Signs of Changing Leadership?

November 6, 2012

Just as Americans cast their ballots for next leader of the United States, there are signs that stock market leadership may be shifting. Domestic markets, especially large-cap growth stocks, have been the place to be for the last year. But foreign markets began to outperform late in the third quarter and that continued in October.

Foreign indexes like the EAFE had slight gains for the month ending October 31, 2012, while domestic indexes like the S&P 500, Dow Jones Industrial Average and NASDAQ all had losses. Even after this month’s sell-off, however, the S&P 500 index is still well ahead of EAFE this year-to-date.

We can’t know today if the recent strength of international markets is a sign of a new long-term trend or if it’s a short-term reversal in the midst of a longer-term domestic trend – and that’s why we’re moving into foreign funds incrementally. Upgrading is designed to capitalize on major market trends that last several years, so we don’t make large dramatic moves into new areas. If the foreign trend shows it has “legs” we’ll continue to add more exposure in the coming months.

What’s Working
Foreign funds surged into the Buys this month for the first time in over a year. This comes after a month when the U.S. market sank, while European stocks spiked. Nearly half of the Buys in Classes 2 and 3 fund categories are foreign funds, particularly Europe funds and ETFs.

In Class 3, international value and large-cap value funds lead, but domestic funds are still well represented. PIMCO StocksPlus Total Return (PSTDX) is the top ranked fund for the third month in a row. In Class 2, small-caps have replaced large-caps in the Buys.

Leadership is fairly consistent among sector funds where home builders, healthcare and biotech continue to be highly ranked. Technology sank this month, while financial services, including a global financial ETF, are now among the Buys.

Fixed Income
Corporate bonds had another satisfying month in October, in the face of feeble but steady economic growth. Bonds continue to be a buffer in turbulent markets and allow investors to squeeze out reasonable returns. Investment-grade intermediate-term corporate debt and high yields performed best, as did inflation-protected TIPS.

Government bonds were the only weak spot, as interest rates increased slightly, resulting in a disproportionate decline in prices. An increase in yield of just 0.07% on the 10-year Treasury led to a 0.40% drop in iShares 7-10 Year Treasury ETF, illustrating the potential risk of Treasuries when yields are so low.

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