Market Outlook

August was the worst month for stocks since May 2012, with the Dow Jones Industrial Average down 4.4 percent and falling for four consecutive weeks. The decline appears to have been nothing more than a pause that refreshes as stocks have rebounded strongly in September, with the Dow enjoying its best week since January 2013 and the S&P 500 rising for seven consecutive days at the start of the month.

Even more bullish, after the Federal Reserve meeting on September 18th, the Nasdaq-100 broke out to a new 13-year high and the Dow, S&P 500, and Russell 2000 all hit all-time highs., as did the transports which thus confirmed a “Dow Theory” buy signal. It’s difficult to justify a bearish position when all of the major stock indices hit new highs. Momentum is super-strong, with 2013 marking the first year since 1995 where the S&P 500 relative-strength index (RSI) has not fallen below the 30 level a single time. Furthemore, the NYSE Operating Company Only Advance-Decline Line also hit a new high, confirming the price breakout. As I mentioned in the July Roadmap, the stock market does not typically top out until several months after the advance/decline line has hit a new high, so this AD-line confirmation is very bullish for the intermediate term.

Short term, however, a market correction remains overdue. The average bull market lasts 35 months and generates a 104-percent gain, while the current bull market (since March 2009) has lasted 54 months and has generated a 140 percent gain. The current bull market is the 6th longest in the past 113 years. A 10-percent correction occurs on average every 16 months and we have not had one in 24 months (since September 2011).

Can the stock market continue without a correction? Sure, but based on historical averages it is due for one. Furthermore, the October-December period in the first year of a U.S. President’s second term has historically been the worst quarter of the entire eight-year presidential cycle (including both four-year first terms and four-year second terms). In addition, dumb-money fund managers are the most overweight stocks in 5 and 1/2 years and smart-money commercial hedgers are the most net short since the last two substantial market drops in September 2012 and May 2013. Lastly, divergences between all-time index price highs and lower highs in technical momentum indicators (MACD, RSI) and percentage of stocks above their 50-day moving average suggests the market may at least stall in the near term.

Jeffrey Saut, Raymond James equity strategist, believes that the U.S. market is only half-way through its correction (Ukarlewitz also says that a washout low has not yet occurred) and the S&P 500 may still test the June lows around 1,560 before rebounding by year’s end. Time Magazine’s September cover shows a picture of a stock-market bull with a party hat on, which typically is a contrary indicator and bearish for the stock market. The decision to add Goldman Sachs (NYSE: GS) to the Dow Jones Industrial Average could also suggest a market top since Goldman is an icon of Wall Street.

Longer term, Saut remains bullish and forecasts a rise to 1,850 sometime during 2014, thanks to a still-modest S&P 500 P/E ratio, rising earnings estimates, and continued technical momentum:

Lowry’s Buying Power Index has traveled above its July high and the Selling Pressure Index is at multi-year lows. All of this suggests higher prices in the months ahead.

JP Morgan’s Tom Lee is also bullish into year’s end.

The U.S. services sector in August hit its highest level in almost eight years (since December 2005). The Economic Cycle Research Institute’s (ECRI) Weekly Leading Index hit its highest level in more than three years. U.S. auto sales hit its highest level in nearly six years during August. On the other hand, August employment was weak (especially downward revisions in June and July), August retail sales were weak, and consumer confidence in September has fallen to the lowest level since last April. Historically, bond yields follow consumer confidence, so the decline in consumer confidence could signal a significant short-term top in bond yields.

The global economy appears to be stabilizing and even strengthening on average. China has “turned a corner” with fears of a real-estate-fueled recession quickly receding. Europe is finally emerging from its long recession, with Europe’s two largest economies, Germany and France, growing by a robust 0.7 percent and 0.5 percent, respectively, from the first quarter to the second. It was France’s biggest quarterly increase in more than two years. England’s economy is growing faster than expected and its services sector recently hit a 15-year high.

High-yield stocks (e.g., utilities, REITs, MLPs) and U.S. Treasuries (e.g., TLT) had been held hostage to investors’ obsession with the prospects of the Federal Reserve tapering its quantitative easing program of $85 billion in monthly bond purchases at its September 18^th meeting. As it turned out, the Fed shocked Wall Street by deciding not to taper yet. At the post-meeting press conference, Chairman Bernanke stated that although the economy has strengthened, the rebound could be unsustainable given the rise in long-term interest rates since May (including home mortgage rates), continued fiscal contraction caused by the federal budget sequester, and fears that a partial government shutdown starting September 1st and debt-ceiling brinkmanship leading up to an October 17th deadline could make things worse very quickly. According to Moody’s Analytics, a three-to-four week
government shutdown could shave 1.4 percent off of fourth-quarter GDP growth and a two-month shutdown would likely precipitate a new recession.

An “Octaper” is considered unlikely because federal budget and debt-ceiling uncertainty may not yet be resolved and there is no press conference scheduled after the Fed’s October 30th meeting — a communication vechicle one would think is necessary to adequately explain such an important change in monetary policy. Nevertheless, St. Louis Fed president James Bullard (voting member) said that an October taper could occur because September was such a “close call.” In a September 23rd speech, NY Fed president William Dudley elaborated on the reasons why a QE taper was not initiated at the September Fed meeting:

While significant progress has been made since the end of the recession, there remain a number of headwinds that have offset the improvement in the underlying fundamentals.  As a result, we have yet to see any meaningful pickup in the economy’s forward momentum.  The most notable recent headwind, of course, has been the large amount of fiscal drag this year from the payroll and income tax increases and the budget sequester. Also noteworthy is the tightening of financial market conditions that has occurred since May. 

As we move into 2014, the fiscal headwinds should abate somewhat.  As that occurs, the improving underlying fundamentals of the economy should begin to dominate, pushing up the overall growth rate. But this is just a forecast, it has not been realized yet.

Chicago Fed president Richard Evans agrees with Dudley and goes so far as to say that tapering may not begin until 2014. Dallas Fed president Richard Fisher (non-voting member in 2013) argued the exact opposite on the same day, stating that the decision to delay tapering hurt the Fed’s credibility. Kansas City Fed president Esther George also was critical of the tapering delay and was the sole dissenter at the September meeting.

The disagreement among Fed bank presidents leaves Wall Street flustered and confused as to when tapering will actually begin and that uncertainty may explain why the stock-market rally in reaction to the no-taper decision was very short-lived, resulting in the S&P 500 now trading below the level it closed at the day prior to the Fed no-taper decision.

Bottom line: small-cap stocks have outperformed large-cap stocks since the financial crisis of 2009 and will likely remain the place to be, especially once the Fed begins to taper its bond-buying program. Tapering means higher interest rates and stronger economic growth — both of which are conditions under which small caps have historically outperformed large caps. As one commentator recently wrote:

Small-cap stocks remain the place to be this year, and they’ll likely stay that way into 2014 and 2015, as the economy picks up steam.

The time to invest in small-cap stocks continues to be now. According to the Ivy Portfolio market-timing system based on the 10-month moving average, U.S. stocks and foreign stocks remain on buy signals, whereas U.S. 10-year Treasuries, REITs, and commodities are all sells.

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 September 27^th

Source: Bloomberg

A majority (16 out of 24) 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 12 holdings (83%) outperforming, while the Momentum Portfolio lags far behind with only six of its 12 holdings (50%) having outperformed the S&P 500. Overall, 20 of 24 holdings (83%) have generated positive absolute returns.

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

Value Portfolio
(through September 27^th)

Momentum Portfolio
(through September 27^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 daily measuring periods over 3 years:

Momentum Portfolio 3-Year Correlations

Value Portfolio 3-Year Correlations

As you can see above, Stewart Information Services provides excellent diversification benefits to the Value Portfolio and Valmont Industries provides moderate diversification to the Momentum Portfolio. Based on my portfolio analysis software, the Value Portfolio was significantly underweight both the “financial services” sector and the “speculative growth” stock type, so Stewart satisfies both of these classifications to a “T.” The Momentum Portfolio, by contrast, was only slightly underweight the “industrial” sector and significantly underweight the “cyclical” stock type, so Valmont Industries does a great job of rounding out the portfolio’s cyclical exposure but its status as an industrial stock only marginally helps. Diversification by both industry sector and stock type are important investment considerations.

Stewart Information Services is most negatively correlated with last month’s recommendation – U.S. Ecology – because Stewart operates in the highly-competitive and cyclical housing finance industry whereas U.S. Ecology has oligopoly status in the stable and economically-insensitive hazardous waste industry. Valmont Industries and Western Refining have low correlation because energy is a significant cost input for Valmont’s manufacturing and transportation activities, whereas Western Refining benefits from high fuel prices.

Total correlation matrices are shown below:

Momentum Portfolio

Value Portfolio