Your Portfolio Is Still Hanging On The Fiscal Cliff: Now What?

| About: SPDR S&P (SPY)

If you reduced risk by selling stocks or other investments after the elections as the "fiscal cliff" was approaching, you weren't alone. While I didn't fall for that, who knows how things might have turned out had they not kicked the can down the road yet again? My read is that we may get another chance to find out later this quarter.

2013 has started off quite strong, with the S&P 500 (NYSEARCA:SPY) shooting up almost 3% in three days. By definition, this can't persist at this rate, or this will be the biggest year ever by far (+250%). Still, while we left a gap after the market began the year well above the spike close we got on 12/31, one can't help but recall that the S&P 500 never traded in 2012 at the 2011 closing price. The closest it got was within 1% at the lows in June. So, if 2013 plays out similarly, then those who chose not to consider bringing their stocks with them as we prepared to dive over the cliff may be in for a test of their patience.

Are you one of those investors who finds yourself on the wrong side of the cliff-trade and out of whack with your long-term goals? I see some parallels between the current situation and this past summer, when it became clear that "sell in May and go away" would fail as a timing strategy. At that time, I addressed the issue, suggesting:

If you reduced your exposure solely because you were trying to play the alleged seasonal, you need to rethink your position, as you are running out of time and the market is looking like a coiled spring. While the S&P 500 is up over 11% in 2012, it's up less than 3% since the 2011 highs. So far, minimal damage from selling in May, but it would be silly to let a marginally bad trade turn into an investment disaster.

What if, though, you went into the trade because you were and remain convinced that the market is not a good deal? In that case, good luck. I expect that the market will keep climbing a wall of worry, as the world is full of challenges, but stocks remain one of the best deals around. The well-known risks seem to be priced in and may not play out as badly as many have feared.

If you recall the set-up, it was that we had cratered and rallied back, but were sitting just below the highs. This is really where we find ourselves today. In the summer, we had peaked at the end of Q1 and the "sell-in-May" trades were put on below the peak, but, in front of Labor Day, the market had eclipsed the May highs (effectively burying the adherents of the strategy). Here's what it looked like:

Now, fast-forward to where we find ourselves; let's refresh the chart by extending it:

In the summer, we found SPY approaching its earlier-in-the-year multi-year high (with iShares Russell 2000 (NYSEARCA:IWM) lagging). As one can see in the bottom panel, the market really took off after Labor Day, with IWM coming back to life. The set up is pretty much the same: Post-cliff, we are just below the recovery high set in mid-September. A few differences are that Financials (NYSEARCA:XLF), the dominant market leader, have cleared the 2012 peak now. So have Small-Caps. Other sectors that have also cleared their levels from the mid-September peak in the market include: Materials (NYSEARCA:XLB), Consumer Staples (NYSEARCA:XLP), Health (NYSEARCA:XLV) and Consumer Discretionary (NYSEARCA:XLY). While no one has a crystal ball, with a cheap market and the fundamentals seemingly more solid than some have imagined, the technical strength should be making those who are underinvested a bit nervous.

So, what to do now? My advice is the same frame-work as before. If you reduced your exposure solely because you were trying to play the fiscal cliff event, you need to rethink your position, as the event is over, at least for now. While the S&P 500 increased in price by from Labor Day through the first three trading sessions of the year, it's only up 4%. In other words, don't let the 4-day move of 4.5% cloud your judgment - it's also a 4-month price return.

My advice in August (the 12th) was encapsulated in this paragraph:

So, are you supposed to listen to what seems like every pundit being interviewed on CNBC and "buy high-quality large-cap dividend-paying stocks"? To me, that trade looks played out, with stampedes into companies like AT&T (NYSE:T), Home Depot (NYSE:HD) and Wal-Mart (NYSE:WMT), all of which are up at least 20%. No, I think that this is a good time to buy smaller stocks and to focus on growth.

While I wish I had left HD out, this proved overall to be the right play, as Small-Caps are up 9% since then compared to 2.3% for the average of the three stocks and 4% for SPY. As usual, if everyone is saying the same thing, it's probably not the right thing.

So, if you are with me so far that it's just not worth it to use hope as a strategy for being able to get in at a better price, I would offer the following ideas:

  • Small-Caps
  • Growth
  • Emerging Markets

I still like Small-Cap; it makes up about 1/3 of my Sector Selector ETF model portfolio, which is benchmarked against the S&P 500. Individual stocks with market-caps below $4 billion comprise about 87% of my Top 20 Model Portfolio, which is also benchmarked against the S&P 500. Better sentiment among individual investors and an improved M&A environment bolster my confidence. I shared my thoughts in more detail in Mid-December. While it's not the laggard that it was, keep in mind that Small-Cap only matched Large-Cap last year and has still lagged since the former recovery high in May 2011.

I also continue to like the idea of paying up a bit for growth. This means different things to different people, so I will elaborate. I don't think that there is a definitive ETF play, as those lines of distinction (between growth and value) are quite blurred. I have been purposely focusing on companies with PE ratios in the 15-20 (or perhaps higher) area, ones that really trade on P/E. Why? A couple of reasons. First, P/E ratios are compressed now in any event. If I am correct that multiples could expand this year, I think those that are slightly-above average will benefit a bit more. Second, I think that portfolio managers have shied away from these types of names because they have had so little confidence in the economy. In my article in August, I cited Middleby (NASDAQ:MIDD) as an example. Now, I would mention a couple like Williams-Sonoma (NYSE:WSM), which is in my Conservative Growth/Balanced model portfolio and is a underappreciated housing recovery play, and MonoType Imaging (NASDAQ:TYPE), which is a unique growth story that we own in the Top 20 Model Portfolio. You probably don't know this one - it's worth your time. Here's a link to its recent Investor Day, its first, which I thought was fantastic.

The third area of focus I recommend you consider is emerging markets. Yes, the area was hot in Q4, but everything seems to be lining up. It's time to again consider the long-term secular theme of middle-class expansion in these economies, as foreign monetary and fiscal policies are now better aligned than they were in 2011. The dollar seems to be in a gradual weakening trend, which supports international stock investing in general. I shared my thoughts on emerging markets and some ETFs in Mid-December, and the Vanguard Emerging Markets ETF (NYSEARCA:VWO) comprises about 20% (the maximum) of my model portfolio.

Paralysis isn't a great strategy. If you erred on the side of caution in front of the fiscal cliff, it's time to readjust your portfolio to be more consistent with your long-term goals. I am very bullish, as I briefly describe below, so my advice about repositioning now rather than later is a bit biased. While it seems possible we could back-fill after bolting out of the gates, we never did last year. Further, the technical indicators I follow suggest that the market is not ahead of itself in terms of being overbought, nor is the rally stale, given we actually produced a negative return in Q4 and had a nice little post-election sell-off. Maybe we get some weakness later this quarter, but it could come from much higher levels.

Some of you may be wondering why I haven't yet shared my official full-year forecast for the S&P 500. I decided after missing it the last two years (1500 for 2011 and 1600 for 2012) to put away the crystal ball. I do have a forecast that I shared on my Invest By Model blog in December: 1664. I base this on ending the year at 14.5 PE on a forward basis (this implies a 2014 EPS estimate of almost $115). It's not worth an article, but I wanted to share this in case anyone actually cares. If I had to guess, my forecast this year will be wrong again, except too conservative rather than too aggressive. In any event, I wish everyone good luck this year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long TYPE, WSM, XLF, VWO and IWM in one or more models managed by the author at Invest By Model

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