The rally from Oct 2011 lows has continued into early 2012, with many asset classes joining the strengthening upturn.
Stronger economic data, such as improving GDP and unemployment figures, has been coupled with easing financial worries in Europe, resulting in rising prices across multiple markets.
Additionally, two of our three deep value themes from 2011 have begun to rebound as expected.
Consequently, portfolios are not only rising, but also beginning to recover relative returns surrendered in 2011 (see Chart 1).
Chart I – Deep Value Themes Gaining in Early 2012
While these themes are expected to outperform in 2012, we believe that investors may be overly optimistic in the short-term, leaving the market in an “overbought” condition (see Chart II below for an example).
While we tend to get aggressive when others are fearful, we also lean towards being more defensive when others are too euphoric.
Chart II – Investor Crowd Sentiment at Overbought Levels
Due to the temporarily overbought conditions, we have reduced risk in client portfolios by harvesting some gains through the sale of our XIV short volatility positions, and the reduction of Emerging Markets & US equities positions.
However, we believe near-term declines could be short-lived, given reasonable long-term valuations, strengthening technical indicators, and positive effects of the 4-year presidential election cycle kicking in during the back-half of this year.
As a result, we will consider using declines as buying opportunities for some of the cash recently harvested in client accounts.
Such opportunities will be evaluated using our proprietary quantitative models, providing us with indications as to whether we have a high probability re-entry point, or whether we should continue to remain defensive.
Our models don’t work every single time, but they do improve our odds of being right more often than not in each market cycle and over the long run.