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The Capital Markets First Challenge for 2011

02/22/2011

The S&P 500 Index (Figure 1.1) has experienced a rather impressive rally since Labor Day 2010. Corrections have been measured in hours, not weeks or months, as was the case during the summer of 2010. In fact, a brief post mid-term election sell-off quickly transitioned into an aggressive advance higher from December until President's Day.

History tells us that the institutional investor outperforms the retail investor. One reason is that the institutional investor correctly maximizes their position sizes during periods of significant market appreciation. They tend to accurately identify the ideal time to allocate aggressively, call it "overweight," or, simply put, "step on the gas."  Clearly, September 2010 thru the middle of February has been an ideal time for "overweight" allocations to risky assets.

On Monday, February 21, the U.S. President's Day holiday, the capital markets began to experience their first significant selling pressure for 2011.  In the subsequent hours many have suggested that a peak for the near 100% rise in the S&P 500 since March 6, 2009 might be in place. At this point, I believe the economic evidence, fundamentals within the capital markets, and technical formations do not support those bearish portrayals. However, there has been a shift in momentum that investors should not ignore.

Unfortunately, the unrest in the Middle East has spread beyond Egypt, Tunisia, and Bahrain, all nations with limited capacity to impact global capital markets. This past weekend, the discourse spread to Libya - a nation with significant ability to impact capital markets via oil supply disruptions. As a result, on February 21, institutional investors begin to pare down overweight holdings. Throughout the next full trading session on Tuesday, February 22, the reduction in allocation sizes continued.

Clearly the discourse in Libya, and the contagion risk to other Middle Eastern oil producing nations, has initiated a pause in the 5 ½ month long "overweight" trade. The capital markets have encountered their first real challenge in 2011. Since Labor Day the term "resistance" has been used infrequently. However "resistance" is now in place for the S&P 500 Index at 1344.07.

Do I agree with resizing allocations from "overweight" to "market weight?"  Yes - it is the prudent strategy.

Below (Figure 1.2) I have identified some of the better performing positions and assets year-to-date. Over the past two days they have come under significant selling pressure in a classic downsizing theme.  However, let me be clear that I am not ready to suggest changing current allocations; I am only suggesting scaling down allocations from "overweight" to "market weight."

I remain confident in my expectation that  2011 will be a positive year for the U.S. capital markets. In fact, I still assign a probability that the 2011 equities markets will perform in a similar fashion to 1995 (Figure 1.3). But, prudence dictates paying heed to the potential slowdown in capital market appreciation. Will it last days, weeks, months?  - that question remains unclear.

Ironically enough, the strife in Libya is lifting oil prices, which, as most of you know, aligns with my expectation that energy allocations are a top priority for me in 2011.

The market's first real challenge in 2011 is here. My strategy is focusing on the size of allocations, not changing the allocations.

Figure 1.1 SP 500 INDEX 4/22/10-2/22/11

Source:  Bloomberg

Figure 1.2 Year-to-Date as of February 22 Close

Corn                   Year to Date +6.638%     Feb 21-Feb 22 -5.49%
XLF                    Year to Date +4.404%     Feb 21-Feb 22 -3.06%
Potash (POT)      Year to Date +9.882%     Feb 21-Feb 22 -5.48%    
Apple (AAPL)      Year to Date +4.976%     Feb 21-Feb 22 -3.40%
Fedex (FDX)        Year to Date +0.301%     Feb 21-Feb 22 -5.11%

Figure 1.3 S&P 500 INDEX 12/31/94-12/31/95

Source:  Bloomberg

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.