Market Outlook

Source: Bloomberg

As I wrote in Small Caps: The Time to Invest is Now, small-cap stocks are more sensitive to the macroeconomic environment, so any hint that the economy is weakening will cause small caps to underperform. PIMCO’s Mohamed El-Erian is worried that the U.S. government’s spending sequester is just starting to have a detrimental ripple effect in the economy. Make no mistake about it; if the U.S. goes back into recession and deflation occurs, small-cap stocks will not be spared. But I don’t believe such a pessimistic scenario is likely.

A study from Ned Davis Research that found bull markets in the S&P 500 continue on average for another 644 days – almost two years – in the 13 instances since the 1950s when the S&P 500 hit a new all-time high after a bear market. And the average gain in the subsequent two years was 40.3 percent!  The “median” numbers (six instances higher and six instances lower, as opposed to a simple average) showed the bull market continuing for an additional one year and gaining 18 percent, which is still impressive and reassuring. Retail investors have just started to re-enter the stock market after years of equity fund outflows and record highs in the stock indices will keep retail demand strong. Even “smart-money” professional investors like Mark Mobius and JP Morgan equity strategist Tom Lee are abandoning their bearish outlooks and turning bullish. Even more bullish is Raymond James equity strategist Jeffrey Saut, who recently stated:

I think there is a decent probability that we are into a new secular bull market that has a decade yet to run; and, nobody believes it.

A market top for 2013 may not yet have occurred, but signs have appeared that the stock market is entering a choppy period. The days of uniform price advances by all stocks and industry sectors is over. On Monday April 15th, stocks sufferied their worst one-day percentage price drop since last year (Nov. 7th; the day after President Obama won re-election). The sell-off started with news that the Chinese economy was slowing down, gaining only 7.7 percent in the first quarter of 2013 compared to expectations of 8.0 percent growth and a deceleration from the 7.9 percent growth in the fourth quarter of 2012. This bad news follows last week’s bad news that Fitch Ratings had downgraded China’s government debt.

China is the world’s primary consumer of industrial metals, so its slowing economic growth caused copper futures to fall to a 17-month low and gold prices dropped to a two-year low after suffering its worst two-day price drop in 30 years! Crude oil prices are also likely to remain subdued thanks to record oil and natural gas drilling in the North Sea. Weakening commodity prices sometimes are a leading bearish indicator for the general stock market, but not always. One commodity that is showing price strength is U.S. natural gas, which is not yet exportable and thus reflects economic strength in the U.S. economy only. In conclusion, commodities reliant on Chinese demand may remain weak, but commodities reliant on U.S. demand may remain strong.

Interest rates remain extremely low. On April 15^th, the 10-year U.S. Treasury yield fell to 1.67 percent – the lowest level since last December and approaching the all-time low of 1.39% hit last year on July 24^th. Low interest rates mean high price-earnings multiples for stocks, which should keep any stock-market corrections brief and contained. The one caveat to this rosy stock outlook is that the U.S. economy must stay out of recession, but Fed Chairman Ben Bernanke recently said that U.S. employment, housing, and industrial production are “improving.” Goldman Sachs recommends shorting gold because it forecasts a faster U.S. economic recovery in the second half of 2013, thus negating the need for a “safe haven” investment like gold. Others argue the exact opposite — weak gold prices signal a weakening economy. The divergence between stock performance and inflation is very pronounced and concerns some analysts because a similar divergence preceded the last two recessions and bear markets. Geopolitical risks in North Korea and the Middle East are a wildcard.

Still, economic growth is likely to remain moderate and “defensive” industry sectors (e.g., healthcare, consumer staples, and utilities) – which have outperformed so far in 2013 – may continue to lead.  According to Capital IQ, since 1990 whenever the stock market had a positive first quarter, it continued to post strong gains the rest of the year 86 percent of the time. The average gain from April through December was 8.5 percent. Shorter term, the second quarter (April through June) could see lagging industry sectors (e.g., technology and materials) temporarily outperform. According to JP Morgan, buying industry sectors that lagged in the first quarter has outperformed in the second quarter four of the last four years, and in 11 of the last 13 years.

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 U.S. Physical Therapy and GrafTech International provide excellent diversification benefits to their respective Roadrunner portfolios. Interestingly, U.S. Physical Therapy and HMS Holdings have a very low correlation with each other, which may seem counter-intuitive since they both operate in the healthcare industry. But it makes sense when you realize that they are on polar opposite ends of the healthcare spectrum — U.S. Physical Therapy makes money through increased government spending on Medicare claims, whereas HMS Holdings makes money by invalidating Medicare claims. It just goes to show that an investor should always run the correlation numbers and not make decisions based on hunches or assumptions regarding a stock’s diversification benefits.