I can’t help but wonder what went through George Steinbrenner’s mind when he decided to push Joe Torre out the door as the manager of the New York Yankees. Under Torre’s leadership the Bronx Bombers made the playoffs 12 consecutive years and won four world championships. Despite Mr. Torre’s outstanding achievements, he somehow fell short of Mr. Steinbrenner’s expectations.

In a strange way I can relate to George… During my investment career the most difficult time to make portfolio changes has always been following a period of outstanding performance. It seems so counterintuitive to sell any stock that has performed well. If you are lucky enough to have a portfolio full of outstanding performers, it creates one significant challenge to decide which names to hold on to and which to sell.

At a basic level stock prices are driven by the ever changing relationship between expectations and what I call “eventual reality”. Throughout every market cycle, the expectations for a stock will fluctuate, sometimes wildly, in response to changes in company fundamentals, as well as economic developments. At the same time the underlying reality also changes, but much less dramatically in most cases. And it is this imbalance that often creates stock market volatility.

Case in point - How high is high?... Oil prices have soared to $90 per barrel, which has propelled the oil service stocks to all-time highs. The sector has significantly outpaced the overall market thus far in 2007 rising 77% vs. a 9% gain in the S&P 500, making it one of the best performing sectors this year. Based on this stock price performance, it is fair to assume that sustained high oil prices are built in to expectations. If reality proves otherwise, stocks in this sector may be poised for a significant decline.

Meanwhile, one of the worst performing sectors has been Retail... With the decline in housing, high oil prices, and negative news on the job front, the consensus outlook for retail spending is decidedly negative. What are the chances that the holiday season could actually turn out to be better than these greatly reduced expectations?

And the financials are struggling as well… Third quarter earnings have been quite disappointing for most of the banks. The culprits for this poor performance include: credit quality issues, mortgage related write-offs, increased provisions for future loan losses, weak investment banking, and lower trading profits.

In a cyclical sense I’m wondering how much worse the fundamentals can get in the financial sector. I suspect there is a potential rally coming some time in the not too distant future, especially in the higher quality names.

One critical question, which portfolio managers perpetually face, is whether to stick with sectors that have outperformed or rotate into those that have lagged. If there is one common mistake that investors continually make, it is that they sell all their poor performing stocks toward the end of the year, typically for tax purposes, and hold on to all their winners. Sometimes this can add value, but often it leaves one with a portfolio of over-valued stocks, and one that is vulnerable to disappointment.

For struggling stocks, the key is to determine if management has a plausible strategy for a turnaround. Unfortunately for even the most accomplished executives, maintaining the status quo, or referring to an outstanding long-term record, is not an effective approach toward job security in today’s environment of activist shareholders and independent-minded boards of directors. Yet, management on the hot seat is management motivated. In some cases, last year’s poor performers become the winners in the following year as motivated management turns the ship around.

What have you done for me lately?... In contrast, for out performing stocks, the pivotal question is how much longer the key drivers of success can continue. This analysis must take into account what competitors are doing that might alter the competitive landscape.

In either case it is essential to maintain a forward-thinking mindset. The competitive relationships between companies across the various sectors and industries are dynamic. Some companies improve through innovation and execution, while others falter for any number of reasons. This perpetual ebb and flow must be analyzed within the context of expectations. Just like it might be unrealistic to expect the Yankees to win the title every year, it might be overly optimistic to expect stock market leadership to remain constant.

For our part, we are easing our way into select retail names, while developing a potential buy list of financial stocks. We also plan to continue to hold many of our outstanding performers, but with an ever watchful eye on the fundamentals relative to expectations. The latter is something maybe Mr. Steinbrenner should give some thought to before reshuffling his star-studded line up.