Market Outlook

Four consecutive up-weeks by the S&P 500 (followed by a minuscule decline last week) has completely erased the 7.5-percent May/June correction and catapulted stocks to all-time highs. The new price highs have been accompanied by new highs in the cumulative advance/decline count:

Source: Bloomberg

Whenever there is a divergence between price and advance/decline, a warning signal is triggered, but that simply is not the case right now – both have simultaneously hit new highs. According to Wellington Shields technical analyst Frank Gretz:

Advances have outnumbered declines for 14 of the last 17 days. That kind of surge in breadth historically has resulted in a durable advance, for even as much as a year later.

Based on a compilation by Ned Davis Research, there were just 50% bulls last November, suggesting extreme pessimism, but over 70% in May. It’s that kind of change that sets the stage for the May correction, and sentiment since then has sobered up. So in terms of sentiment as well as market momentum, there should be room to run on the upside.

At past stock-market peaks, the advance/decline has topped out months in advance. For example, at the October 2007 stock-market peak, the New York Stock Exchange (NYSE) advance/decline peaked more than four months earlier in June 2007:

Source: Bloomberg

The main reason that the advance/decline of NYSE stocks has hit new highs is the tremendous strength in small-cap stocks, which make up the majority of NYSE issues. Through Monday, July 21^st, the small-cap Russell 2000 index had risen in 12 out of the past 13 trading sessions! In the 17 prior instances since 1979 where the Russell 2000 gained ground in at least seven consecutive trading sessions, small-cap stocks averaged a gain of 1.45% in the subsequent four weeks with positive returns 76.5% of the time. With one-month returns looking positive, and at least four months of positive returns based on a new peak in the advance-decline line, one must reach the conclusion that stocks remain in bullish mode. Also encouraging is the fact that the spread between the yields of junk bonds and U.S. Treasuries continues in a downtrend, indicating a lack of excessive fear in corporate bond defaults, which is a necessary mindset for continued investing in risky assets like common stocks.

As Goldman Sachs points out, small-cap outperformance is a sign of a strengthening U.S. economy and rising interest rates:

Small caps’ leverage to US economic growth explains our EPS growth forecasts and much of their recent performance. Roughly 80% of Russell 2000 sales are derived domestically, compared with 66% for the S&P 500, which is more exposed to foreign economic growth and foreign exchange.

Our economists expect that US GDP growth will accelerate from about 1.5% now to over 3% in 2014-2016. The high exposure to domestic growth also insulates small caps from recent investor concerns about the impact of a strong dollar and uncertain EM growth on US corporate earnings.

Rising rates have also provided a tailwind to Russell 2000 performance. Small cap cost of debt, and therefore margins and earnings, have a low sensitivity to moves in the Treasury yield. The concern that small caps could not take advantage of historically low interest rates was commonly cited by investors when we first published our small cap analysis, but the same insensitivity should support their performance as rates rise.

Despite recent small-cap outperformance, fund manager Oliver Pursche sees it continuing because small-cap stocks have better earnings growth:

I believe small-cap value stocks could become (actually, remain) market leaders. Although small-cap stocks have outperformed their large-cap brethren, their fundamentals and valuations remain more attractive.

While S&P earnings have only grown by roughly 5% over the past 12 months, small-cap earnings have increased by over 9%. Moreover, revenue growth and future growth expectations for small-cap stocks are much stronger than it is for large-cap stocks.

Many of the lower-volatility small-cap stocks also have better profit margins than their large-cap counterparts. While many large companies have improved margins and profits through aggressive cost cuts, small-cap stocks have done so through product innovation, international expansion, and growing their business overall.

Simply put, small caps outperform in bull markets and the bull market is expected to continue, so small caps should continue to outperform. According to 12-month moving averages, common stocks and real estate investment trusts (REITs) remain in bullish trends.

This does not mean, however, that the ride for the stock market will be straight up. We’re entering a seasonally-weak period of the year, with August and September – two of the worst-performing months of the year — straight ahead. Perhaps this seasonality is why Raymond James equity strategist Jeffrey Saut predicts that July 19^th is a short-term peak that will be followed by a 10-12 percent correction and money manager Paul Schatz foresees a steeper 10-20 percent decline. “Fat Pitch” financial blogger Ukarlewitz seems to agree that a correction is near:

The majority of technicals look constructive (that’s the ball to keep your eye on), but we are at the stage where this has brought with it high bullishness and now unfavorable valuation.

Although early indications show that corporate earnings are beating expectations, the truth is that analyst estimates of Q2 earnings growth have been slashed from more than 3 percent in May to less than 1 percent now. Consequently, earnings beats based on such lowered estimates aren’t very impressive. The bankruptcy of Detroit – the largest U.S. city ever to file – is disconcerting. The good news is that Ukarlewitz thinks any correction will be short-lived and “expects new highs into year-end.” One reason: if the economy falters, Federal Reserve Chairman Ben Bernanke recently reassured Congress that tapering of quantitative easing (QE) is not a done deal and may be postponed. The economy looks relatively strong, with crude oil inventories experiencing their largest three-week decline in more than 30 years, homebuilder sentiment at a 7.5 year high, and the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) at more than a two-year high.

The U.S. may be facing a Goldilocks economic recovery of not too weak and not too strong, but just right. A chart of 10-Year U.S. Treasury Yields shows that the huge yield rise since the beginning of May is likely to be peaking, having touched the bottom of a steeply declining trend line. Commercial banks have sold off their holdings in U.S. Treasuries to a 13-month low, which suggests a capitulation selling climax that could soon reverse. Retail fixed-income investors have also thrown in the towel, resulting in Vanguard Funds experiencing in June its first monthly net cash outflow in 20 years. PIMCO bond king Bill Gross recently tweeted that bonds have “come out of their coffin” and sees strong price support near current levels until the Fed decides to raise the short-term Fed Funds rate, which Gross doesn’t expect to occur until 2016.

Internationally, European manufacturing hit a 16-month high in June and Barron’s Magazine reports that Europe could finally emerge from its long recession in the fourth quarter of this year. German Chancellor Angela Merkel will not want to cause any investor worry prior to the country’s important national election on September 22^nd, so that’s a short-term positive.  The big re-election win of the Japanese Liberal Democratic Party (LDP) on July 21^st provides Prime Minister Shinzo Abe with a mandate to continue with economic reforms that could catapult the world’s third-largest economy out of its multi-decade malaise.

The economic slowdown in China continues, with second-quarter growth of 7.5 percent marking its slowest growth in more than two decades and the second-consecutive quarter of economic deceleration. Importantly, China’s slowdown is focused on real estate construction (too many ghost cities), which hurts commodity producers, but lower commodity prices could actually benefit many U.S. and European industrial and manufacturing companies that rely on commodities as cost inputs. Furthermore, the Chinese economy is in the process of rebalancing more towards consumer demand, so U.S. companies with strong consumer brands that cater to the burgeoning middle class rather than government infrastructure projects can still do very well. After all, even a deceleration to 7 percent annual growth still gives China much stronger growth than exists almost anywhere else in the world.

Roadrunner Stocks Relative Performance

Since the Roadrunner service launched on January 24^th, the small-cap Russell 2000 has outperformed large caps.  In fact, the Russell 2000 has outperformed the large-cap S&P 500 in all six periods between the release of a Roadrunner monthly issue and the market close on Thursday, July 25^th: This small-cap outperformance vindicates my January prediction in the article entitled Small Caps: The Time to Invest is Now.

Total Return Through July 25^th

Source: Bloomberg

A majority (14 out of 20) of Roadrunner recommendations have outperformed the S&P 500 and both the Value and Momentum portfolios have a positive average return. The Value Portfolio continues to be the real star, with eight out of ten holdings (80%) outperforming, but the Momentum Portfolio isn’t far behind with six of its ten holdings (60%) having outperformed the S&P 500. Overall, 17 of 20 holdings (85%) have generated positive absolute returns.

Each portfolio list below starts with the best relative performer on top:

Value Portfolio
(through July 25^th)

Momentum Portfolio
(through July 25^th)

 Source: Bloomberg

Q&A – When to Sell Winners

Question: Several Roadrunner recommendations are up more than 20 percent. I’m itching to sell and lock in my profit (thank you!). Are you planning to sell any of Roadrunner’s winners anytime soon?

Answer: Unless the investment thesis of a Roadrunner recommendation has been fundamentally broken, I don’t plan to issue a sell until the portfolios reach their ultimate size of 20 stocks each. Unless you are buying these small-cap stocks in an IRA, selling entails substantial tax liabilities — especially if held less than 366 days. Warren Buffett hates to pay taxes and his ideal holding period is “forever.” I don’t plan to hold on to a stock forever, but less trading offers substantial benefits in terms of lower transaction and tax costs.

Keep in mind that small-cap stocks have tremendous growth potential — much more than large-cap stocks. Consequently, where it often makes sense to take profits after a large-cap stock rises 50 percent or more, small-cap stocks can rise many hundreds of percent before leveling off. I can’t count how many investors I know who have voiced their regret after selling a small-cap stock too soon. Legendary fund manager Peter Lynch in his book Beating the Street (pp. 158-59) wrote how Wal-Mart rose 20-fold between its 1971 IP0 and 1980, but anyone who bought in 1980 went on to enjoy a 30-fold gain between 1980 and 1990.

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, LeapFrog Enterprises provides excellent diversification benefits to the Momentum Portfolio and ManTech International provides moderate diversification to the Value Portfolio. 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.

Leapfrog Enterprises and HomeAway are negatively correlated with each other because Leapfrog caters to young parents with children, whereas HomeAway’s clientele include many “empty nester” retirees with leisure time for vacations. Mantech and Fresh Del Monte have low correlation because consumer demand for fruit has nothing to do with government spending on anti-terror programs.