Market Outlook

On May 21, both the S&P 500 and the Dow Jones Industrials hit new all-time highs. The “buying stampede” I mentioned two weeks ago continues at full thrust. The positive price momentum is virtually unprecedented. According to “Fat Pitch” financial blogger Ukarlewitz:

The S&P 500 has now gained an uncorrected 24% since its November low. This is the longest comparable streak in more than 30 years. SPX is up 17% for 2013, over 50% more than its average annual gain. Nasdaq is on pace for a 7th consecutive month higher, an occurrence with just a 3 in 100 probability.

Such tremendous momentum is very bullish long-term:

If your timeframe is long, the current strength should be followed by further gains in 2013 and probably 2014. New highs like those being achieved now are rarely the end of the trend. That should be your long term bias.

But a mid-year stock correction of at least 5% is extremely likely:

The only time in more than 30 years that an annual correction did not take place was 1995, so it has happened before, but it is a long-shot. In 80% of these years, a drawdown of more than 8% has occurred. 75% of the corrections occurred in 3Q. All except one happened between May and October.

Laszlo Birinyi says that it is impossible to predict when 5% stock corrections occur, whereas Raymond James equity strategist Jeffrey Saut predicts that a “low double-digit” correction will occur in either July or August. Both Birinyi and Saut are bullish long-term, however, with permabull Birinyi predicting an additional 40% to 50% upside.

The U.S. economy appears to be strengthening, as the Conference Board’s April Index of Leading Economic Indicators hit its highest level in almost five years (since June 2008). Consumer confidence is also at a five-year high. Stocks and bonds are following a similar script — since the beginning of May, cyclical stocks have started to lead defensive stocks and U.S. Treasuries have sold off (yields have risen). According to Goldman Sachs, cyclical stocks are now more undervalued relative to defensive stocks than at any time over the past 15 years! Only time will tell if this market action in favor of cyclicals is a temporary blip or a signals of a sustainably-stronger economy. Just recently, Australia and South Korea joined the global monetary stimulus party with rate cuts. Fears of an Italian government debt default have evaporated, with one-year Italian debt recently trading at a record-low yield.

Investors panicked on Wednesday (May 22nd), selling off stocks on fears that the Federal Reserve’s $85 billion in monthly asset purchases (a.k.a. quantitative easing) could be reduced (a.k.a. “tapering”) before the end of 2013, a possibility introduced in the Fed’s just-released May 1st meeting minutes. However, a more recent indication of Fed intent occurred on May 21st, when New York Fed bank president William Dudley, a voting member of the Fed, offered up the alternative possibility that Fed asset purchases could actually be increased further in the coming months due to uncertainty over the economy. Although nobody expects a QE increase anytime soon, Dudley’s statement suggested that a QE tapering at the Fed’s next meeting on June 19^th was now officially off the table, which heartened investors. PIMCO bond king Bill Gross says that the 30-year bull market in bonds is over, but a stagnant global economy will counteract any QE tapering over the next 12-18 months to create a stable interest-rate environment that might be nirvana for U.S. stocks. Jeffrey Gundlach agrees, saying that interest rates are unlikely to rise substantially regardless of changes in QE.

David Tepper, who was the top-earning hedge fund manager of 2012 (he made $2.2 billion last year), told CNBC on May 14th that he remains just as bullish about the stock market now as he was in September 2010 when the S&P 500 was trading 45 percent lower! Tepper is not worried about the Fed scaling back bond purchases because the monetary stimulus is currently so massive that if the Fed doesn’t scale back, the stock market could go into “hyper drive” in the second half of 2013 and resemble the melt-up bubble market of 1999. In other words, the stock market is going up whether the Fed scales back or not — the only difference being how fast it goes up. Tepper argued that the U.S. budget deficit is shrinking fast, so $400 billion in monetary stimulus will no longer be needed to fund government spending, but instead will go directly into the stock market. Tepper summed his market view this way:

Guys that are short, they had better have a shovel to get themselves out of the grave that they’re in.

Even permabear investment strategist David Rosenberg no longer thinks recession is likely, and predicts a protracted period of stagflation is in the offing. Research from consulting firm McKinsey & Co. found that deleveraging cycles typically last five to seven years. The 2008 global financial crisis is now almost five years old, so deleveraging is nearing the end of its reign. With less deleveraging, more income can go to new spending rather than debt reduction, which should help the economy’s growth rate improve. In such a world, Warren Buffett states that long-term government bonds will be a “terrible investment.” PIMCO’s Mohamad El-Erien recently offered investment advice that recommends short-term stock exposure but with a downside hedge to protect against the inevitable popping of the monetary-stimulus bubble:

1. In the short term, “ride the central bank wave” of global monetary stimulus by investing in equities in the short term, but . . .

2. In the long term,

“understand that all waves eventually break. The question is whether you crash or “walk off” the surf board. This wave will crash. When it does it will depend on how you are positioned that will determine whether you suffer or not.”

3. Reduce “equity beta in things that have done extremely well, and are priced to perfection.” Equity beta is a fancy term for passive stock-market exposure to the S&P 500 index. Translation: the bubble in the S&P 500 index will burst first because it is a proxy for monetary stimulus. El-Erian recommends replacing equity beta with “alpha,” which is a fancy term for active stock-picking:

“Think about being more defensive, and much more selective when becoming offensive. Whether we like it or not … beta is not going to be there. Alpha is going to have to do a lot more heavy lifting.” 

4. Generating alpha requires hedging investment bets with alternative asset classes (currencies, options, managed futures, small-cap stocks) that are less vulnerable to a change in interest rates:

“Investors that are overly invested in stocks will eventually pay a very high price for taking on excessive risk. We are approaching the end of the journey for this experiment and it will either result in a return to organic growth or economic disaster. The problem is that we really don’t know which it will be. What we do know is that eventually, regardless of the outcome of these monetary experiments, the disconnect between the fundamentals and the markets will revert which will prove painful for unhedged investors.”

El-Erian is spot-on when he focuses on small-cap stocks as a hedge against the end of monetary stimulus. As I wrote in Small-Cap Stocks: The Time to Invest is Now, since small companies don’t hold much debt or suffer from unfunded pension obligations, higher interest rates don’t affect them much (positive or negative), and they consequently outperform large companies carrying heavy debt loads in times when interest rates are rising. Richard Bernstein, former equity strategist at Merrill Lynch, is also extremely bullish on U.S. small caps while being bearish on emerging markets:

I am very bullish on US domestic companies with indexes like the S&P SmallCap 600 (IJR) estimated to grow at more than twice the projected rate of most emerging markets.

Small-cap fund manager Jim Oberweis is also bullish on small caps (not a surprise), noting that they are currently trading at historically-attractive valuations:

The rush into yield has plumped up valuations of big-dividend payers, but small-cap growth stocks are still lean from a multiple standpoint. I’m talking about stocks with market capitalizations less than $1 billion that are growing earnings and revenue at 30%. Right now median forward earnings multiples are 13, versus a ten-year average of 17. I expect small stocks to fare considerably better than their large-cap value brethren as the economy improves. 

Bottom line: Mohamed El-Erian is probably right to be cautious in the long term, but I’ll go with David Tepper’s stock-market bullishness in the short term. Central-bank monetary stimulus is just too strong to fight against! And regardless of QE tapering, small caps are ready to play catch-up on the upside.

Roadrunner Relative Performance

Since the Roadrunner service launched on January 24^th, the large-cap S&P 500 has outperformed small caps — probably because of the massive monetary stimulus that forces cash to get parked in the most liquid large caps.  In fact, the S&P 500 has outperformed small caps in three of the four periods between the release of a Roadrunner monthly issue and May 21^st:

Total Return Through May 21st

Source: Bloomberg

Given this large-cap outperformance, it is not surprising that the relative performance of the Roadrunner portfolios has been mixed, but I’m gratified that – so far – a majority (nine out of 16) of Roadrunner recommendations have outperformed the S&P 500. The Value Portfolio has been the real star, with six of eight holdings outperforming, and the Momentum Portfolio has lagged behind with only three of eight outperforming. Each portfolio list starts on top with the best relative performance:

Value Portfolio

Momentum Portfolio

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 G-III Apparel and Fresh Del Monte provide excellent diversification benefits to their respective Roadrunner portfolios. Based on my portfolio analysis software, the Momentum Portfolio had no “consumer cyclical” companies, so G-III Apparel was a perfect fit. The Value Portfolio needed “consumer defensive” exposure and Fresh Del Monte operates in this space.  Diversification by industry sector is important to me.

G-III Apparel and HMS Holdings are virtually uncorrelated with each other because G-III Apparel caters to healthy and affluent young people who are fashion conscious, whereas HMS makes money from ill and elderly people on Medicaid and Medicare. Fresh Del Monte and Carbo Ceramics are negatively correlated because energy is an input cost for FDP whereas Carbo Ceramics benefits from high energy prices.