February 2013 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management's clients. It is reproduced here for informational purposes for the readers of this blog.

Dear Investors,

So far 2013 has unfolded mostly in line with the expectations voiced in last month’s letter. Valuation, stimulus and sentiment have combined to give the market a generous boost to start the year. The S&P 500 was up 5% in January which, like last year, was the best January since 1997.

In last year’s February letter I pointed out that a good January has historically been a good sign for the rest of the year: “Since 1957 there have been 18 times that the S&P 500 was up 4% or more in January. In those 18 years, the S&P was up an average of 21%, and returned double digits for the full year 17 out of 18 times.” I wrote then that these statistics were encouraging, but that a high single digit to low double digit return was more likely for 2012. This year I am inclined to believe that the S&P 500 could be up 20% at some point mid-year, but it would be surprising to me if it held on to close the year at that level.

It is worth noting that the Dow, which has a longer history than the S&P 500, also shows strong returns in years with a large gain in January. However, 1914, 1929 and 1987 were also all years with big gains in the first month. These years have the unfortunate distinction of being ones in which the Dow had its three worst days in history, all of which came in the last few months of the year. That’s not to say a crash is likely, but it is something to keep in mind should markets become over-extended as the year goes on.

For now, investors aren't spending much time thinking about negative scenarios. As the year started, people were still gloomy about the prospects for 2013, but one month into the year the mood has gotten much more optimistic much faster than I expected. Signs of optimism are numerous: flows into equity funds were the largest in a decade, negative economic reports have had little effect on the market, the Euro has recovered back to €/$1.35, and even the US Congress is getting the benefit of the doubt. After years of constant crisis people seem ready to take risks again, including CEO's, who have been very upbeat on recent conference calls.

When investors become this bullish, it means that it’s important to act cautiously. Rapidly rising prices are warning signs that price insensitive investors have entered the markets. They bring with them the opportunity to sell at higher than reasonable prices, but also introduce added volatility.

This is an uncomfortable circumstance for investors who are price sensitive, but it’s not yet time to sound the alarms for two principal reasons. 1) Valuation is becoming stretched but not necessarily extreme. My work at the individual stock level suggests that the average stock could rise another 20% before valuation makes no logical sense. 2) I suspect that most of the new found bulls are really bears in bull clothing ready to turn on the market at a moment’s notice. We’re not quite at the level where there is unanimous belief in the bull, which is typically the final phase of a bull market.

Still, such positive sentiment does increase the chances that there could be short term pullbacks over the next few weeks and months. Markets never rise in a straight line and so mild corrections are within normal expectations. Absent unique opportunities, we are unlikely to be large buyers of stocks for the time being. We continue to be happy to sell at the right prices.

Scott Krisiloff, CFA

Opinions voiced in the letter should not be viewed as a recommendation of any specific investment. Past performance is not a guarantee or reliable indicator of future results. Investing is subject to risk including loss of principal. Investors should consider the suitability of any investment strategy within the context of their personal portfolio.