Market Outlook

Both the Dow Jones Industrials and the S&P 500 closed last week at record highs (above 16,000 and 1,800, respectively), rising for the seventh consecutive week. This marks the longest weekly win streak for the Dow since January 2011 and is only the third time the S&P 500 has achieved such a streak in the last 10 years. Can you say momentum?

As Ukarlewitz puts it: “The top is likely not in” and the seasonal run-up between now and Christmas is “very powerful.”  The market should continue higher for at least another two months before taking a breather. At least that’s what happened the last two times that the S&P 500 rose for seven consecutive weeks (in 2004 and 2011). With the three big geo-political crises in remission — Iran’s nuclear program, Europe’s debt contagion, and China’s economic slowdown – it makes sense that investors are throwing caution to the winds. Record auctions are occurring in art and automobiles. Janet Yellen, who is expected to become Chairman of the Federal Reserve on February 1^st, 2014, testified at her confirmation hearing that the Fed has “has more work to do,” which suggests any tapering of quantitative easing (QE) will be delayed and very gradual. The European Central Bank unexpectedly cut rates at its Nov. 7^th meeting, so the world’s monetary authorities remain with their “pedals to the metal” and have no fear that inflation is a near-term risk. Indeed, excluding the 2008-09 financial crisis, inflation is currently at its lowest level in almost 50 years! With inflation non-existent, Goldman Sachs forecasts steep price drops to continue for both gold bullion and iron ore in 2014.

As a result of continued monetary stimulus as far as the eye can see, investor sentiment has reached “euphoric” levels that have historically led to market declines over the subsequent 12 months 83-percent of the time. Similarly, Investors Intelligence – which measures newsletter writers’ sentiment – says that only 16 percent of newsletters are currently bearish, which is the lowest level in 26 years (since 1987). Historically, whenever the bearish percentage gets this low, the market has averaged a negative return over the subsequent six months. Lastly, smart-money commercial hedgers are even more net short Nasdaq futures now than they were back in September.

The trailing 12-month PE multiple of the S&P 500 remains moderate at 16.8 times, which has some analysts predicting continued price appreciation in 2014 given that the operating-earnings estimate for 2014 is $120.81. Multiply 16.8 by $120.81 and you get a 2014 valuation for the S&P 500 of 2,029, which is 12.3 percent above the current level of 1,806. If multiples increase above 16.8, the gain would be even greater.

Among the bulls is hedge-fund manager David Tepper, who predicts another 20-percent gain for the stock market next year based on a double-whammy of improving earnings and higher earnings multiples. Tepper’s greatest fear is for those investors who are cautious and won’t benefit fully from next year’s market rally. You can’t get much more bullish than that! Even Tepper, however, concedes that the market could suffer some temporary indigestion at the start of QE tapering and suffer a 5-10 percent correction. BlackRock CEO Larry Fink sees the potential for an even-larger 12-15 percent correction in the coming months.

Tepper’s extreme bullishness depends on stronger earnings growth in 2014 and many analysts don’t see it, including former Treasury Secretary Larry Summers. The 10-year average PE multiple is at extreme levels and suggests long-term market stagnation with expected returns over the next decade below 2 percent (actually negative without dividends). Henry Blodget is also pessimistic, noting that corporate profit margins are at all-time highs with no room to move higher. In fact, profits are set to fall because consumer spending cannot grow in the face of income inequality that sees wages at the lowest percentage of U.S. GDP ever. But Blodget’s prediction has not yet come true; retail sales remain resilient – for now.

One reason for the resilient consumer may be the indirect “tax cut” consumers are receiving from lower energy prices. The Energy Information Administration reported that U.S. crude oil production hit a 24-year high in October and exceeded imports for the first time since February 1995. The Iran nuclear deal has caused Brent crude oil prices to drop even further. Gasoline prices are at a three-year low. According to Raymond James chief investment strategist Jeffrey Saut, the industry sectors that historically perform best in the three months following a 10-percent decline in gasoline prices are:

• Consumer Discretionary
• Financials
• Technology
• Energy
• Industrials

Small and mid-cap stocks have an average P/E ratio that is more than two percentage points higher than large caps, which is historically expensive compared to the long-term average P/E premium of one percentage point. According to Bank of America Merrill Lynch, since 1979 whenever small caps have been as relatively expensive as they are now, they have underperformed large-caps by 500 basis points over the subsequent 12-month period. GMO’s 7-Year Asset Class Forecast (free registration required) also predicts small caps will underperform. But keep in mind that small caps is a huge stock universe and my job is to separate the winners from the losers!

2014 will be the second year of the presidential cycle, which is historically the weakest market year – up on average only 4.0 percent since 1901. Combine that with the fact that the first year of the presidential cycle (2013) was positive, and the average return of the second year is even weaker (only 2.4 percent). In addition, except for the Internet bubble period between 1995 and 1999, over the past 40 years the stock market has never risen in the year after a 20-percent up year (like 2013) if the year prior to the 20-percent up year was also strong (like 2012). The following commentator sums up the paradox of current market conditions well:

When sentiment and positioning data consistently produce new extremes month after month, it tells us that the eventual backlash is likely to be quite a doozy. Given that money printing continues as before, it is admittedly hard to see what could trigger a reversal – but this is also a “hook” that is likely to eventually mislead market participants.

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 nine  of the ten periods between the release of a Roadrunner monthly issue and the market close on Tuesday, November 26^th: This small-cap outperformance vindicates my January prediction in the article entitled Small Caps: The Time to Invest is Now.

Total Return Thru November 26^th

Source: Bloomberg

A majority (18 out of 28) of Roadrunner recommendations have outperformed the S&P 500 and both the Value and Momentum portfolios have a double-digit positive average return. The Value Portfolio continues to be the real star, with 10 out of 14 holdings (71.4%) outperforming, but the Momentum Portfolio isn’t far behind with eight of its 14 holdings (57.1%) having outperformed the S&P 500. Although the average return of the Momentum Portfolio continues to trail the S&P 500, the underperformance has been cut to less than one percent (0.61%), which is the lowest it has ever been since I started tracking this metric in the May issue of Roadrunner.

Overall, 23 of 28 Roadrunner holdings (82.1%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru November 26^th)

Momentum Portfolio
(thru November 26^th)

Correlation Analysis

The two Front Runners added to the portfolios this week have 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 three years:

Momentum Portfolio 3-Year Correlations

Value Portfolio 3-Year Correlations

As you can see above, both International Speedway and Lydall provide good diversification benefits to the Momentum Portfolio and Value portfolios. Based on my portfolio analysis software, the Momentum Portfolio was slightly underweight the “consumer cyclical” sector and “cyclical” stock type, so a sports venue like International Speedway was a good fit. In contrast, the Value Portfolio was underweight the “industrial” sector and “cyclical” stock type, so a conglomerate like Lydall solved this deficit. Diversification by both industry sector and stock type are important investment considerations. With the global economy potentially strengthening in 2014, increasing the amount of cyclical exposure in both portfolios right now in late 2013 makes a lot of sense!

International Speedway is most negatively correlated with HomeAway and PriceSmart because International Speedway focuses on the discretionary entertainment spending of lower-class males in the Midwestern and Southern U.S., whereas HomeAway focuses on upper-class U.S. vacationers on the West and East Coasts and PriceSmart focuses on non-U.S. shoppers in Central America. Lydall has negative correlations with both Buckle and Graftech because Lydall is focused on U.S. industrial applications whereas Buckle focuses on U.S. teen fashion and Graftech’s steel business is mostly outside of the U.S.

Looking at the correlation matrices below, the best diversifiers are those with a lot of red shadings. If you don’t already own Darling International in the Momentum Portfolio and/or Fresh Del Monte 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