February 25, 2004As we have discussed in previous letters and meetings, we believe a major shift in leadership may have occurred in December 2003. A significant decline in liquidity, coupled with the realization that valuations had become stretched in certain sectors, led investors to rotate out of the low quality stocks which had performed so well all year and into stable growth, reasonably-valued segments of the market. At the time, we told you that we believed the trend could continue. While it has not always been a clearly defined trend, we do believe it continues to be in place and supported by additional data points.
On January 28, 2004 the Federal Reserve issued their policy statement. The Fed Funds Rate was left unchanged but they did alter the wording on their policy from “considerable period” to “patience.” Beginning with that change in the statement, there has been a definite shift in investor preference for risk. High interest rates may foretell of higher inflation and generally result in multiple contraction for the market and a diminishing risk appetite. The markets risk appetite can be seen best in the chart below, showing the Nasdaq Composite performance (a risk proxy) relative to the S&P 500.
As the market’s appetite for risk has declined during February, money has rotated out of risky, more expensive sectors like technology and into defensive, cheaper sectors like consumer staples and health care. (See chart) Our relative performance has reflected this change in sentiment so far this month.
As we have done historically, Westwood continues to focus on producing the best risk-adjusted return. Therefore, we are continuously evaluating what could go wrong as well as what could go right. We believe this strategy is the most appropriate way for long-term investors to meet their investment goals. As a result, we believe our portfolios are well positioned to benefit from the search for high-quality value that we believe began in December.
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