Sutton Place Capital Management LLC

New York, New York

 

January 8, 2013

S&P 500: 1457.15

VIX: 13.62

“Almost Back to Basics”

 

Summary of the Fourth Quarter and Outlook

            The gain in the stock market during the fourth quarter was led by several sectors including Financials, Industrials, and Materials.  The Telecommunication, Technology and Utility sectors lagged.  The market growth for 2012 was very concentrated, specifically in financials and a few selective stocks.  The financial sector’s performance finished last in 2011, but an accommodating regulatory environment aided a strong rebound.  Nevertheless, it was a difficult final quarter to the year when it came to planning for 2013.  Tax codes dictate a lot of business decisions and the year finished with a politically charged month.

            In 2013, expect there to be less volatility but more aggravation as uncertainty will be the issue for the first half of the year.  Although there were answers provided about the tax piece of the fiscal cliff, a lot of matters were pushed out.  The market has accepted that a lot of the issues have not been resolved, but a compromised solution provided a floor.  The lack of clarity on the scope of spending cuts leaves questions about future layoffs and the appetite for corporate and consumer spending.  But fewer and fewer obstacles are in the pipeline and once executives unlock the padlock on the cash reserves, the market should explode.  This event is sometime in the future.  Right now, we move into earnings season which has an outlook for low expectations; but at least the market readily understands earnings season compared to Washington politics.

Economic Background

The outlook for the global economy is still weak and may grow about 3% in line with the year just ended.  The outlook for growth by the major economies should be about 2% for the United States coupled with a contraction in Europe and single high digits for China.  As such, very similar picture to last year.  Last year was marked by persistent low interest rates as central banks attempted to stimulate their economies and postpone the worry about inflation.  Low rates are expected to continue worldwide.  European debt issues received a lot of bailouts to sustain their economy and the bulk of the pain has yet to be felt by the individual countries who are will be facing stiff labor issues.

The current year will look similar to last year, but under the surface, will be more encouraging for equity investments.  This is because of three reasons: 1) time profile has improved; 2) risk of spillover from Europe is more contained; 3) oil constraint on global growth is less tight.  This combination bodes well for growth over the next few years. 

  Market Valuation and Equity Strategy

At the time of this note, the Standard and Poor’s 500 Index trades at 13.50 times 2013 full year estimates.  This is a very fair level to add to the equity allocation when looking out beyond the next two years.  The longer-term forecast is due to the struggle that the U.S. equity market faces to expand its valuation multiple due to low growth in revenues compared to a trillion dollar government deficit.  Our portfolios have a large cap bias and these names grow into their valuation as the economy displays sustainable signs of improvement.  It is unlikely that the third quarter contraction in the S&P earnings is a one-off experience.  Fourth quarter earnings were impacted by inertia due to the fiscal cliff, ravishing storms, and global growth concerns.  The pullbacks that negative news should offer will be viewed as a buying opportunity.

During the quarter just ended, the Utilities position was sold in favor of companies with faster growing dividends.  Energy holdings were re-allocated to companies with more favorable growth models.  In our opinion, the valuation for a consumer staple company and its spin out was reached and swapped for a younger peer with stronger margin prospects.  Current shifts to the holdings include adding to financials and evaluating companies who should benefit from improved auto and housing sectors.  A slight rise in yields will help banks and, a better tone from China, will aid materials and chemicals.  Since the 2008 debacle, our investment attitude towards financials has been to underweight this sector in comparison to the allocation in major indices primarily because the fundamentals of the money center banks warrant asset write downs.  Government decisions have been very favorable to those financial institutions but at some time, the two have to balance out and this is a tricky situation for investment choices.  The investment preference has been to gain exposure to the financial sector through insurance stocks, preferred securities or bonds issued by money center banks.  As decisions on the tax piece of the fiscal cliff became less of a cliff hanger, the preference for mergers or acquisitions may supplant spin outs.   At current market levels, the total return expectation for stocks offers a better value to bonds as the tone for unemployment and lending has improved. 

Fixed Income Strategy

The challenge looking into the current year is yield which is low and will move modestly higher.   The 10-year Treasury note finished 2012 at 1.88% and likely will finish just above 2% in the current year.  The positives for the bond market are that inflation is not likely to rise much and the Federal Reserve will provide a strong basis for the market with its mortgage back securities and treasury purchases.  The Federal Reserve continues to target key short term rates to remain at zero through mid 2015 though this trigger point is now data based not calendar based.  Nevertheless, short-maturities are unattractive and the preference is to own preferred stocks with a less than three year call option.  Returns for preferred stocks should remain positive, but come from income rather than price appreciation.  Bond maturities under five years are preferred and we will selectively dip down on the credit spectrum.  With a Medicare surcharge implemented on higher income earners, municipal purchases are more attractive, but the long term appeal will depend on the outcome of the debate on tax policy changes.

Regards,

Maribeth Holland

Portfolio Manager and CIO

(646) 401-2780

 

 

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