Market Outlook

The long-awaited market correction finally arrived, but has proven to be short lived! The S&P 500 fell 2.1 percent last week – its worst week since mid-April – and also experienced the worst two-day price decline in 19 months (since November 2011). From its all-time high price of 1,687.18 on May 22^nd, the S&P 500 dropped 7.5 percent to 1,560.33 on June 24^th before recovering almost half the loss over the next few days.

The cause of the market rout was Federal Reserve Chairman Ben Bernanke’s press conference after the June 19^th open market committee meeting. If you simply read the committee’s June 19^th press release, nothing seemed out of the ordinary – policy remained unchanged, including the $85 billion per month in quantitative-easing (QE) bond purchases. Non-committal boilerplate language that the committee could “increase or reduce” the pace of bond purchases in the future depending on economic conditions is the same phrase from its previous May 1^st  press release.   

But all Hell broke loose in the press conference when Bernanke went far beyond the press release by stating that the Fed would start reducing bond purchases later this year and end them entirely by mid-2014 if the economy improves as currently projected. Wow!  On page 5 of the press conference transcript, Bernanke said the following:

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent.

Prior to this announcement, the Fed had never quantified what labor-market improvement was necessary to warrant a tapering of QE bond purchases. The economic thresholds for ending the zero interest rate policy (ZIRP) are completely separate from QE and have always been 2.5 percent inflation and 6.5 percent unemployment (although on pp. 11-12 Bernanke hinted that the 6.5 percent unemployment threshold for ZIRP could be adjusted downward if the labor participation rate remains low). A majority of Fed members don’t expect ZIRP to end until 2015 (pp. 3-4).

For the first time at the June 19^th press conference, the Fed specified that a 7.0 percent unemployment rate will be the threshold for ending QE. With the current unemployment rate at 7.6 percent, some analysts were startled that the 7.0 percent threshold for ending quantitative easing was higher than the 6.5 percent threshold for ending ZIRP. Bernanke emphasized that a threshold is not an automatic trigger, so even when unemployment gets down to 7.0 percent, the end of QE is not a certainty. Rhetorical question: why did Bernanke only mention this major monetary policy clarification in the press conference and not discuss it in the official press release? If he was trying to minimize the importance of the news, he failed and probably made things worse because investors aren’t dumb and would prefer candid communication. Hiding news does not inspire confidence or trust.

In the press conference, Bernanke voiced surprise that the bond-market reaction had been so severely negative, suffering its worst one-month performance in nine years. Mortgage rates rose for six straight weeks. The 10-Year U.S. Treasury yield (^TNX) has risen from 1.63 on May 2^nd to 2.51 percent on June 21^st and the iShares Barclays 20+-Year U.S. Treasury Bond ETF (TLT) has fallen 12.5 percent:

Source: Bloomberg

It’s not like the Fed decision to eventually taper bond purchases is new information – on June 7^th a survey of economists already were forecasting that QE tapering would begin at the October 29-30 Fed meeting and entail reducing the monthly purchases to $65 billion from $85 billion. Prior to the May 1^st Fed meeting, economists had expected an even-larger October tapering to $50 billion. Perhaps investors were shocked to learn that economists might actually turn out to have made an accurate prediction for once? In any event, the bond-market selloff appears overblown and likely to partially reverse or at least plateau for one simple reason: inflation is at a 53-year low! How can interest rates rise much when inflation remains in a cyclical downtrend? St. Louis Fed Bank President James Bullard issued a press release on Friday June 21^st criticizing Bernanke’s decision to announce a timeline for QE tapering, stating:

Inflation in the U.S. has surprised on the downside during 2013.  Measured as the percent change from one year earlier, the personal consumption expenditures (PCE) headline inflation rate is running below 1 percent, and the PCE core inflation rate is close to 1 percent. 

The Economic Cycle Research Institute (ECRI) noted recently that core inflation fell below 1.1 percent in May, the lowest on record:

Some are surprised that inflation has failed to take off despite massive amounts of quantitative easing. The explanation is simple: recession kills inflation. 

As a result, core inflation – defined as year-over-year growth in the Personal Consumption Expenditure (PCE) deflator excluding food and energy – has now dropped under 1.1%, to the lowest reading in its entire 53-year record. 

Bernanke’s decision to discuss QE tapering now despite falling inflation is based on his belief – as mentioned in the June 19^th press release – that inflation has been falling because of “transitory influences” and that long-term inflation expectations have not been falling but remain stable. Nobody is sure what Bernanke means by “transitory influences” (non-core food and energy prices? U.S. budget sequester? European debt crisis?), but a 53-year low in core inflation does not reflect stability, nor does the Cleveland Fed’s chart of 10-year inflation expectations. Granted, inflation stabilized in May and stanched the downward momentum, but one month of data does not signal a trend.

Perhaps Bernanke is following the recommendation of former Fed Chairman Alan Greenspan, who recently said on CNBC that QE tapering should start even if the economy does not appear ready for it. Greenspan argued that the Fed’s $3.4 trillion balance sheet is too large and is retarding stock-price appreciation because investors are concerned that unlimited QE is destabilizing and will spur inflation and much higher interest rates.  Even after the huge run-up in bond yields, there still exists a four-percentage-point gap between 10-year U.S. Treasury yields and the earnings yield (i.e., earnings/price) of the S&P 500 index.—this is more than double the average gap of 1.9 percent since the turn of the century. Increased investor confidence that the Fed is not destabilizing the economy could unlock stock values and bring the stock/bond yield gap back to normal levels.

On the flip side, tapering too soon could also reduce investor confidence by catapulting the economy back into recession. Besides record-low inflation, employment remains very weak – much weaker than the unemployment rate suggests because the unemployment rate excludes discouraged workers who have stopped looking for a job. Nobel-Prize- winning economist Paul Krugman agrees with St. Louis Fed president Bullard that talk of QE tapering is premature and could be a “historic mistake.” The International Monetary Fund (IMF) recently cut its forecast of U.S. economic growth in 2014 to 2.7 percent from 3.0 percent (much lower than the Fed’s forecasted range of 3.0 to 3.5 percent) and urged the Federal Reserve not to taper QE too quickly. Bond house PIMCO says there is a 60 percent probability of a global recession within three-to-five years.

Let’s not go overboard! Keep in mind that talk of future tapering is much different from tapering right now. The fact remains that the Fed is not yet tapering and maintains the flexibility never to start tapering if future economic data does not improve as currently forecast. The June 5^th Beige Book reported economic growth increasing at a “modest to moderate pace” across all Federal Reserve districts except Dallas which saw “strong” growth. As hedge fund manager David Tepper sees it, there is nothing to fear from QE tapering because it will only happen if the economy strengthens and a stronger economy means higher profits and higher stock prices:

All the concern in the markets is because the Fed sees the economy stronger in the future. The bond (market) is concerned about the strength,” he said. “A 10-year bond at 2.4 or even at 3 percent) because of strength is ultimately healthy. I obviously thought they should start to taper. Bottom line, when the dust settles there is only one place to be: STOCKS.

Goldman Sachs agrees with Tepper (or vice versa), issuing a report in May arguing that when interest rates are extremely low like now, stocks actually benefit from higher rates because they signal a stronger economy:

Whenever 10-year bond yields are below 4% to 5%, the relationship between moves in yields and equities has been a positive one.

Goldman forecasts that in 2014 the U.S. will experience above-trend economic growth for the first time in six years! Furthermore, studies show that P/E multiples typically expand by an average of 15 percent during the year before GDP growth returns to trend, which for the U.S. means this year (2013). So, since the S&P 500 P/E ratio at the end of 2012 was 16.49 and as of June 21^st 2013 it is 17.99, the P/E multiple has so far risen in 2013 by 9.1 percent. This means that the P/E multiple can rise an additional 5.4 percent during the remainder of 2013.

In reaction to higher interest rates, the biggest stock-market losers so far have been emerging markets, coal miners, gold, REITs, and utilities. Yield-hungry investors looking for an equity “bond surrogate” had bid up the price of defensive-industry dividend payers (REITs and utilities) to extreme valuations. Gold requires negative real interest rates (inflation higher than nominal interest rates) to outperform and the current combination of low inflation and higher nominal interest rates is poison for gold. Emerging markets have been absolute death (recently falling to nine-month lows and breaking a technical support level), thanks in large part to China which is experiencing an economic slowdown and tight monetary policy. One analyst has called emerging markets the “bubble to end all bubbles.”  

On June 20^th (the day after the Fed’s press conference), China’s seven-day repo rate, the interest rate Chinese banks charge each other for one-week loans, rose to 12.61 percent, the highest level since at least 2004, and the overnight repo rate skyrocketed to 30 percent. As of Monday June 24^th, Chinese interest rates had receded back down to more normal levels, but the People’s Bank of China reiterated that “the era of cheap money is over.” China is adopting a tight monetary policy because bank loans are out of control; Fitch Ratings calls China’s current credit bubble the worst in world history.

Because China is a leading global consumer of commodities like coal, oil, iron ore, copper, and soybeans, a slowdown in China’s economy is bad news for producers of these commodities. Coal is suffering a double-whammy not only from China’s slowdown, but also from anti-pollution EPA regulations being pushed by President Obama, the most anti-coal president in U.S. history. The stock of Peabody Energy (BTU), widely considered the strongest coal company, has lost more than 80 percent of its value since April 2011. Other commodity stocks haven’t fared much better – U.S. Steel (X) has lost 75 percent, iron-ore producer Vale (VALE) has lost 66 percent, and the gold miners ETF (GDX) has lost 65 percent (in 2013, gold bullion has suffered its worst start to a year since 1988).

At some point, commodity stocks will be screaming buys, but the turmoil in China and historically bearish seasonality during the summer months, suggests that the time for deep-cyclical commodity stocks to shine is not yet here.  Normally, defensive stocks like healthcare, utilities, telecom, and consumer staples do best in the summer, especially during periods of downward market correction. This year may be different given the huge price run-up these defensive dividend payers experienced earlier in 2013, followed by the carnage they suffered in May/June on account of Fed tapering fears. Once market-leading sectors break down, they rarely re-assume market leadership after a correction.

According to Bank of America Merrill Lynch equity strategist Savita Subramanian, whenever market volatility spikes and a correction takes place, industry-sector leadership changes. The spike in the S&P 500 Volatility Index (VIX) to 21.91 on June 24^th is almost double the March 14^th low of 11.05 and qualifies as a volatility spike. Consequently, once the current market correction is over, new industry-sector leadership will take over from defensive stocks. Specifically, new leadership is likely to emerge from economically-sensitive growth cyclicals. Growth cyclicals include technology stocks, industrial manufacturers, truckers, specialty financials, and some types of consumer discretionary. Goldman Sachs agrees, recently stating that “cyclical stocks are more undervalued versus defensives than at any time in the past 15 years.” Charles Schwab recommends overweighting only two sectors right now: industrials and information technology. Utilities and consumer stapes are the two sectors to underweight.

Bottom line: Deep cyclicals (e.g., commodity producers) and economically-insensitive defensive stocks (e.g., utilities) are out and middle-ground industry sectors that exhibit both long-term growth and economic cyclicality are in.

With regards to the overall stock market, the current 7.5-percent correction appears to be nothing more than the pause that refreshes. The S&P 500 is currently trading at 1,573. The 12-month moving average of the S&P 500 is currently 1,489 and rising. Nothing seriously bad happens when the S&P 500 is above its 12-month moving average and the moving average is in an uptrend. No need to worry! I agree with both Jim Stack and Lowry’s who remain long-term bullish:

1. Jim Stack: “The market may be overdue for a correction, but technical and fundamental data remain positive. Bear-market warning flags that would warrant a more defensive stance are not evident at this time.
2. Lowry’s: “Stock market is in a correction phase at present, with expected strength for the remainder of 2013.”

Roadrunner Relative Performance

Since the Roadrunner service launched on January 24^th, the small-cap Russell 2000 ETF (IWM) has outperformed the large-cap S&P 500 ETF in four of the five periods between the release of a Roadrunner monthly issue and June 25th. This small-cap outperformance matches my January prediction in the article entitled Small Caps: The Time to Invest is Now:

Total Return Through June 25th

Source: Bloomberg

A majority (12 out of 18) of Roadrunner recommendations have outperformed the S&P 500 and both the Value and Momentum portfolios have a positive average return. The Value Portfolio contnues to be the real star, with eight of ten holdings (80%) outperforming, but the Momentum Portfolio is most improved from last month, with five of its ten holdings (50%) having outperformed the S&P 500. 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, Darling International provides excellent diversification benefits to the Momentum Portfolio, whereas Stepan doesn’t help the Value Portfolio as much. Based on my portfolio analysis software, the Momentum Portfolio was underweight “industrial” companies, so Darling was a good fit, not to mention allowing the Momentum Portfolio to get in on the biofuel action. The Value Portfolio is already overweight “basic materials,” so adding a specialty chemical producer like Stepan doesn’t improve diversification signficantly. Oh well. Diversification by industry sector is important, but  not always the deciding factor, especially when I expect economically-sensitive growth cyclicals like specialty materials are primed to outperform.

Darling is uncorrelated with most of the other Momentum stocks because meat and bakery waste recycling is a rather unique industry. Stepan is highly correlated with fellow growth cyclicals Gentex and Carbo Ceramics, but growth cyclicals are likely to outperform so I’m okay with that.