The S&P 500 surpassed the 1,600 level last week for the first time in history despite the fact that global economy remains in the dumps. What is going on? Why does the market go up without the support of economic fundamentals?

Euro Zone unemployment hit a record high of 12.1% in March (since tracking began in 2000), rising for the 23^rd consecutive month. Furthermore, the unemployment rate is expected to worsen later this year and remain stuck near record highs through most of 2014. No wonder the European Central Bank decided to cut short-term interest rates!

The U.S. economy is in better shape, with an unemployment rate of “only” 7.5%, but this number is historically recessionary and is deceptive because its denominator is based on people “looking” for work (in contrast to those “eligible” to work) and the subset looking for work (i.e., the labor participation rate) is only 63.3% of those eligible — the lowest since May 1979.  The unemployment rate would be 11.3 percent if the labor participation rate was at its pre-2008 level of 66%. Despite the relatively healthy April jobs report (165,000 new jobs), the U.S. still has 2.6 million fewer jobs than existed in 2007 before the “Great Recession” of 2008-09, and economists estimate that 8.6 million additional jobs are actually needed to break even if population growth since 2007 is taken into account.

U.S. corporate earnings in the first quarter have been mediocre, with 59% of companies beating already-lowered analyst estimates (slightly below average) and only 52% beating revenue estimates (significantly below average). Still, the mediocre first-quarter gains were enough to register record earnings for S&P 500 companies, which are benefitting from employer stinginess at raising wages (high unemployment enables employers to be stingy).

The S&P 500’s record-high rise last week was an extreme move that finds the index more than two standard deviations above its 50-day moving average – stocks typically stall when the rubber band is stretched this tight. Technical analyst Louise Yamada sees some warning signs in the divergent weakness exhibited by transportation stocks and small/mid caps, but remains long-term bullish. Keep in mind that “stall” is different from “correct,” and the mini-correction in mid-April may be the only significant downside the market sees until the autumn. Bullish market momentum is unprecedented, according to Raymond James equity strategist Jeffrey Saut. Since December 28, 2012, the Dow Jones Industrials has not suffered a single period where the index has closed down for three consecutive days. Saut calls this 87-trading-day streak a “buying stampede” that has blown away the previous 50-year record of 53 straight trading days:

The equity markets do not face a period of serious vulnerability until this summer, unlike the last three years where “Sell in May and go away” has played so well. I don’t think the scenario plays that way this year.

So far the bears, rubbing their collective hands together with glee over the fiscal cliff, sequestration, the continuing resolution, the debt ceiling, etc., have been totally w-r-o-n-g. I feel sorry for the bears waiting for the “crash” that they have been expecting for the past four years, all to no avail. It looks to me as if the stock market will continue its move irregularly higher until we get indications that something is irrevocably wrong. So far, nothing in the stock market’s internal structure has told us to be anything more than cautious, but not bearish.

Similarly, money manager Jeff Macke remains bullish:

This is the same rally we’ve had forever.  We’re due for a pause, the data’s not that great – just shut up and stay long. The economy’s slowly improving, earnings are OK, there’s nowhere else to go and – You know what? – sometimes a bullish market is just a bullish market.

Fund flow data from Lipper supports the idea that investors are just starting to increase their risk appetite and move cash out of money-market funds and into stocks. Interest rates on junk bonds have hit an all time low of 5% — a level that indicates investors have thrown caution to the wind. Warren Buffett says that stocks will go “far higher” over the long term. But the short term . . .

The problem for short-term investors looking to ride the momentum wave is that they assume a bell will ring at the stock-market top and they will be able to get out before a crash. Oppenheimer technical analyst Carter Worth says that a market decline – when it occurs — could be “worse than normal.” Private-equity investor Leon Black of Apollo Global Management (APO) is skeptical such astute market-top timing is possible and advocates starting to sell now while things look perfect and prices are liquid because selling becomes much harder and illiquid when everyone tries to exit the door at the same time. At the Milken Institute Global Conference, Black was quoted saying:

We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down. And if we’re not selling, we’re refinancing.

The financing market is as good as we have ever seen it. It’s back to 2007 levels. There is no institutional memory.

As I mentioned at the beginning of this article, there is a tremendous divergence between the stock market and the Citigroup Economic Surprise Index (CESI), as shown  in the following chart:

Source: Business Insider, Bloomberg

Normally, stocks and positive economic surprises move in tandem, but since late 2012 they have diverged – another one of those worrisome divergences. It’s unclear whether the CESI is a leading indicator of the stock market (or vice versa), but if CESI leads that is a problem.

Besides the negative CESI, the negative price action of copper (the only commodity with a Ph.D. in economics) is also a warning sign about the economy. According to Oppenheimer’s Carter Worth (45-second mark), in the five years since May 2008 economically-sensitive industry sectors like materials and energy have each declined more than 22% while defensive industry sectors like utilities and health care have each risen more than 30%. The same severe bifurcation in performance between industry sectors occurred in 2007 before the 2008 crash. The performance gap is so extreme that it needs to close. Either the weak sectors need to catch up with the strong sectors or the strong need to fall down to join the weak. Based on history, Worth says the latter scenario is more likely:

Bifurcation typically ends with the strong ones succumbing and the weak ones staying weak.

The reason stocks continue to move higher and ignore the real economy is because of the extraordinary monetary stimulus and quantitative easing that is being coordinated by central banks worldwide. The Federal Reserve continues to buy $85 billion per month in U.S. Treasuries and mortgage-backed securities, and analysts expect them to spend a total of $1.25 trillion on this latest round of quantitative easing before they are done.

The World According to Altucher: Buy Small-Cap Stocks

Former daytrader and financial blogger James Altucher argues that this monetary stimulus has rigged the stock market. Companies are flush with cash but don’t invest in business expansion because the real economy is moribund, so they use the cash to buy back their own stock, reducing supply and pushing prices up. To remain public companies, however, there are limits to this buyback activity and Altucher believes the limits have nearly been reached. So, the price support provided the stock market by buybacks and decreasing supply is ending. Investor demand, in contrast, has been weak for years and will likely continue weak because those lucky enough to have jobs in this punk economy are insecure about their futures and have stagnant wages, so they don’t have enough discretionary income for long-term investing. The result is that “stocks go down or struggle to stay afloat.”

The stock market is increasingly controlled by big institutions that focus only on the largest stocks, pushing prices up and down based on “risk on” and “risk off” macro views of the global economy. The fundamentals of individual large-cap companies mean nothing anymore – all large caps rise and fall in unison because they are traded in big baskets of ETFs. The small investor doesn’t have a chance:

For the first time in a long time, I’m not a super bull on the overall market. I refuse to compete for information against massive hedge funds and mutual funds that do everything they can to cheat the system (insider trading, manipulative trading, high frequency trading, special access to secondaries, etc.).

Altucher is not against stock investing; quite the contrary, he is invested in several stocks. But he only invests in stocks in which he stands a fighting chance – those that aren’t part of the “criminal enterprise” and “sucker’s game” known as the overall stock market.

What are the “right” kind of stocks” According to Altucher, the answer is small-cap stocks! Only stocks that are too small to capture the attention and manipulative efforts of the hedge funds and hyper-frequency traders will act according to their fundamentals and reward the individual investor who puts in the time and effort to analyze the business and competitive landscape.

Altucher’s preferred small-caps are highly-speculative and money-losing micro-caps trading on the electronic bulletin board. Those are too high risk for me – most of them turn out to be losers. In contrast, I focus on small and mid-caps that have proven business models and generate substantial free cash flow and earnings. Separating the winners from the losers is the key to small-cap investing.

To invest profitably, one need not take excessive risks; the goal is simply to invest in successful companies while they are small, so that you can ride their appreciation potential to the fullest during the high-growth stage of their corporate existence. Low-risk profitable companies trading at reasonable valuations are the kind of small caps that the Roadrunner Stocks investment service seeks out and recommends.

Around the Roadrunner Portfolios

Brocade Communications (Nasdaq: BRCD) issued an earnings and revenue warning for its upcoming second-quarter financial report on May 16^th. CEO Lloyd Carney blamed “softness” in customer demand for Storage Area Networking (SAN) products. The stock fell more than 6% on the news.

This demand weakness for technology products is not specific to Brocade, but is endemic throughout the tech sector right now (see the update on SolarWinds below). Long term, Brocade CEO Carney remains optimistic:

Brocade continues to be well-positioned for long-term success in the data center.

Gentex (Nasdaq: GNTX) reported declining revenue and flat earnings per share in its first-quarter financial report, but investors reacted positively because analysts had expected worse. The stock has actually risen 9 percent since the report’s release as investors cheer the company’s continued ability to cut costs and boost its gross profit margin. Automobile production fell in most of its markets (e.g., Europe, Japan, Korea), which detrimentally impacts the company’s original equipment manufacturer (OEM) auto parts shipments. North American car production is a bright spot (4% growth expected in Q2), but the company warned that weak economic conditions in the rest of the world are probably not going to end anytime soon:

Unstable macroeconomic factors continue to be a concern, particularly in Europe, as it remains the Company’s largest shipping destination.   

After four regulatory delays, the National Highway Traffic Safety Administration (NHTSA) has committed to issuing final rules mandating rearview camera displays (RCD) in all cars sometime during the federal government’s fiscal 2013 (ends in September). Although final RCD rules should marginally increase Gentex sales in 2014, the effect will be muted because many auto manufacturers have decided to install the rearview cameras in the car console rather than in Gentex’s rearview mirrors. The big growth drivers looking forward are auto-dimming rearview mirrors and SmartBeam technology that automates the usage of headlamp high beams.

For the second straight quarter, the company did repurchase any stock – despite the fact that the company has $518 million cash on the balance sheet and 4 million shares remain in its share repurchase plan.  The good news is that this untapped repurchase authority is a future catalyst for additional stock-price appreciation.

The cost-cutting and efficiency initiatives Gentex has implemented during these weak economic times will pay off in spades in the future when economic growth improves and auto production rebounds. Peak profits in the next up-cycle could easily hit $2.25 per share or more. If you tack on a very-conservative 15 P/E multiple (Gentex has historically commanded a P/E ratio above 20), that translates into a target price of $33.75, which amounts to more than 48% upside from the current price of $22.66.

Diamond Hill (Nasdaq: DHIL) filed its Form 10-Q with the SEC, which elaborated on its first-quarter financial results that had been released a week earlier. Revenue and earnings per share were both up 10% year-over-year. Book value per share and assets under management were up 8.6% and 13.0%, respectively. A good, solid quarter.

One of the things that had worried me in the company’s previous Q4 report were net outflows from its institutional accounts. Management’s explanation in the annual report (pp. 5-7) was that its portfolios had a heavy exposure to the energy sector and energy had underperformed, resulting in some client defections. As I mentioned in the April issue of Roadrunner Stocks, however, Diamond Hill’s portfolio managers turned things around during the first quarter and outperformed their benchmarks.

The result is that net outflows from the portfolios were much less during the first quarter, which is a good thing. In the sub-advised funds, outflows fell from $149 million in the fourth quarter to only $37 million in the first quarter, and in institutional accounts outflows fell from $499 million to $33 million. As was the case in the fourth quarter, investment performance more than outweighed the cash outflows, so that assets under management increased, which is what counts from an advisory fee perspective —  up 10% year-over-year (page 18 of 10-K).

Two interesting facts from the 10-K:

• Page 9: The company is almost doubling the dollar amount of assets under management that are subject to “incentive” advisory fees rather than flat advisory fees. This means that the company will earn more fees than the base percentage if the portfolios outperform their benchmark and earn fewer fees than the base if the portfolios underperform. This is good news if you have faith in the investment talent of the portfolio managers, and I do.
  
  
• Page 17: The “Small-Mid Cap” mutual fund experienced the largest increase in assets under management (up 54%). This suggests that investor demand for the universe of equities Roadrunner Stocks  focuses on is heating up, which is good news for stock-price appreciation in the small and mid-cap space. Looking at the relative performance of Diamond Hill’s mutual funds, the Small-Mid Cap fund is the best-performing fund in each of the 1-year, 3-year, and 5-year time periods, which speaks volumes about the attractiveness of this asset class over the long term.

HMS Holdings (Nasdaq: HMSY) posted first-quarter financial results that saw revenues up 8% year-over-year and earnings flat; both figures were below analyst estimates, In addition, the company reduced its fiscal 2013 guidance on both revenues and earnings by $75 million and $0.07 per share, respectively. The stock opened down on the news, but quickly recovered to finish up on the day as investors realized that the reduced guidance was almost entirely a timing issue and not a reflection of business fundamentals.

When the federal government is your primary client, you are subject to the political whims of the procurement process and government delays in issuing contracts and making payments is an unfortunate reality. The good news is that HMS will ultimately get all of the revenue it is expecting, but it is being pushed back into 2014. As CEO Bill Lucia explained:

We face a number of near-term uncertainties, the most significant of which relate to the extended delay in the Medicare Coordination of Benefits (COB) award resolution and the re-procurement of the Medicare Recovery Audit Contractor (RAC) contract, together with potential changes to that contract’s structure.

While either of these federal procurements may resolve in our favor, we do not have clarity around the timing or outcome of the resolutions. 

In other words, the reduced forward guidance is based on timing uncertainty and was made out of an abundance of caution. In the conference call, CEO Lucia said:

Most of the uncertainty around our business this year is a function of unexpected twists and turns in the Federal government procurement process, which we could not reasonably have anticipated. 

Analysts at Wells Fargo Securities are not concerned, stating that 90% of the forward guidance reduction is timing only:

Given that about 90% of the reduction in revenue guidance relates to the timing of when the two big Medicare contracts (COB and the re-procurement of RAC) ramp, we don’t believe the reduction in revenue guidance should be viewed as a material negative.

Significant tailwinds continue to exist for HMSY heading into 2014-15 (Medicaid expansion through reform, Medicaid RAC ramp, larger Medicare RAC territory, Medicare COB ramp and the potential to increase services around the Medicaid COB lives that have transitioned to managed care).

Clearing the decks and setting up for big growth in 2014:  The picture for 2014 looks bright with multiple drivers of an estimated 32% revenue growth and 38% EPS growth.

HomeAway (Nasdaq: AWAY) announced first-quarter financials that beat analyst estimates for both revenues and earnings. CEO Brian Sharples said that he was “thrilled” with the results. The stock fell on the news, however, because forward guidance for the second quarter was weaker than expectations. In the conference call, CEO Sharples explained that the lowered guidance was due entirely to a weaker Euro currency. HomeAway gets 36% of its total revenue from Europe, so a weaker Euro has a significant effect when translated back into fewer U.S. dollars.

Interestingly, Sharples said that the forward guidance actually includes an increased growth rate on a currency-neutral basis. The company’s fundamental business is stronger than ever!  Currency effects are meaningless and simply cloud the true earnings power of a business. While investors are dumping the shares, analysts are getting more bullish. Both JP Morgan and William Blair maintained their top buy ratings on the stock, and JP Morgan actually raised its short-term price target to $35 from $30.  Big growth drivers in the future are tiered pricing (lessors pay more for listing more prominently displayed) and a pay-per-listing option (expected to launch in the third quarter) in addition to the regular annual subscription option. JP Morgan sees the pay-per-listing option having a very positive effect on 2014 financial results and William Blair loves tiered pricing:

HomeAway is successfully demonstrating the ability to increase average revenue per listing (ARPL) through its tiered pricing initiative. Further, with tiered pricing only on one-third of eligible listings and a long-term target of about 60% penetration, there continues to be a multiyear runway for ARPL lifts as tiered pricing adoption increases.

I think the stock’s 9% selloff since the earnings release reflects a misunderstanding of the company’s future growth and presents a buying opportunity for those investors who don’t yet own the stock.

Ocwen Financial (NYSE: OCN) is one of the few companies that is able to report triple-digit growth in both earnings and revenues! In its first-quarter report, earnings per share rose 121% and revenues rose 147%. Earnings hit a record high, although missed analysts’ inflated expectations, while revenues beat expectations. The big driver of performance in the first quarter was the acquisition of mortgage servicing rights (MSRs) from Residential Capital on $269 billion worth of mortgages. The April acquisition of Fannie and Freddie MSRs on $84.6 billion worth of mortgages from Ally Bank will boost growth in the second quarter. The more MSRs, the more servicing fees – it’s as simple as that.

Even better, Chairman of the Board Bill Erbey said that the company’s increased operating expenses are temporary (expenses often go up temporarily when new mortgage portfolios are acquired) and should soon fall as a percentage of revenue, resulting in “better performance versus our original expectations.” Ocwen is a great stock to own as a portfolio diversifier because its business actually benefits from a weak economy and housing market – the more distressed homeowners feel, the more likely they are to need a mortgage loan modification, and Ocwen collects fees for such modifications.

With a super-low PEG ratio of 0.2 and full-year 2013 earnings expected to more than triple, Ocwen looks like an undervalued growth stock set to reach new all-time highs throughout the year. 

SolarWinds (NYSE: SWI) announced first-quarter results that were a mixed bag, but investors focused on the negative and the stock fell more than 14% on Wednesday May 1^st. On the positive side, quarterly earnings per share hit a record high, operating profit margin was the second-highest in the company’s public history, 53% year-over-year growth in transaction volume set a record, and revenues and earnings grew 22% and 37%, respectively. Quarterly earnings beat analyst estimates.

On the negative side, quarterly revenue missed analyst estimates, new license revenue grew only 12% — the lowest growth rate in 3 ½ years (since Q3 2009) – and revenue and earnings guidance for Q2 and full-year 2013 was slightly below analyst estimates. CEO Kevin Thompson conceded that:

Solid interest in many of our core products did not translate into the level of new license sales we anticipated and we did not deliver the level of new license sales and total revenue growth we expected for the first quarter of 2013.

The company is taking corrective action and Thompson assured investors that license growth would soon begin re-accelerating:

Our team is focused on continuing to grow our business quickly. We believe we have taken the appropriate actions and have the right demand generation and product strategies in place in order to accelerate our pace of new business growth while delivering a continued combination of strong profitability and free cash flow to shareholders.

I’m not worried long term because the growth slowdown is a general problem faced by the entire technology industry. Just look at slowing growth at tech giants Apple, IBM, F5 Networks, and Oracle. But the industry slowdown is temporary and now is the time to remain invested in anticipation of a tech-spending recovery. The tech industry (along with materials and energy) has been one of the worst –performing sectors in 2013, but the good news is that tech stocks are now sporting the cheapest valuations in seven years! Investment strategists are starting to pound the table in favor of tech.

Bottom line: SolarWinds’ disruptive sales model reduces costs for its client base of IT professionals — which is the business model that succeeds in a low-growth economy. I believe the company will be one of the first tech stocks to rebound when the current industry malaise subsides. Brokerage firm Pacific Crest has already determined through channel checks that license growth has improved during the month of April. Long-time bull JP Morgan also remains bullish on SolarWinds because it has “best-in-class operating margins.” Granted, JP Morgan reduced its December 2013 price target to $73 from $76 because of the “soft macro backdrop,” but $73 still constitutes appreciation potential of 60% from the current price!

United Therapeutics (Nasdaq: UTHR) offered investors good news in its first-quarter financial report. Revenues – the true measure of growth – grew 20% year-over-year and beat analyst estimates. Earnings were down, but the decline was totally based on non-cash charges – primarily share-based compensation that was more expensive due to this year’s higher stock price. Ignoring non-cash charges, earnings actually increased substantially by 27.4%.

In the conference call, CEO Martine Rothblatt was very optimistic about the future and noted:

Tyvaso sales will end up surpassing Remodulin sales in the very near future to become the company’s primary product.

This is important because the company’s primary treprostinil product now for treatment of pulmonary arterial hypertension (PAH) – injectable Remodulin – loses patent protection in October 2014 and is the subject of a patent infringement lawsuit with Sandoz, the generic drug division of Novartis. In contrast, Tyvaso – the inhalable form of treprostinil — doesn’t lose patent protection until 2018 in the U.S. and 2020 in the European Union (page 43). Most people would prefer to inhale a drug rather than inject it, so Tyvaso is the superior product for those patients with less-severe symptoms who benefit from it.

CEO Rothblatt also said that the company’s developmental-drug “pipeline has never been stronger.” A promising new treatment for PAH involves placental stem cells, which the company is exploring with Israeli partner Pluristem Therapeutics. A Phase I drug trial began in April.

Despite having risen 24% since I recommended it in January, the stock is still trading at a very low price-to-earnings (P/E) ratio of 10 times this year’s earnings and has an extremely low PEG ratio of 0.30. I am confident the stock will soon surpass its all-time high price of $70.74 set in April 2011 – with room to spare. 

Western Refining (NYSE: WNR) delivered first-quarter financial results that CEO Jeff Stevens called:

another strong quarter as we continued to build on the momentum of our outstanding 2012 financial performance. 

Quarterly earnings were up 16% but missed analyst estimates, whereas revenues were down 6.5%, but beat analyst estimates. A mixed report, but the revenue shortfall was caused to a large extent by a “turnaround” shutdown at the El Paso refinery for scheduled maintenance. The second quarter of 2013 looks better. CEO Stevens assured investors during the conference call that “our 2013 turnaround work is behind us.” Furthermore, Stevens said:

It has been a great start to the second quarter for Western. In April, we amended and extended our revolver, resulting in lower interest expense and greater financial flexibility.

Our Board declared a second quarter dividend of $0.12 per share and we continued to repurchase shares of Western common stock as we remain committed to returning cash to our shareholders. From the inception of our share repurchase program, through April 26, 2013, we have purchased approximately 8.1 million shares at an average cost of $29.56 per share. We have also begun operating the first phase of our Delaware Basin gathering system which will give us access to additional cost-advantaged shale crude oil in the Permian Basin.”

We established ambitious goals for 2013 and we are well on our way to accomplishing them. We continue to invest in high return capital projects while maintaining our commitment to return cash to shareholders.

I am very excited about the Delaware Basin project because it will further catapult Western Refining ahead of the competition in its ability to source cheap shale crude oil as foodstock for its refineries. Reducing its foodstock costs and refinancing its debt at lower interest rates will help the company withstand narrowing crack spreads. With crude oil inventories at record highs and gasoline inventories near average, the crack spread should start widening again soon, which will benefit refiners like WNR. The company’s plans to spin off pipeline assets into a tax-advantaged MLP, as well as to expand its El Paso refinery and export diesel to Mexico, should both enhance value even further and permit additional dividends and stock buybacks.

Credit Suisse also interpreted the financial report positively, upgrading the stock to “outperform”. Barron’s Magazine ranks Western Refining as the 8^th cheapest in its “Barron’s 500” list of high-growth, high-return companies. In 2012, the 30 cheapest stocks in the Barron’s 500 outperformed the S&P 500 over the ensuing 12 months by almost triple.