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Denting the bullish sentiment in the past few weeks has been a spate of uncertainty weighing on investors’ minds, causing volatility to spike with the VIX hitting new highs. Investors fretted over central bank policy in both Japan and America and stressed over negative corporate guidance. Stocks finished the week in negative territory, with nearly $3 trillion of paper wealth being erased in the world’s equity markets over the past three weeks. Adding to the misery, the International Monetary Fund (IMF) this past week trimmed its 2013 projection for U.S. economic growth to 2.7 percent, down from 3.0 percent.

Market volatility is up and likely to increase in the months ahead, given the uncertainty surrounding global growth and corporate earnings. A record number of S&P 500 firms have warned about potential profit shortfalls (in 6:1 ratio) in the second quarter of 2013, for every upgrade—triple the normal level. Correlations between the ten main equity sectors on the MSCI AC World Index now stands at 68%, down from 80% at the start of the year, marking the lowest level since the beginning of 2008. With overall market volatility on the rise and stock correlations continuing to decline, passive investment strategies are likely to lag active stock picking strategies in the months ahead.

Despite the recent warning signs that the IMF has been flashing and the downdraft in the stock market, the story of the real economy in the U.S. looks decidedly more upbeat. A host of indicators—from home prices to jobless claims to government deficits—point to an economy that is stronger than it’s been since the financial crisis. The worries over the “fiscal cliff” and the debt ceiling seem like a distant memory. Last month, the Congressional Budget Office slashed its deficit estimate for the fiscal year ending in September to $642 billion, or about 4 percent of gross domestic product, the smallest shortfall since 2008.

Housing, which has underpinned every previous U.S. economic rebound, is again experiencing a boom. New home sales were almost 30 percent higher in April than a year earlier. The cities that were hardest hit in the 2008/2009 downturn are now leading the turnaround in housing. Prices in Phoenix rose 22.5 percent in March from a year earlier and Las Vegas climbed 20.6 percent, according to the most recent reading of the S&P/Case-Shiller big-city price index.

In May, the S&P 500 shifted gears with cyclicals outperforming defensives for the first time in 2013. With the “end-of-QE” talk intensifying, the ten-year Treasury yield backed up more than 50 basis points in the month, sending low beta yield-oriented equities tumbling. Telecoms fell -7.4%, while Staples were down -2.4% and Utilities were off -9.6%, over the month, while cyclical sectors came back with a vengeance. Financials soared +5.9%, Industrials were up +4.6%, while Technology shares rallied +4.2% in May.

The strengthening U.S. dollar and rising bond yields helped boost the fortunes of the S&P 500 over the past six weeks, but wreaked havoc on most other major world indices. Emerging Markets continued their slide in May with the MSCI EM Index falling -2.9% with Latin America bourses being particularly weak, falling -7.2%, over the month. Emerging Markets were all the rage for investors, but since the start of 2013, emerging markets have been lagging developed markets by more than ten percent, the widest margin since the late 1990s.

Small cap U.S. stocks have also been outperforming their larger brethren by a solid margin since mid-April. During the last two months, small caps stocks have returned 8.5% compared with a paltry 4.7% for large caps, in a reversal of fortune from earlier in the year. While small caps will likely to ride a wave of investor optimism for a little while longer, historical data suggests that the rally in small cap stocks may be short-lived.

While the last few weeks have been disconcerting and a continuing pause in the S&P 500 rally is likely, given the ongoing macro uncertainty, it will be short-lived. Lately, I have been trimming exposure to the lower-growth yield oriented names in my portfolio and raising cash for the next leg up in the S&P 500. Going forward, I'm looking to continue to increase my exposure to the Financials, Consumer Discretionary and Technology sectors, which should be the biggest beneficiaries in the second half of the year.

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