3rd Quarter 2012 SMA Commentary
Despite a solid rally that began in late July, mostly on the heels of comments from the president of the European Central Bank (ECB) that the bank would provide whatever liquidity needed to save the EU, many investors remain fixated on the macroeconomic problems in Europe, the looming “fiscal cliff” here in the U.S., and the upcoming U.S. elections. Although the market has shown remarkable resiliency, the problems facing global economies are very real. The market is a tremendous discounting mechanism that we think is coming around to the fact that with government spending beyond its means and the Federal Reserve largely out of monetary “bullets”, we are now in desperate need for fiscal reform to fix the damage that both parties in Congress have heaped on the American people and its economic system.
What would this mean for markets? More certainty about taxes, regulations and spending that could translate into multiple expansion for equities. We think it would lower correlations between stocks and dramatically reduce the market’s dependency on macroeconomic events, allowing for more emphasis on company fundamentals. Until that happens, however, markets are likely to continue to be driven by volatile macroeconomic events.
The strategy underperformed its Russell 1000 Growth Index benchmark during the quarter. There were two primary areas of weakness—Healthcare and Industrials—with most of the relative underperformance occurring in July. The portfolio came back nicely in August and September, but not enough to overcome the deficit from the opening month of the quarter. Aviation-related holdings were the problem within Industrials, and are no longer held in the portfolio.
Worries over utilization rates affected a number of Healthcare holdings, but it was a specialty pharmaceuticals company that hurt returns the most. It suffered from rumors that generic competition from a European compound might threaten the position of its primary drug product, used as the last line of defense in some debilitating diseases. We trimmed back on the portfolio’s sizeable stake in the face of this news, and then sold the position immediately when a major health insurer decided not to reimburse for the treatment, limiting further losses.
Holdings in Consumer Discretionary, Technology, and Financials outperformed the index during the quarter. Consumer Discretionary exposure was the standout led by holdings in retailers and homebuilders. Homebuilders surged on positive data from the housing market, including five-year lows for inventories and foreclosures. Despite a slight underweighting in the area, holdings in Technology boosted returns as well.
As the market digests its move off the bottom from the correction of late spring and early summer, we truly believe that the “pain trade” is to the upside as lagging hedge funds feel compelled to play catch up. Thus, we think managers will run after stocks that have worked thus far, namely in the Consumer, Healthcare, and Financials sectors.
Charles F. Mercer, Jr. CFA B. Anthony Weber Michael E. Johnson, CFA