GLUSKIN-SHEFF

"Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names."

Bob Farrell's Rule #7

What a quarter! The Dow up 8% and enjoying a record quarter in terms of points — 994 of them to be exact and in percent terms, now just 7% of attaining a new all-time high. The S&P 500 surged 12% (and 3.1% for March; 28% from the October 2011 lows), which was the best performance since 1998. It seems so strange to draw comparisons to 1998, which was the infancy of the Internet revolution; a period of fiscal stability, 5% risk-free rates, sustained 4% real growth in the economy, strong housing markets, political stability, sub-5% unemployment, a stable and predictable central bank.

And look at the composition of the rally. Apple soared 48% and accounted for nearly 20% of the appreciation in the S&P 500 (it now makes up 3% of the 200 largest hedge fund portfolios — three times as much as any other name; 4% of the S&P 500 market cap; and 11% of the Nasdaq). Not since Microsoft in was one stock this dominant, though the valuations are not comparable (MSFT then was trading with a 70x P/E multiple).

But outside of Apple, what led the rally were the low-quality names that got so beat up last year, such as Bank of America bouncing 72% (it was the Dow's worst performer in 2011; financials in aggregate rose 22%). Sears Holdings has skyrocketed 108% this year even though the company doesn't expect to make money this year or next.

The small caps, the mid-caps, the broad NYSE composite, the SOX index, both the Value Line arithmetic and geometric indices, the Dow Transports, CRB industrials and Treasury yields have all failed to make new highs even as the Dow, S&P 500 and Nasdaq have. As we said in many of the recent Breakfast with Dave musings, divergences are not exactly in short supply.

What does that tell you? What it says is that this bull run was really more about pricing out a possible financial disaster coming out of Europe than anything that could really be described as positive on the global macroeconomic front. Low-quality stocks in the S&P 500 outperformed high-quality stocks in Q1 by 500 basis points and high-beta stocks within the Russell 1000 outperformed low-beta by 900bps. On a global scale, what has been a poorer place to put capital to work than Japan? And yet the Nikkei posted a ripping 19% advance in Q1, the best start to any year since the pre-bubble-burst times of 1988. Emerging markets are up 13% year-to-date. Greece rallied 7% in Q1 — that also tells you something about this rally. It's called a dead-cat bounce. Meanwhile, the stodgy sectors that worked so well last year are biding their time — utilities so far in 2012 are down 3%, telecom is flat, and staples are up a mere 5%.

Most investors can dig back to 2000 if they really try. It was not uncommon for typically risk-averse investors such as retirees to be insistent that at least half of their portfolios consisted of Microsoft, Intel, Cisco and Dell. Each of these stocks had gone parabolic and none of them paid dividends, which was a good thing because that left them with all those earnings to plow back into the business. If you needed to buy groceries, you could just sell a few shares for cash flow.

My how things have changed. Today, "dividend paying stocks" are all the focus of attention — not to mention fund flows. McDonalds, Proctor & Gamble and Johnson & Johnson are emblematic. Apple has just begun getting into the act by declaring its first dividend and Intel and Microsoft are now on the list after ramping up dividends soon after the tech stock meltdown in the early 2000s (even the gold miners are providing a yield comparable to what you can garner from the 5-year Treasury note).

What these companies have in common is that they are blue chip names and they have taken on a "one decision" aura. For example, Proctor & Gamble has raised its dividend every year for 55 years. These are growth stocks for the most part so dividend increases are expected to continue. And they are usually "global mega-caps", meaning that they are very big companies that do business (often the majority of their business) outside the United States.

Returning to Rule #7, there are indications that a handful of blue chip stocks are driving the stock market and that points to more vulnerability than meets the naked eye. The underlying appeal to stocks so far this year is growth in the form of capital appreciation rather than dividend yield at current levels — but as we saw a year ago, that pattern is likely not sustainable. The narrowness of the list of favorites adds to overall market risk — risk that can be somewhat immunized by a focus on the dividend stream that an income-equity strategy can deliver. Investors are also looking for other ways to try and generate equity-type returns without taking on equity-like risk — which is why, with corporate balance sheets so strong, inflows into credit funds have been so robust with 'junk bond' issuance totaling $75.7 billion so far this year, a record (going back to 1980).

Indeed, what is still so fascinating is how the private client sector simply refuses to drink from the Fed liquidity spiked punch bowl, having been burnt by two central bank-induced bubbles separated less than a decade apart. Investors continue to use stock price appreciation as an opportunity to rebalance and diversify rather than chase performance — pulling $15.6 billion from U.S. equity mutual funds so far this year while taxable bond funds have seen net inflows amounting to $59 billion.

In the meantime, and as we have pointed out repeatedly, the one behavioral shift that looks to be secular in nature, is the relentless investor focus on spinning off a cash flow stream. The re-discovery of dividend growth and dividend yield as a core component of the total return is critical, and must be viewed in a long-run wealth-building context: In the past three decades, a $10,000 investment in the S&P 500 would be worth just $110,740 today — with capital appreciation only. Tack on the reinvested dividend, and that initial investment becomes $255,600.

The less cyclical plays may shift into favor as well — the ones that offer earnings stability and visibility. We say this because earnings are slowing notably and hence becoming more scarce. We came off a Q4 that saw just 52% of companies beat their estimates, below the 60% historical average and the lowest share since the recovery began in mid-2009. The slowing in earnings becomes even more apparent once Apple is stripped out. Indeed, operating EPS for the S&P 500 was 13% in Q4, but would have been 10% if not for Apple; even more glaring is that on a reported GAAP basis, S&P 500 earnings actually declined by 2.3% YoY in the fourth quarter, and that turns into a 5.7% loss if Apple's performance is stripped out.

Looking at our trusty Barron's, we see (on page 26) that Q1 operating EPS growth is set to weaken to a puny +1.4% YoY pace, or FLAT on an ex-Apple basis. Of the 112 companies that have provided guidance thus far, 68 of them have warned that earnings will come in below consensus estimates, 36 raised expectations. So this does not exactly add up to an economy being driven by fundamentals as much as by sentiment.

In fact, market sentiment has moved to the extreme side of bullishness. The Market Vane is at 68% bulls and the Consensus Index is at 77% (see page 11 of Barron's). Investor's Intelligence is at 50.5% and barely above 20% for the bulls. Meanwhile, we know that the retail investor has not been buying into this liquidity rally. Volume has been sluggish — daily turnover of just 3.82 billion this year on the NYSE is 14% below year-ago levels and the lowest since 2007. We see again from page 11 of Barron's that corporate executives are not buying this market either — the ratio of selling to buying by insiders is now up to 40-to-1. It has been at above 20 in six of the past 10 weeks and we have not seen that since early May 2011 (when it was time to go away). And the lack of any real significant back-up in bond yields suggests that the asset allocators have been idle as well.

It would then seem as though this is a market being driven by traders. Then again, it has been a very tradable rally, just as the post-QE1 and post-QE2 jumps were. Ditto for the current post-LTRO rally. But liquidity is not an antidote for fundamentals. And a market that lacks breadth, participation and volume is not generally one you can rely on for sustained strength, notwithstanding the terrific first quarter that risky assets delivered. We lived through this exactly a year ago.

Meanwhile, we have real estate deflation rearing its ugly head in China, a spreading European recession (for all the talk of German resilience, retail sales volumes sank 1.1% in February and have contracted now in four of the past five months), acute debt problems in Portugal and Spain (there is already talk in Greece about the need for a third bailout), and the U.S. data have been coming out rather mixed (it should have enjoyed a much bigger bounce than it did in recent months from the extremely warm weather — it was the fourth warmest winter since 1896; 15% warmer than usual. In Chicago, it was the warmest March ever and second balmiest March on record in New York City. For the latter, it was 9 degrees above normal and would have lined up in the top 10 for any April!). That the employment, housing and spending data weren't even stronger than what they showed — likely little better than a 2% pace for Q1 real GDP — is the real story beneath the story. The fact that the 10-year note yield stopped at 2.4% and has since rallied 20 basis points instead of making the expected technical challenge of 2.65% suggests that the bond market crowd may be figuring out what this means for the Q2 landscape as the weather skew to the data subsides.

At this stage, it pays to reiterate the cornerstone of our S.I.R.P. (Safety in Income at a Reasonable Price) strategy: It rests on 3-D principles — deleveraging, demographics and deflation. As for deleveraging, it is still so evident in the fact that money multipliers and measures of money velocity are still contracting. The ratio of non-liquid assets to total commercial bank assets has yet to signal the onset of a new credit creation cycle, which is likely years away. Mortgage debt, in particular, continues to get destroyed — on a net basis. How could it not? Nearly one in eight American households with a mortgage are either already in the foreclosure process or at least 30 days past due. The entire inventory of homes that are either vacant or unsold with a 'For Sale' sign on the front lawn is roughly 8 million units. There are an estimated 11 million homeowners who are "upside down on their mortgage" (23% share of the population) and we hear another 2.5 million that will be with another 5% drop in home prices. So the process of extinguishing debt, especially the leverage tied to the housing market, continues unabated, even as investors begin the process of gobbling up distressed properties in the areas of the country most negatively affected by the severe deflation in residential real estate (which actually surpassed the 1930s).

As for demographics, let's face it, the boomer median age is 55 going on 56 and the first age cohort that controls most of the wealth is already 65. And the life cycle dictates a need for conservative investing with a focus on capital preservation and income orientation. Makes perfect sense to us and this doesn't mean that we won't see the odd three or six month period of beta-bets dominating in periods when the world's central banks go wild on liquidity provision (this is the post-LTRO rally — the ECB basically giving the euro area banks 1 trillion euros of nearly free money for three-year terms ... sweet). But these liquidity rallies, as we saw in 2010 and again in 2011, are trader rallies that are rent-able; not own-able.

Then there is the deflation — we could go on and on about the core PCE deflator and what it did (or didn't do) in the February consumer spending data that came out on Friday. But for a real-world example of how retailers are increasingly forced to compete at a time when the household income pie is not expanding, see Pizza for $1, 79 cents, 75 cents, a Slice! on page A15 of the Saturday NYT. Anyone who is complaining about inflation today is not ordering