What Areas of the Market Will Remain in the Limelight? February 28, 2014

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

The current bull market has been five years in the making. Since the bottom on March 9, 2009, the S&P 500 Index has grown an incredible 174 percent. With this spectacular performance, investors are asking if U.S. companies will stay in the limelight or if it is time to draw the curtain on equities.

While I am in Los Angeles at a leadership event for CEOs from around the world, I asked John Derrick, CFA, director of research, to shed some light on the subject.

We believe investors should remain in equities, but selectively find high-quality growth companies trading at reasonable prices and located in the strongest areas of the market. One of the funds he co-manages, the Holmes Macro Trends Fund (ACBGX), has had significant success over the past year employing this strategy.

You can see in the chart below that, as of February 27, the fund has outperformed the S&P 1500 Composite Index by almost 11 percent in one year. See the fund’s performance history.

Gold Jewelry, Bar and Coin Demand Resilient in 2013
click to enlarge

Here are the questions I posed to John along with his responses.

Q. Can you discuss the macroeconomic factors that contributed to the fund’s outperformance and do you think it will continue?

Comparing the fund to the benchmark index by sector, we had particular stock-picking success in the consumer discretionary, health care and industrials sectors.

This isn’t surprising due to the synchronized global recovery out of the U.S., China and Europe thatwe’ve talked about many times before. Companies’ economic confidence has increased and as spirits lift, many businesses are sitting on piles of cash. As a result, they’ve been boosting their capital budgets to invest in their businesses.

Over the past year, this environment has been very positive for cyclical stocks that typically sell goods and services beyond basic needs.

We talked about the major effect that increased investment spending would have on cyclical companies. We wrote that capital investment helps propel the economy and boosts productivity and profits. Investors also tend to see a boost: As companies begin spending their cash on things such as productivity-increasing software and capital equipment, businesses in technology and industrials sectors likely benefit.

We’re especially pleased the Holmes Macro Trends Fund model identified these cyclical areas of the market, which helped the fund outperform.

Q. Please talk more about the fund’s model and how it identifies the strongest sectors.

We start with a top-down, macro view of the S&P 500 Index by analyzing the returns of each of the 10 sectors over different periods of time. The fund dynamically adapts to those sectors that show the best returns over all of these time periods. This helps us identify potentially long-term trends before they become widely accepted in the marketplace.

Oftentimes, the trends are a result of a change in demographics, market dynamics or government policy.

Q. Can you give an example of a long-term trend?

Take a look at the periodic table of sector returns, which helps illustrate historical long-term sector trends. For example, from 2004 through 2007, energy sector returns were consistently strong. Four years in a row, energy was either the best-performing sector or second-best. All years showed double-digit returns.

This multi-year run was significantly influenced by government policies. If you’ll remember, China’s economy was quickly maturing, with its massive urbanization trend and incredible infrastructure buildout. The country’s growth significantly changed its energy structure. Oil consumption increased significantly, and the country’s growth trickled down to other commodity-dependent countries such as Brazil, Russia and the Middle East.

The Market

Q. U.S. Global is known as a growth-at-a-reasonable price investor. Talk about how   this GARP approach melds with the sector analysis.

Because sectors exhibiting current strength today can sustain that vigor over an extended period of time, we gain confidence in investing in stocks in those particular sectors. From there, we look for the faster growing companies with robust fundamentals. Specifically, we like businesses growing revenues at more than 10 percent, generating at least 20 percent earnings growth and providing a 20 percent return-on-equity.

However, before we purchase shares, we consider valuation, quality of management, debt levels, potential catalysts and other factors.

Index Summary

  • Major market indices finished higher this week.  The Dow Jones Industrial Average rose 1.36 percent. The S&P 500 Stock Index gained 1.26 percent, while the Nasdaq Composite advanced 1.05 percent. The Russell 2000 small capitalization index rose by 1.58 percent this week.
  • The Hang Seng Composite rose 0.89 percent; Taiwan gained 0.44 percent while the KOSPI advanced 1.13 percent.
  • The 10-year Treasury bond yield fell 8 basis points this week to 2.65 percent.

Domestic Equity Market

The S&P 500 Index rose to new highs this week. The market was led by cyclical areas primarily driven by confidence in expected growth prospects. Defensive areas such as telecommunication services and utilities were down for the week even as treasury yields rallied and ended the week lower.

S&P Economic Sectors
click to enlarge

Strengths

  • The consumer discretion sector was the leader this week as retailers were strong. Target, Kohls and Best Buy were among the best performers this week. All three companies reported earnings that were ahead of expectations.
  • The materials sector was also strong this week, with chemical companies generally leading the way. FMC Corp, PPG Industries, Dow Chemical and Eastman Chemical were all among the best performers on expectations of better pricing and a recovery in the agricultural chemical space.
  • Newfield Exploration was the best performer in the S&P 500 this week rising 14.13 percent. The company released quarterly earnings results which were ahead of expectation on operation efficiency, and the company is nearing completion of a significant foreign asset sale which the market took positively.

Weaknesses

  • The utilities and telecom services sectors underperformed. Performance was mixed, but it was a “risk on” week for the market and defensive areas generally underperformed.
  • The technology sector was also a laggard in a strong market as Autodesk, Juniper Networks and Micron Technology were down for the week.
  • Cliffs Natural Resources was the worst performer in the S&P 500 this week, falling 8.83 percent. Falling iron ore prices and fears that China demand will falter were the primary drivers of the share price drop.

Opportunities

  • The current macro environment remains positive as economic data remains robust enough to give investors confidence in an economic recovery, but not too strong as to force the Federal Reserve to aggressively change course in the near term.
  • Money flows are likely to find their way into domestic U.S. equities and out of bonds and emerging markets.
  • The improving economic situation could possibly drive equity prices well into 2014.

Threats

  • A short-term market consolidation period after such strong performance over the past six months cannot be ruled out.
  • Higher interest rates are a threat for the whole economy. The Fed must walk a fine line and there is potential for policy error.
  • A lot of good news is potentially priced into the market and the economy will need to deliver to maintain the positive momentum.

The Economy

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