Market Outlook

On October 17^th the S&P 500 climbed to yet another all-time high as politicians in Washington agreed to end the government shutdown after 16 days and extend the federal debt ceiling, thus avoiding default on U.S. debt. Under the temporary agreement, the government will remain open until at least January 15^th and the debt ceiling is open-ended until February 7^th.  Even after February 7^th, however, the government may be able to juggle accounts after February 7^th without a debt-ceiling extension and continue paying interest on the $17 trillion in national debt through April 15^th or later. 

Given that the budget and debt agreements are only temporary, it may seem strange that the market would jump to all-time highs, but the real reason for investor giddiness is the effect the shutdown had on the mindset of the Federal Reserve. Standard & Poor’s estimates that the shutdown reduced U.S. GDP by $24 billion and will cut fourth-quarter GDP growth to 2.4 percent from the originally-forecasted 3.0 percent. The weakened economy makes a tapering of the Fed’s $85 billion in monthly bond buying less justified. The Fed’s October 30th policy statement  — confirming that no tapering would occur — expressly noted for the first time that “the recovery in the housing sector slowed somewhat in recent months.” Economists now don’t expect tapering of quantitative easing (QE) to commence until the March 19^th meeting. Hedge-fun manager David Tepper says QE tapering may not occur until June 2014, which could result in a “pretty large increase in stock prices.”

On the other hand, the temporary government deal does nothing to solve the long-term fundamental problems of exploding debt and budget deficits. According to Citigroup, the stock market will not be able to realize its full potential until these long-term fundamental problems are addressed. A UBS analyst is “disgusted” by political dysfunction in Washington and recommends that investors move money out of the U.S. and into European stocks. Fund manager Richard Bernstein agrees that European stocks will outperform U.S. large-cap stocks, but he thinks the best growth prospects in the coming year are in Japan and U.S. small-cap stocks.

Fitch Ratings placed the U.S. triple-A (AAA) credit rating on “rating watch negative” for possible downgrade and issued a report on October 22^nd suggesting a downgrade will occur once the U.S. gross government debt exceeds 110 percent of GDP. As of 2012, the U.S. debt ratio was 106.525 percent and rising fast.

With QE tapering put on hold, all of the angst investors have felt since last May about an improving economy causing interest rates to rise and high-yield stocks to underperform has disappeared. The S&P 500 volatility index (VIX), which measures investor fear, collapsed from a high above 21 on October 9^th to a low under 12.50 on October 18^th.  Bond prices are rising (yields are dropping) and high-yield bond proxies like MLPs, REITs, and utilities are experiencing a resurgence.

U.S. economic growth is decelerating, as evidenced by a weak September jobs report and the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index, which experienced is lowest rate of year-over-year growth since August 2012. Citigroup’s Economic Surprise Index has been going straight down since October 1st and is on the verge of going negative. U.S. inflationary expectations are at a 20-month low and European inflation is at a 44-month low.

U.S. corporate earnings estimates for the third quarter have fallen dramatically by more than 50% since July 1^st. Just since October 1^st, estimates of third-quarter earnings growth have fallen from 4.5 percent to only 1.9 percent. From a contrarian perspective, such an “unprecedented” level of earnings pessimism could lead to a relief rally when actual results are not as bad as feared. Indeed, third-quarter S&P 500 earnings are coming in better than expected and may actually reach both a quarterly and trailing four-quarter all-time high — and the stock market is responding by also hitting all-time highs. According to FactSet Research, of the 244 S&P 500 companies that have reported third-quarter earnings, 75 percent have reported earnings that have beaten reduced analyst estimates and 52 percent have beaten revenue estimates.

The fourth quarter may be the real earnings bummer, however, because 49 S&P 500 companies have already issued negative guidance about Q4 compared to only eight announcing positive guidance. This negative percentage of 86 percent is well above the five-year average of 63 percent. Raymond James investment strategist Jeffrey Saut says that Q4 earnings worries, along with his market timing models, make a market correction likely in the mid-November to early December time period.

Technically, the recent all-time highs by the S&P 500, MidCap 400, and Russell 2000 – confirmed by a new high in the advance/decline line — make the stock market prognosis bullish over the near term. Ralph Acampora – the godfather of technical analysis — threw in the towel on his summertime bearish call and now expects the S&P 500 to hit 1,800 by the end of 2013. Wharton finance professor Jeremy Siegel sees the Dow Jones Industrials gaining an additional 10 percent in 2014. Bank of America Merrill Lynch is similarly bullish, predicting that 2014 will be “The Year of the Boom.” Other market observers, however, like Tom DeMark, Mark Spitznagel, and Andrew Kassen, are sounding a note of caution and warn that a severe market correction  — even a crash — could start soon.

Ukarlewitz sums the bullish case up nicely: “Trend, Breadth, Volatility and Seasonality Are All Positives.” Lastly, Lowry’s is also bullish, stating on October 22^nd:

Year-to-date gains are among the highest of the past 60 years, with the S&P 500 up 24% year-to-date, while the S&P Cap Index has gained over 35%. Despite these big advances, the bull market still shows few, if any, signs of ending. So, although advances may be more subdued, the market appears poised for additional gains between now and year end. 

The seasonally-bullish late October/early November period began at the close on Friday October 25^th and ends at the close on November 4th.

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 eight of the nine periods between the release of a Roadrunner monthly issue and the market close on Friday, October 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 October 25^th

Source: Bloomberg

A majority (16 out of 26) 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
(thru October 25^th)

Momentum Portfolio
(thru October 25^th)

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 3-Year Correlations

Value Portfolio 3-Year Correlations

As you can see above in the first of the two correlation charts, Apogee Enterprises provides excellent diversification benefits to the Momentum Portfolio. In the second correlation chart, one can see that Exactech provides moderate diversification to the Value Portfolio. Based on my portfolio analysis software, the Value Portfolio was slightly underweight the “healthcare” sector, so Exactech helped correct this deficit. In contrast, the Momentum Portfolio had zero exposure to the “basic materials” sector and was also significantly underweight the “cyclical” stock type, so Apogee Enterprises does a great job enhancing the portfolio on both of these fronts (i.e., industry sector and stock type). Diversification by both industry sector and stock type are important investment considerations. It’s not a surprise that the stock that corrects the most portfolio imbalances (i.e., Apogee) offers better diversification benefits than the stock added to an already-well-balanced portfolio (i.e., Exactech).

Apogee Enterprises is most negatively correlated with HomeAway because Apogee focuses on commercial (i.e., non-residential) construction whereas HomeAway focuses squarely on vacation residences. Exactech has negative correlations with both Brocade and Buckle because elderly joint replacements are unaffected by commercial memory storage and teen fashion.

Looking at the correlation matrices below, the best diversifiers are those with a lot of red shadings. If you don’t already own LeapFrog Enterprises in the Momentum Portfolio and/or Buckle in the Value Portfolio, now would be a good time to pick up some shares in both.  

Total correlation matrices are shown below:

Momentum Portfolio

Value Portfolio