May 2, 2013
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Stocks continued upward in April with the S&P 500 Index posting a gain of 1.9%, representing its sixth consecutive positive month. Foreign stocks, as measured by the MSCI EAFE Index, also moved higher in April, ending the month with a 5.3% return. After two months of underperformance, foreign stocks topped their domestic counterparts by a meaningful margin.

The timing of the turnaround in foreign stocks proved fortunate as our system generated a sell signal on many of our international funds in April. However, as is sometimes the case, we thought that the signal was bad. Foreign stocks had outperformed domestic stocks for six consecutive months (August to January) and by a wide margin during that timeframe (18.7% to 9.9%, respectively). It struck us as odd that just two subsequent months of underperformance (February and March) could sink what appeared to be a strong, emerging trend in foreign stocks.

It was not just the sell signal on foreign stocks that had us concerned as our system was also suggesting a buy on small- and mid-cap domestic stocks. We have noted in previous letters that U.S. large-cap stocks are about 15% overvalued relative to their history, yet small- and mid-size companies are trading at even steeper premiums to their long-term average valuations. Making a shift from undervalued foreign stocks to overvalued, high-beta small/mid-cap stocks seemed like the wrong move to be making ahead of the historically weaker season for stocks that is May to October.

On top of all of this, we were starting to see foreign stocks improve relative to domestic stocks as April commenced. At the same time, small- and mid-cap stocks were showing signs of weakness. (Small ended up down in April while mid lagged.) As a result, we did not have much conviction in our system’s call to cut back on foreign stocks in favor of small/mid-sized U.S.-based companies. While the results from April suggest that staying put was the correct move, we will continue to monitor our foreign allocation closely in the weeks and months ahead to make certain that it continues to progress in the right direction.

While our overall allocation is largely unchanged from March, we did make one trade last month: selling out of Hong Kong. Like much of our international exposure, this country triggered a sell signal from our system in April; however, we were able to reallocate the proceeds to Japan, which remains a strong buy. This lateral move within Asia allowed us to maintain the same level of international exposure and alleviated all of our concerns listed above, which is why we made the change.

Sincerely,

Matthew P. King, CFA
Chief Investment Officer