Market Outlook

At the beginning of August, the Dow Jones Industrial Average (^DJI) and the Down Jones Transportation Average (^DJT) simultaneously hit all-time highs, which is the latest confirmation of a Dow Theory “buy” signal that also triggered on July 18^th  and on March 5^th.   Not to be outdone, both the large-cap S&P 500 (^GSPC) and the small-cap Russell 2000 (^RUT) also hit all-time highs.

The positive price action in early August may have been partly due to the “bad news is good news” trade. Second-quarter earnings of S&P 500 companies rose only 2.1%, the third-lowest rate of the past four years (page 4) and earnings actually dropped 3.1% if financial companies are excluded. The Federal Reserve’s July 31^st policy statement revealed that the Fed had changed its view of U.S. economic growth from “moderate” to “modest” – reflecting the fact that first-quarter GDP growth was revised downward to only 1.1%, marking a massive downward revision from 1.8%, which itself was a massive downward revision from the initial 2.4% estimate. Lakshman Achuthan, co-founder of the Economic Cycle Research Institute (ECRI), is smiling because he has been predicting downward GDP revisions and continues to believe that a U.S. recession began in mid-2012. If the Fed is less sanguine about economic growth, some investors were hopeful that the start of QE tapering would be delayed past the September 18^th Fed meeting.

The early August euphoria has faded quickly, with the S&P 500 dropping 4.4% and the Dow Jones Industrials falling for four consecutive weeks by an even-larger 5.3% margin. Weak economic data on new home sales and durable goods orders, a spike in oil prices to a two-year high, and geo-political fears of military air strikes on Syria, combined to bring down the market. Goldman Sachs continues to believe that the QE taper will begin in September, but that the July 31^st policy statement’s word change from “expect” to “reaffirm its view” concerning its zero-interest-rate policy (ZIRP) means that  the Fed will ease the pain of QE taper by prolonging ZIRP beyond what is currently expected. Minutes of the July 31st Fed meeting revealed that “almost all participants” now agree with Chairman Bernanke’s plan to start QE tapering this year if the economy continues to improve.

Chicago bank president Charles Evans predicted that economic growth would accelerate in the second half of the year and justify QE tapering. The fact that Evans — a 2013 voting member of the open market committee — is generally known as “dovish” toward monetary policy, makes his pro-taper view carry more weight. On the other hand, St. Louis bank president James Bullard – another voting member this year — wants to hold off on any QE taper until inflation starts to rise, but he dissented from the Fed’s June 19^th policy statement and does not represent the consensus view.

If the Fed does start QE tapering in later this year (non-voting Atlanta bank president Dennis Lockhart says it could happen at any of the three remaining meetings in September, October, or December), what does it mean for the stock market? PIMCO CEO Mohamed El-Erian is worried that the Fed will start QE tapering this year even if the U.S. economy does not pick up – after all, Fed Chairman Bernanke only offered an unemployment threshold of 7.0%  for the end of QE tapering, not its beginning. Blackstone Vice Chairman Byron Wien does not believe economic growth will accelerate in the second half of 2013 because mortgage rates have risen and slowed home buying, corporate profit margins are peaking, earnings estimates are falling, and retail sales growth in 2013 has been weak. Even China is afraid the Fed will taper too soon.

Citigroup equity strategist Tobias Levkovich notes that intra-stock correlation between the 50 largest-cap stocks has collapsed, which suggests investors are complacent and is at a level that has signaled market tops in the past. Vanguard is advising clients to rebalance portfolios by selling stocks and buying bonds, noting that stocks have risen substantially and are now valued 10% above their long-term median P/E ratio (17.4 vs. 15.9), while bond prices have fallen substantially. Such one-way price momentum is unsustainable and often leads the returns of both asset classes to revert back toward their means (i.e., stocks down and bonds up). Some rebalancing into bonds may have already begun, with weekly cash flows into investment-grade bond funds turning positive for the first time in 10 weeks.

Short-term seasonality is turning bearish. Since 2013 is post-election year, the seasonal chart tops out . . . right about now in August and doesn’t bottom until early November. The autumn months of September/October in a post-election year are particularly bad when it involves a second-term president (like now). Lastly, the Stock Trader’s Almanac recently noted that whenever the Dow Jones Industrial Average rises by 3.5 percent or more during the month of July (July 2013 was up 4.0 percent), subsequent stock-market declines during the remainder of the calendar year average a hefty 6.9 percent.  The largest cluster of “Hindenburg Omens” (i.e., high percentage of both 52-week highs and 52-week lows) since the market tops in 2007 and 2000 also suggests a correction of some significance is likely.

Looking on the positive side, China’s economy is “stabilizing,” U.S. existing-home prices continue to rise, consumer confidence is up, and Citigroup’s Economic Surprise Index (CESI) in the U.S. has turned positive for the first time since early 2013.  A positive and rising CESI is correlated with higher corporate earnings and P/E multiples. Technically, the market remains in a strong uptrend with very little evidence of deteriorating internals. Financial blogger Ukarlewitz is short-term cautious because:

The Dow has retraced more than 62% of the June/July uptrend. Large caps have led the move lower and weakness here could pull SPX closer to its 1560 June low. If growth and inflation remain subdued, as S&P 500 quarterly earnings results seem to indicate, then the big move in bond yields is likely over. Bonds are slightly outperforming stocks so far in August and while funds are near record overweight equities, they are near record underweight bonds.

Lowry’s reaches a mostly-bullish conclusion:

While showing signs of market weakness, Lowry’s short-term indicators suggest the probabilities favor a rather modest decline. Beyond the short-term, though, signs of an impending major top, or even of a major correction, remain scarce. Seasonal factors are, historically, far less important than an analysis of current market conditions. And, an analysis of current conditions suggests a still-healthy bull market.

Longer term, some analysts are forecasting a new secular bull market and see the current market environment as reminiscent of 1982, which marked the beginning of a huge, 18-year market advance. Jeffrey Saut, Raymond James chief investment strategist, is long-term bullish for three reasons: (1) American industrial renaissance; (2) American energy independence by 2020-25; and (3) end of political gridlock in Washington.  Short-term, however, Saut forecasts a decline that carries the S&P 500 into a zone between 1530 (April low) and 1560 (June low):

I continue to believe the game is not worth the candle, and that the rebuilding of the stock market’s internal energy is likely going to be released on the downside into mid-September. This is NOT a time to “buy the dips”!

Besides Middle-East tension, a catalyst for a market correction is the upcoming partisan battle over the U.S. debt ceiling extension. The government is scheduled to run out of borrowing authority in mid-October, but Republican Speaker of the House John Boehner promises a “whale of a fight.“

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 Wednesday, August 28^th: This small-cap outperformance vindicates my January prediction in the article entitled Small Caps: The Time to Invest is Now.

Total Return Through August 28^th

Source: Bloomberg

A majority (14 out of 22) 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 10 out of 11 holdings (91%) outperforming, while the Momentum Portfolio lags far behind with only four of its 11 holdings (36%) having outperformed the S&P 500. Overall, 18 of 22 holdings (82%) have generated positive absolute returns.

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

Value Portfolio
(through August 28^th)

Momentum Portfolio
(through August 28^th)

Source: Bloomberg

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 Hill-Rom Holdings and US Ecology provide diversification benefits to the Value and Momentum portfolios, respectively. Based on my portfolio analysis software, the Momentum Portfolio was modestly underweight “healthcare,” so Hill-Rom fit the bill. The Value Portfolio was seriously underweight “industrials” and US Ecology operates in this space.  Diversification by industry sector is an important means to reduce portfolio risk and enhance returns.

Hill-Rom Holdings and HMS Holdings are negatively correlated with each other, which may seem ironic given that they both operate in the healthcare arena, but it actually makes sense because Hill-Rom relies on hospitals having the cash to buy its products, whereas HMS tries to invalidate government payments that have been made to hospitals.  US Ecology and United Therapeutics have low correlation because industrial demand for hazardous waste removal has nothing to do with patient demand for PAH drug treatments.