Strategic Portfolio Re-Allocation as Fed Cuts Rates (Aug. 21, 2007)

Fed expected to Cut

We've been experiencing a painful market correction centered around subprime problems, mortgages, and a US liquidity crunch. Because of all this, the Fed is now expected to cut the Fed's Funds Rate from 0.50% to 0.75% by First Quarter of 2008 from various sources.

Sector Rotation Model based on Fed Cutting Rates

When the Fed acts to raise or cut rates, we should act accordingly. These are important turning points. According to Standard and Poor's Sam Stovall's Sector Rotation Model, and Jim Cramer's Sector Rotation Model (Page 115 of his Jim Cramer's book: "Real Money: Sane Investing in an Insane World") as the Fed tightens or cuts rates, it is profitable to get out of certain sectors and into others.

In Jim Cramer's Sector Rotation Chart, we should be doing the following (Interpretation of the chart can differ depending on whether you look at GDP growth or look at the actions of the Fed):
1. Sell "smokestack" stocks such as Caterpillar (CAT), or 3M (MMM).
2. Sell metals and mineral stocks such as Alcoa (AA) or Newmont Mining (NEM)
3. Buy high multiple tech stocks such as Google (GOOG)
4. Buy Banks and Financials such as JP Morgan (JPM) or Wells Fargo (WFC)
5. Eventually, as the economy slows, buy Retailers.

However, there is another story that may conflict with the advice above: The Global Growth Story.

The Global Growth Story

Because emerging markets like China are growing fast, they need materials such as Copper, and industrial equipment like those made by Caterpillar (CAT). This goes against some of the advice based on the Sector Rotation model above.

I do believe the Global Growth Story is a multi-year/multi-decade long cycle.

Portfolio Strategic Repositioning

So what can we do to strategically position ourselves for the intermediate future?

I have several different portfolios with different styles (most are well diversified portfolios). However, in one of the portfolios, I apply a more concentrated method, and this is what I've been doing during the last month with this portfolio:

1. Sell Oil and Oil Services

Oil and Oil Services have not been doing well recently as crude prices have been going down and may settle in the $60 to $65 per barrel range. If we are to see an economic slowdown in the US, demand could weaken. Yes, over the long term, the global growth story needs oil. So while my concentrated portfolio has no oil, my long term diversified portfolios have sufficient exposure to this sector.

2. Sell Coal

Coal, as embodied by the stock Peabody Energy (BTU) has been going down. Peabody Energy reported reduced guidance because of delays in ramping production at recently acquired mines.

3. Sell Minerals

I took profits in Freeport McMoran (FCX) whose stock price had been dropping like a rock. Also, the Sector Rotation model above suggests that we do sell mineral stocks. However, I still believe in the Global Growth Story. I am looking for ways to get back into Freeport McMoran (FCX), a Gold and Copper company.

4. Sell Selected Financial Companies

Goldman Sachs (GS) is a quality company, but it had been dropping hard, and during the time when it was uncertain that the Fed was going to do anything, I had to sell Goldman Sachs in order to stop the freefall and to raise cash to purchase other securities. Some of Goldman Sach's Hedge Funds suffered big losses.

5. Reduce Emerging Market Wireless Telecom (Overweight to Neutral)

I still believe in the strength of Emerging Market Wireless Telecom especially companies such as Mexico's America Movil (AMX). I had overweighted America Movil, but I reduced it to a neutral position so I can invest in other names.

6. Hold Computer and Video Gaming Company

I am continuing to hold Gamestop (GME), a retailer of computer and video game consoles, equipment and software. Gamestop has been doing well, and is part of the great Computer and Video Game Cycle. This cycle will remain strong, and Jim Cramer even mentions this very positively in a discussion with TheStreet.com's Michael Comeau.

7. Hold Infrastructure Company

Countries around the world needs infrastructure as they grow, and I continue to hold ABB Limited (ABB), a Swiss Infrastructure company providing power and automation technologies to utility and industry customers worldwide. Infrastructure is still needed around the world.

8. Overweight High Growth Tech:

Currently continuing to hold Google (GOOG), Apple (AAPL), and added Garmin (GRMN) and all have been doing well recently. These are the key high tech growth stories that can be owned for many years. They are the leaders, and innovators, and their forward PE ratio are all under 30 for their great growth. The sector rotation model also suggests this, and these stocks have held up well during the downturn and will do very well in the future.

9. Add Selected Financials with No Subprime Risk

After discovering that a financial company, Hudson City Bank (HCBK) had been holding up well during the most recent market correction where financial companies stock prices were being punished, I decided to look deeper. James Altucher, of TheStreet.com pointed out a link to the Bergen Reporter. The article, written by Dunstan Prial, says that "Officials at Hudson City Savings Bank, Columbia Bank and Valley National Bank said fallout from the subprime mortgage crisis that has roiled markets in recent weeks has so far been minimal. The primary reason, said Hudson City Chief Executive Officer Ron Hermance, is smaller regional banks tend to hold on to the mortgages they generate instead of reselling them into so-called secondary markets, where they are resold as investment products." CNN even reports that Hudson City Bancorp is the Anti-Countrywide. Jim Cramer also is bullish on regional banks in this part of the cycle.

Hudson City Bank is also a fast growing bank with conservative lending practices. In a falling rate environment with many financials suffering from a liquidity crunch and subprime problems, Hudson City Bank (HCBK) stands to benefit.

10. Hold and Add to Cash Rich Companies with Great Investors

Leucadia (LUK) is a cash rich company run by two Guru investors, Ian Cumming and Joseph Steinberg. American Real Estate Partners (ACP) is a very cash rich Real Estate company that recently includes veteran activist investor Carl Icahn. In a cash strapped environment, whoever has cash holds a very valuable commodity. And if the allocator of Capital is a talented investor such as Ian Cumming, Joseph Steinberg, and Carl Icahn, who like to buy undervalued and distressed securities, then the return on investment is even better.

I continue to accumulate Leucadia (LUK) and have added a position in ACP (American Real Estate Partners). Both have held up very well during the market downturn and both will do well in this environment.

11. Hold Aerospace Company

The Aerospace Cycle is still strong. Boeing (BA) would be an obvious play, but I continue to hold Transdigm Group (TDG). Transdigm Group is a $1.8 Billion company, with a forward PE of 15.55, a five year estimated growth rate of 28.5% for a very low Price Earnings to Growth (PEG) ratio of 0.55, very cheap! (less than 1 is very cheap).

12. Hold Defense Play

The defense bull market is still there, and is levered more to government spending than consumer spending. Obvious names include Raytheon (RTN) or Lockheed Martin (LMT), but I prefer investing in Harris (HRS).

Harris (HRS) is a $7.7 Billion company that provides special equipment to the government and the military. They operate four segments, Government Communications Systems, RF Communications, Microwave Communications and Broadcast Communications. It has a forward PE of 15.11 and a five year estimated growth rate of 27% for a very low PEG of 0.56.

13. Hold Emerging Market Beverage Play

I continue to hold Wimm Bill Dann (WBD), a high growth diary and juice producer in Russia. This play should not have a large correlation with the US Financial situation and is more levered to the local Russian economy. TheStreet.com Ratings often lists Wimm Bill Dann as one of its five top growing stocks.