Sector Rotation point to market gains.

Our view remains bullish over the coming twelve months due to several metrics we analyze, including the current sector rotation we are seeing. Figure 1 shows market gains by sector over the past thirty days. The leading stocks are coming from the Industrials, Energy, Materials and Consumer Discretionary sectors. This is encouraging to see as these are highly cyclical sectors tied directly to economic growth and typically lead the market into a new bull run.

For comparison purposes, figure 2 shows the same sector performance heading into the downward market cycle that started in the early summer. As can be seen, Health Care, Consumer Staples and Utilities outperformed the other sectors as investor’s rotated cash into traditionally economically defensive sectors.

Figure 3 shows our Cyclical –Defensive indicator. This indicator simply compares price performance between cyclical and defensive sectors. As stated earlier, when this indicator bottoms, cash tends to rotate back into cyclical sectors and a new and/or existing bull market takes hold.

The one unusual item missing from the sector rotation scenario is Financials. During a market recovery, the financial sector usually leads, but this has been something that is missing at this point largely due to the European debt crisis that infects the global banking industry.

In fact, Vito Racanelli from Barron's points out this weekend that, "This year, the S&P 500 investment banks index is down 45%, the worst performer, and regional financial institutions are off 22%. As a percentage of the S&P 500's market­cap, financials are below 14%, near the lows of April 2009. They continue to suffer from the 200809 financial­crisis fallout and a market view that future profit growth will be limited by tougher regulations, poor capital adequacy and further loan losses."

Strong Retail Sales

Given our over-­weight position in the Consumer Discretionary sector, (22.7% of our portfolio is in the Services sector) and especially the retail industry within that sector, we have been watching the retail sales figures with great interest.

According to the Commerce Department, total sales in October rose 0.5% vs. September. This figure topped the estimates for 0.4%. Sales excluding autos climbed 0.6% vs. views for 0.2%. Sales excluding autos, gasoline and building materials rose 0.7% which is the best result since February.

Sales of electronics and appliances rose 3.7% helped in part by Apple's mid­October iPhone release. Building material and gardening sales rose 1.5% on the heels of a blow­out quarter by Home Depot. Consumer spending accounts for 70% of our economic activity in this country and we are entering the all important holiday shopping season. Real incomes have been relatively flat so consumers are tapping into savings and credit for their shopping needs. Our view is that the American consumer is very much fatigued by the current economic slowdown and are more willing, after two years of balance sheet improvement, to open their wallet. We are leaning towards owning stocks in the high end retailers that are more closely tied to gains in the stock market than discount retailers more closely aligned with gas prices.

Another take-­away from this weeks economic numbers is the benign inflation environment that we are seeing. Both the PPI and the CPI were well within reason , so its encouraging to see the increased retail figures were not due to inflation. Full price selling by higher end stores show this is a less promotional environment than we have become accustomed to since the slowdown. This bodes well for margins and ultimately the high end retailers that we own in our portfolio.

Our Retail Portfolio Figure 5 shows the retail holdings in our portfolio and their annual gains to date. The first column is the SPDR Consumer Discretionary ETF (XLY). The retailers with the greatest year­to­date gains include VF Corp (VFC) +60.7%, The Limited (LTD) +46.5%, Chipotle Mexican Grill (CMG) +46.4% and Ross Stores (ROST) +41.9%.

Consumer Discretionary Sector -Fundamentally Undervalued

Analysts are currently forecasting twelve­-month forward earnings for the Consumer Discretionary sector to be $22.48. This represents just over 13% growth in earnings over the next year. Using the current price of the index of $298.85 gives us an earnings yield of 7.5% (22.48/298.85). The best times to buy the components of this sector is when the earnings yield is sitting between 7.1% and 8.0%. The average yield dating back to 2006 has been 6.3%. So using these metrics, the historical earnings yield indicates this sector is roughly 20% undervalued at these levels.

Our views on retailing are certainly not shared by everyone. "Sorry, Santa Won't Be Staying" by Jacqueline Doherty in this weeks Barron's puts an extremely negative spin on the current state of retailing and all but advises anyone that owns a stock in this space to go running for the hills.

Doherty makes a point when she states that the savings rate in the US has dropped precipitously since 2008. In addition, she makes a valid point that household net worth, a figure that should move inversely to the savings rate has not done so this time around. Tack on flat wages, high unemployment and the likelihood of higher taxes in the future and one can make a strong case that making money with retailing stocks is a longshot.

The S&P retailers index is trading 15.4x twelve­-month forward earnings of $33.99. The twelve­-month forward earnings yield for the index is 6.5%, roughly in-­line with its historical average; therefore the index is not facing extreme valuations at the moment.

"Retailers have cut costs and inventories to remain profitable, even in this slow­-growth environment" says Patrick McKeever from MKM Partners.

Should the economy continue to improve, albeit at a modest pace and the stock market continue its rally from the October lows, it is our opinion that we may have a stronger than anticipated holiday season.

Supercommittee to the Rescue

This week was supposed to be a light, holiday shortened week with minimal trading activity. That may not be the case this year as the congressional supercommittee is supposed to be releasing the guidelines towards our $1.2 trillion, 10­-year deficit reduction plan. It is due out the Wednesday before Thanksgiving, but according to the deal struck in August, the members of the supercommittee cannot vote on the deal until it is reviewed by both the Congressional Budget Office and the public for two full days. That means we need to have a plan in place by midnight Monday in order to meet this deadline.

Based on my reading recently, it seems that pundits are putting virtually a ZERO percent chance that a deal is struck. Moreover, many are saying that no deal is optimal. Many prefer the sequester option, the alternative to striking a deal now. The sequester option simply states that if no deal is made now, then automatic spending cuts will be triggered starting in fiscal 2013 (after election season). Under the sequestion option, almost half the cuts will stem from defense and homeland security and the other half from domestic programs such as roads, education, energy and housing.

What the outcome and the ultimate effect on the market from this process remains to be seen. We are of the opinion that the market is not expecting anything spectacular from the supercommittee so if they decide to punt, we think the market reaction may be muted. On the other hand, if they do propose some type of plan, no matter how vague and unfinished, then we could see more of a market reaction in either direction.

Confidence in Congress

It's hard to ignore the complete lack of confidence and faith in Congress these days.

"A McClatchy­-Marist poll found that 85% of respondents were either not very confident or confident at all that the supercommittee would succeed." Debt Panel Failure May Be Option For Now ­ David Hogberg, IBD 11/21/11

"As we've noted, this whole "supercommittee" process is a joke played on the American people by President Obama and his pals in the Democratic Congress". Spending Cuts, Not Tax Hikes ­ IBD opinion, 11/21/11

"The supercommittee's current trigger ­an across-­the-­board cut of $1.2 trillion that would hit particularly hard at defense programs still has not produced an agreement. Instead, several Republicans have talked about disarming the trigger if the panel deadlocks later this week. We are no fans of the supercommittee process. But bailing out at this point would deal a serious blow to this country's financial credibility. Republicans on the committee need to get down to the real business of raising revenues, not just cutting spending. That is the only way to tackle the deficit." Another Plan for Tax Cuts ­ NY Times opinion, 11/16/11

"The sequester option will also call into question Congress's warped priorities. How can Democratic leaders defend deep reductions in the military and cuts in the domestic programs they say are vital "investments", while they block reforms that would reduce the growth rate of the major entitlements, which under even the House GOP plan would still grow by more than 50% over the next decade?" ­ The Sequester Option ­ Wall Street Journal opinion, 11/18/11

"As written, if a sequester is triggered, it would occur on Jan. 2, 2013. If Republicans win a majority in the House and Senate, they could use the provisions of the revived Gramm-­Rudman Act to replace or modify the 2013 sequester with entitlement reforms or other changes in discretionary spending." ­ The Budget Sequester's Silver Lining ­ Phil Gramm and Mike Solon ­ Wall Street Journal opinion, 11/18/11

"Also, any deal reached now would almost surely end up worsening the economic slump. Slashing spending while the economy is depressed destroys jobs, and it's probably even counterproductive in terms of deficit reduction, since it leads to lower revenue both now and in the future...

...Better to have no deal than a deal that imposes spending cuts in the next few years...

Eventually, one side or the other of that divide will get the kind of popular mandate it needs to resolve our long­run budget issues. Until then, attempts to strike a Grand Bargain are fundamentally destructive. If the supercommittee fails, as expected, it will be time to celebrate". Failure Is Good ­ Paul Krugman ­ NY Times opinion, 11/18/11

"Let's face it, the Joint Select Committee on Deficit Reduction, or supercommittee, is unlikely to come close to cutting the nations red ink by the $3 trillion to $4 trillion fiscal experts say is necessary to head off a European style debt crisis. Given the climate of inter-party intolerance, you could consider it a political miracle if the committee's six Democrats and six Republicans agree on a 10-year, $1.2 trillion debt reduction ­the bare minimum needed to avoid automatic cuts that size between 2013 and 2023, with half from defense spending." Partisan Politics' Threat to Your Portfolio ­ Jim McTague ­ Barron's opinion, 11/21/11

The absurdity of the jockeying and positioning ahead of this deal is apparent. It seems DC lawmakers are looking for every solution around this situation without addressing the urgent need for the obvious. We NEED to stop wasteful, fraudulent and abusive spending in Washington. Our current leaders in DC have already shown that they are incapable of addressing and solving this problem. The general public is for fiscal responsibility in Washington, unfortunately the same general public does not want their benefits affected in anyway.

The tricky part is how to do it without pushing the economy further into recession.

Chairman Bernanke has been forced to go above and beyond traditional monetary policy stimulus measures because Washington is in such a funk. Both parties have engaged in ideological sparring and have completely rendered traditional fiscal policy measures inept. The last decade of abusive spending in Washington has drained our resources at a time when we could use them.

Instead of following a true fiscal stimulus plan which should include cutting taxes and increasing spending, each party has dug their heels in the ground on measures that are counter-­intuitive to growth.

Democrats need to stop the "eat the rich" mentality and consider lower taxes and less regulation. Republicans should understand that fiscal responsibility is a hugely important issue but one that shouldn't be taken in the face of a prolonged slowdown. The supercommittee should present something productive or risk another US debt downgrade. Growth and prosperity lead to a balanced budget, circa the late 1990's.

It appears our leaders in Washington need a pending crisis to get something accomplished. Well...we hit $15 trillion in debt last week and are expected to see that figure grow by $1 trillion per year going forward. Our debt to GDP sits close to 63%. Not the crisis levels of Greece (143%), Italy (118%), Ireland (95%), Portugal (93%), Germany (83%) and France (82%), but approaching the critical level in which an orderly solution will not be possible.

If we choose to kick the can down the road and leave our decisions until the last minute, the bond vigilantes will not be so patient. Higher rates will force change...and painfully so if we let it get to that point.

Happy and Healthy Thanksgiving .

Joseph S. Kalinowski, CFA