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Broyhill Asset Management Feb 2013 Update

Broyhill Asset Management Feb 2013 Update

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Published by Devon Shire
Broyhill Asset Management Feb 2013 Update
Broyhill Asset Management Feb 2013 Update

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Published by: Devon Shire on Mar 01, 2013
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February 26, 2013Our last investment update was published shortly after the November elections. At the time, wesuggested that historically, markets don’t care very much about election results and noted that year-endrallies were quite typical in election years. Since then, stocks have rallied double digits and three monthslater, investors are confronted with yet another set of uncertainties. So we figured this was a decent timefor an update on portfolio strategy and our investment outlook for capital markets in an environmentnow naively classified as
The Great Rotation 
. This letter serves to share a few of the points we've discussedinternally during the past week. The bottom line can be expressed as follows: Too much optimism in theshort term; better value abroad in the long term. Three years in a row, the market has launched out of the starting gate in January, and last month was thebest in almost two decades. But the pattern in the past two years has been for the market to go limpafter a strong start. This year is setting up to prove Mark Twain right again, as the weight of the evidencepoints to rough waters ahead. At Broyhill, we are sitting on higher than normal cash levels across ourportfolios, waiting to buy at lower prices. After putting some of our dry powder to work around theNovember elections last year, we now believe investors should consider positioning more defensively andhold off on additional equity purchases. Importantly, there is a big difference in the set-up today vs theset-up pre-cliff. Back in November, markets were oversold and sentiment was washed out. Accordingly, we made a case for a tactical rally in stocks. But today, we are confronting much more challenging conditions. The chart below shows that economic activity is likely to roll over soon and markets arelikely to be disappointed given inflated expectations. This has been a great indicator post crisis and justflashed its fourth sell signal since the 2009 lows. Each of the prior signals preceded a cyclical top in risk assets. We are not expecting a different result this time around.
Pointing to a Pullback 
Furthermore, investor sentiment has reached euphoric levels, the market is overbought and the VIX recently hit its lowest levels since 2007. Capitulation is everywhere and the bears are running for cover. Acorrection is overdue and the cycles we monitor warn of a soft patch ahead. According to our friends atHussman Funds, present market conditions are not exactly welcoming and now match only six otherinstances in history: August 1929 (followed by the 85% market decline of the Great Depression),November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a marketcrash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007(followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limitedto just under 20% as a result of central bank intervention). “These conditions represent a syndrome of overvalued, overbought, overbullish, rising yield conditions that has emerged near the most significantmarket peaks – and preceded the most severe market declines – in history." We are not ringing the '87 alarm just yet, but we do believe that a run-of-the-mill 10% correction instocks should not come as a surprise here, particularly considering that the first quarter of thePresidential Cycle has historically been the weakest, January’s performance notwithstanding. A pullback of this magnitude would be just enough to relieve overbought conditions and excess optimism and givethe SPY's one last run toward all-time highs before facing the long term realities of record high profitmargins and uncomfortably high valuations.
Looking for a Catalyst
Last week, markets reacted swiftly to the Federal Reserve’s growing discomfort with easy-money policiesas some suggested the Fed might tighten policy sooner than expected. While we believe the chances of anearly-end to QE are somewhere between slim and none, what we believe isn't worth a whole lot. Rather,the market will be driven by consensus expectations, and given the likelihood of rising inflation pressuresover the next couple quarters, those expectations will begin to shift their focus toward policy tightening,creating a large headwind for the market in the second half of the year. Granted, this headwind may arrive sooner than expected given the relentless spike in gasoline prices, as shown in the chart below.
Putting all this together, we see a number of catalysts on the immediate horizon which could spark a sell-off in risk assets. In addition to the growing risk of central bank policy mistakes, the debt ceiling deadlineis looming in May, and in the near term, we have to monitor the event risk posed by Italian elections andthe US sequester. We believe keeping some dry powder on the sidelines to scoop up cheap assets isprudent here. We are also selling call options on the stocks we own to take in some premium and sell off some upside beyond what we believe is a fair price.
Better Value Abroad
 With a number of major markets approaching record highs, some investors are suffering from nasty flashbacks. While the current advance is similarly overextended as the last major market peak, there areenough differences to warrant a more constructive stance today. Many market internals remain healthy,global economic momentum is likely to improve, and most importantly, long term valuation measurespoint to value in international equities.
Bottom Line: The median correction in post-election yearshas been 9.6% so our eyes are open for buying opportunities into an expected decline andfocused on companies domiciled outside the states, which are more attractively priced today.

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