Market Outlook

At the end of February, the S&P 500 experienced a minuscule 3-percent correction on worries about sequestration (i.e., $85 billion in automatic spending cuts through September) that went into effect on March 1^st. But when investors realized that the immediate impact of automatic spending cuts wasn’t that bad, the market quickly reversed higher again.

Stock-market momentum remains extremely strong. This past Monday (Mar. 25^th), the Dow Jones Industrials hit a new all-time high! On Thursday (Mar. 28th), the S&P 500 finally exceeded its 2007 all-time closing high of 1565.15 and thus joins the several other equity indices that already have achieved new all-time highs. As market forecasting firm  Lowry’s wrote last week, new bull-market highs in both advance-decline lines and number of operating-company stocks hitting price highs have just occurred, and such highs are leading indicators that occur months prior to final stock-market tops:

Historically, advance-decline lines begin to diverge from their price indexes by 4-6 months for the big cap indexes and, typically, even earlier for the mid- and small-cap advance-decline lines. Thus, this week’s new highs in the NY and Mid-Cap advance-decline lines suggest a major top is still months away.  

In summary, while the current rally is extended and thus vulnerable to a correction, the market’s primary uptrend shows little sign of weakening. Consequently, any pullbacks should be used to cull weak stocks and reposition cash into stocks in the strongest sectors.

Among the currently strong industry sectors are financials, industrials, consumer staples, and utilities. Telecommunications and information technology remain on the weaker side. The more-conservative “risk off” sectors have dominated the stock-market rally over the past three years, but at some point – particularly if economic growth strengthens – the “risk on” sectors like tech will start to outperform.

The U.S. economy continues to show strength, with housing, durable goods, and manufacturing all improving. On March 13^th, UCLA Senior Economist David Shulman made a bold call that the U.S. economy is finally ready to grow strongly:

The U.S. economy seems poised for real growth after four years of weak recovery. Housing and auto sales will lead the way.

Retail sales jumped 1.1 percent in February, the largest jump in five months. February spending occurred before sequestration, but after the increased payroll tax went into effect in January. According to economist Joel Naroff:

The increase in taxes has had minimal impact on household spending, showing that the economy retains a lot of momentum.

The Federal Reserve, at its March 20^th meeting, similarly forecasts both economic growth and inflation to rise through 2015. As for inflation, it is already here. In February 2013, the Consumer Price Index (CPI) Rose 0.7% — the largest monthly increase in almost four years (since June 2009). If you look at the chart below, you’ll see that inflation has been in a continual upward slope since the beginning of 2009:

Even more inflation – perhaps much more — is coming. The Federal Reserve is buying $85 billion per month in Treasury bonds and Mortgage-backed securities! This bond buying is creating a massive increase in the U.S. monetary base – an increase never seen before in history. At the March 20^th meeting, the Fed remained committed to continuing both the bond-buying quantitative easing (QE) program and the zero-interest-rate policy (ZIRP) until inflation hits 2.5 percent, which is above the Fed’s long-term annual inflation target of only 2.0 percent. In other words, the Fed wants to create inflation above 2% target. And what the Fed wants, it eventually gets:

The “flies in the ointment” to this rosy economic scenario include:

• weak U.S. consumer confidence
• stock prices historically rise during economic recessions 20 percent of the time
• 4.4 times as many companies are lowering first-quarter earnings expectations as are raising expectations – the worst negative-to-positive ratio since 2001
• The Cyprus bailout may be sowing the seeds for the next round of the European debt crisis.
• European economic weakness continues and Q1 2013 turning out to be a sixth-consecutive quarter of negative growth a virtual certainty.
• Copper prices, which are called the only metal with a Ph.D. in economics, are falling and that suggests economic weakness.

On the bright side:

• 80 percent of the time rising stock prices signal no recession is on the horizon.
• S&P 500 stocks are trading at less than 14 times forward earnings estimates, which is less than the 15-year average of 16.6. Consequently, stocks could continue to rise almost 20 percent from here based on P/E multiple expansion alone
• Fidelity’s chief technical analyst projects the Dow Jones Industrials continuing to rise to 17,000 – based on both inverted head and shoulders and Fibonacci extension analysis — which would constitute a 17 percent rise from current levels.

With U.S. economic growth and inflation looks primed to accelerate, the conditions look excellent for small-cap outperformance – as I discussed at length in my article entitled Small-Cap Stocks: The Time to Invest is Now.

Roadrunner Stocks Continue to Outperform the S&P 500

Between January 24^th and March 26^th, the S&P 500 has risen 5.0 percent. Of the ten initial Roadrunner stocks recommended on January 24^th, six have outperformed this figure and four have underperformed. The initial five stocks in the Value Portfolio are collectively trouncing the S&P 500 by more than double (10.3% vs. 5.0%). The initial five stocks in the Momentum Portfolio are collectively slightly behind the S&P 500 (4.7% vs. 5.0%). But when you include the two stocks added in February, both the Value and Momentum Portfolios are outperforming the S&P 500:

Value Portfolio

Momentum Portfolio

Roadrunner Portfolio Analysis: Industry Sectors

When selecting stock recommendations for the Roadrunner portfolios, I try to diversify among underlying stocks to ensure exposure to different investment styles (growth vs. value), market caps (large vs. small) and industry sectors. Have I succeeded? To find out, I decided to run the Roadrunner portfolios (Value and Momentum combined) through the Morningstar portfolio-analysis application. Here are some of the results:

Industry Sector Analysis

The Roadrunner Portfolios are defensively positioned. I conclude this not based on the allocation to the “defensive” category of stocks, because this allocation is roughly in line with the benchmark. But “cyclical” stocks – the most aggressive category – are under-weight by more than six percentage points, whereas the middle-of-the-road “economically sensitive” category is overweight by roughly the same amount.

Most Overweight: Technology (25.00% vs. 15.19%), Energy (16.68% vs. 6.55%), and Aggressive Growth (25.04% vs. 13.81%)

Most Underweight: Industrials (8.33% vs. 19.73%), Basic Materials (0.0% vs. 5.66%), and Speculative Growth (0.0% vs. 6.33%)

Valuation and Profitability

Roadrunner stocks sport cheaper valuations, much higher profitability, and stronger earnings growth than the typical S&P 500 stock. 

Investment Style

Since Roadrunner Stocks is a small and mid-cap stock advisory, it should come as no surprise that the Roadrunner portfolios have no allocation to large-cap stocks. What is surprising is that Morningstar classifies only 17% (10/59) of Roadrunner small caps as “value” and only 19.5% of Roadrunner mid caps (8/41) stocks as “value.” After all, half of Roadrunner Stocks are in the Value Portfolio!

But the result becomes less surprising once you understand how Morningstar classifies stocks as “value” or “growth.” Morningstar evaluates stocks twice – according to value and growth criteria separately. Consequently, it is possible for a stock to score highly as both value and growth.  If the value and growth scores are similar, the stock will be classified as “core.” If the growth score is higher than value, then it is classified as “growth” and vice versa.  Since Roadrunner Value Portfolio stocks are all currently priced cheaply at under 8.5 times EBITDA, they definitely constitute “value,” but many also sport very high revenue and earnings growth rates which make Morningstar classify them as “growth” since their growth is more extreme than their cheapness.  That’s okay with me since my goal is not to find the absolute cheapest stocks, but simply inexpensive stocks that also offer strong growth.   

The Computer-Generated Conclusion:

Investment Style: Mid/Small-Cap

Compared with the broader market, your portfolio’s stock exposure is biased toward small- and mid-cap companies. Among these issues, it is worth noting that you have a healthy mix of conservatively priced value stocks and aggressively-priced growth issues.

Correlation Analysis

The two Front Runners added to the portfolios this week have very low correlations with the other existing holdings. Using a stock correlation calculator, I created correlation matrices for both Roadrunner portfolios, including this month’s recommendations. The time frames for the correlations were weekly measuring periods over 1 year:

Momentum Portfolio 1-Year Correlations

Value Portfolio  1-Year Correlations

As you can see above, both CommVault Systems and Future Fuel provide excellent diversification benefits to their respective Roadrunner portfolios.