptions. But I think this market is way more complicated than that. Valuations are high and economic fundamentals in much of the global economy are weak or weakening, but then cash flows from global central banks are simply off any recent scale.

In Uncharted Territory
We're in uncharted territory. And that makes big calls tempting. But it also makes it very easy to get them wrong.

This column is instead a little call. It's a description of investing small-ball of the sort that should get you a decent return in 2013 without an indecent risk. It's not the kind of strategy to set your heart aflutter. But I don't think it will give you a heart attack either.

So here's how I'd position myself for 2013 with what we know right now.

Every time during the last six months that it has felt like time to sell because a US stock market trading at historic highs was ready to take a breather or worse, the move down has turned out to be a minor head fake and the Standard & Poor's 500 Index (SPX) has moved even higher. That's what happened when the market dipped in late February, and it could be happening again in April, when a week's worth of weakness has refused to turn into a meaningful downward trend.

If you sold on those dips in the hope of getting in at a lower price, you were probably caught in cash when the market moved higher. Your choice then was either to stay in cash hoping for a dip in the future—in which case you earned close to nothing on your cash position. The average money market account is paying 0.136%, well below the rate of inflation in the United States. Or you could have decided to bite the bullet and buy back in once the market showed it was headed higher. Selling low and buying high can take a chunk out of your portfolio over time.

Even if you didn't try to play the dips in the market and instead just sold individual stocks when they hit your target prices, this was probably a trying six months or more. I know because in my Jubak's Picks portfolio, some of my sells on valuation worked—Cummins (CMI), for example, was down almost 7% as of April 26 from when I sold it on Feb. 11, and Banco Bilbao Vizcaya (BBVA) was down 4.5% from my March 13 sell—while others that I called fully valued keep on climbing, or at least did not fall.

My Dec. 28 decision to sell Dollar General (DG) to raise cash was painfully wrong. The stock was up 23% from that sell through April 26. And I took a 10% loss on the position when I sold. My sell of Costco Wholesale (COST) on the same date—again to raise cash—was almost as painful; the stock rose 12.5% from that sell through the April 26 close.

Even when the sell didn't result in a significant loss of potential profits—Nestle (NSRGY) was down less than 1% from my sell, for example—raising cash hardly seemed worth the effort.

Don't Want to Buy High
Once you've made mistakes like these, it's especially hard to rectify them in a market that is climbing from high to high. After all, you sold these shares because you thought you saw a dip coming or because you thought stocks were more expensive than the fundamentals or even the cash flows from global central bank justified. Now you're going to buy back into a market that is even more expensive than the one you sold out of? That's hard.

I tell you that from experience. I spent 2012 trying to reduce the cash position in Jubak's Picks without much success. The portfolio ended 2011 37% in cash and, after a year of trying to put money to work at good value I ended the year at 29% cash.

For 2012 the portfolio returned 7.3%, substantially trailing the 16% return on the S&P 500 for the year. Certainly the portfolio's high cash position isn't to blame for all of that underperformance—it's hard to match the index when your picks include Nokia (NOK) and OncoGenex (OGXI)—but it sure didn't help to have 30% of the portfolio in cash earning nothing.

Doing some rough what ifs for 2012 on the effect of holding all that cash—and assuming a rough 30% cash position on average for 2012—I get a 15.7% return on the money that the portfolio actually had invested in the stock market in 2012. That still trails the return on the S&P 500 but not nearly as badly as the actual portfolio did. Most of the underperformance of the portfolio in 2012, then, is a result of keeping too much of the portfolio in cash that year.

That's not an excuse for the 7.3% return in 2012—after all, I am the one who decided how much to keep in cash—but an explanation that might help make 2013 a better year. If an explanation for the underperformance of Jubak's Picks—or your portfolio—is that you held too much in cash, then one solution would be to be more fully invested in 2013.

Hard to Increase Your Exposure
Except—and it's a big except—a decision to be more fully invested n 2013 runs straight into the valuation and risk issues that led me to be under-invested in 2012 to begin with. The market isn't any cheaper than it was last year. The fundamentals aren't any better. And the less-risky alternatives, such as dividend-paying blue chips, that have been a place to put money to work are looking pricy indeed.

Right now, in fact, if you compare this point in 2013 to a year ago, I think you should reasonably conclude that growth is dodgier in the Eurozone and China than it was a year ago. That valuations look more stretched, given the likely slump in earnings growth in the first and second quarters of 2013 on slower global growth and the effects of the sequester. And that this bull market seems to be showing its age with sentiment starting to look for a correction in the summer.

Which does make it hard to increase your exposure to this market if you're sitting in cash. And which does raise the issue of whether you should even be trying to reduce cash exposures at this point in the rally. The next dip, if there is one, could be the dip that you've been reserving cash for, after all.

If you're looking for a bold solution to this puzzle, I'm afraid you've come to the wrong place. My suggestion—and the strategy that I've been pursuing in Jubak's Picks so far in 2013—isn't some kind of bold call on the direction of this market. I think the market is overvalued on the fundamentals but I can't discount the power of central bank cash to push stock prices still higher.

With huge amounts of stimulus from the European Central Bank, the Federal Reserve, and the Bank of Japan—and with additional stimulus from China's unofficial lending markets too—I think we are in uncharted territory.

We simply don't know how much higher central bank cash will push asset prices.

And while I'll all in favor of following the adage "Don't fight the Fed" and its current re-invention as "Don't fight the global central banks," I can't say that I see this as the time to add risk to a portfolio just to put cash to work in a rally that may be running out of gas just in case central banks still have the power to push asset prices higher.

That leaves me, I'm afraid, with the kind of one-stock-at-a-time strategy that I've pursued so far in 2013.

Selling on Valuation
This hasn't made much of a dent in the portfolio's cash position. In 2013 to date I've made six buys and executed five sells.

I've continued to sell on valuation—out with Westpac Banking (WBK) and Akamai Technologies (AKAM) in recent weeks—as stocks hit my valuations and I can't think of sound reasons for resetting them higher. (You can find a list of recent sells here.)

I've looked for relatively low-risk opportunities—you might call them special situations—to add to the portfolio. These are occasions where fundamentals or global cash flows or temporary market overreactions to news give me a reasonable confidence that the risk/reward ratio is slanted in my favor. My recent additions of Toyota Motor (TM) and Mitsubishi Financial UFJ (MTU) fall in that category. In the short-term, say one to three months, I think the weak yen policy of the Bank of Japan puts a strong macro wind at the back of Japanese stocks. The risk/reward ratio in that market is slanted in your favor.

I continue to worry about the economic and political trends in the Eurozone. I think we can look for one more big crisis in the Eurozone before the German election in September. That makes me extremely reluctant to buy in Europe, even though I think stocks such as Danone (DANOY) are extremely attractive in the long run.

I continue to worry about over-inflated expectations for economic growth in China. To me it looks like the Chinese government has decided NOT to go for a return to 9% annual growth, but to stick with 7.5% to 8% growth. That will be a disappointment—and, to a degree, it already has been—for investors in companies, such as commodity producers that have put capital plans in place predicated on that kind of acceleration.

At the same time I recognize that these fears—and the very real, very slow growth in Japan and the Eurozone—make it likely that the United States will outperform most of the world's stock markets again this year. The most recent stage of the US rally has been driven by dividend paying, consumer blue chips. McDonald's (MCD) was up 15.25% for 2013 as of April 26, and Abbott Laboratories (ABT) was up 17.23%, for example.

Seeking Special Situations
I'm hoping that recent additions to Jubak's Picks of diabetes specialist DaVita Healthcare Partners (DVA) and electronic payments leader eBay (EBAY) will get the same kind of boost, so I was willing to buy them on temporary, stock-specific drops.

I'm not willing to chase dividend-paying blue chips here because they are already relatively expensive against historical norms. But I am likely to hold onto them longer than I might otherwise in recognition of the extra value this market is putting on dividends and predictability.

In the US market, I think one of the strongest trends is the way that the natural gas and oil from shale boom is transforming swathes of US industry and infrastructure. I've got a pick or two from that trend in mind for the coming weeks—especially if I can get the stocks in question on dips.

Another special situation that I'm looking to buy is what I call improving balance sheet plays. These are companies where the supply of cheap money and decent economic growth are combining to lift their credit ratings from junk to investment grade. That improvement by itself gives these stocks a considerable edge even if growth slows modestly, since improved balance sheets should push enough cash to the bottom line of the income statements to provide an insurance policy against slower growth. I'll have a pick or two from this category in the next couple of weeks.

At the same time, though, I anticipate that I'll be making a sell or two or three to reduce the potential risk in the portfolio.

That's likely to leave Jubak's Picks pretty much where it is now at about 30% cash.

Unless, of course, we do get a summer slump in the US or a big selloff somewhere else that presents me with exactly the kind of bargains I've been waiting for.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did own positions in McDonald's, Mitsubishi UFJ Financial and Toyota Motor as of the end of March. For a full list of the stocks in the fund as of the end of December see the fund's portfolio here.

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