Market Outlook

The first five trading days of January were negative, which is not a good sign for 2014. When the first five days are up, the market is up 85 percent of the time over the full calendar year. When they are down, the market is up only 50 percent of the time. 50-50 odds are not terrible, but not great either. The selling has continued throughout January, with the week of Jan. 20-Jan. 24 resulting in the S&P 500 and Dow Jones Industrials suffering their worst weekly declines since June 2012 and November 2011, respectively. So far in January, the S&P 500 is down 4.0 percent with only two days to go. If January ends down, the odds of a bad 2014 rise markedly. Since 1938, stocks have declined 3% or more in January 18 times and ended the year in the red 12 times (67% of the time). The average annual return is -5.4% and only three times (16.7% of the time) did the year end with a gain of more than 2.6%.

Causes for the January decline include:

• Worst selloff in emerging-market currencies in five years. If the 1997 emerging-market currency crisis is any indication, the negative effect on the overall U.S. stock market should be temporary and mild, even though U.S. multinationals with significant revenues denominated in foreign currencies could be hurt.
• Chinese manufacturing declines for first time in six months, possibly threatening the global economic recovery.
• Disappointing earnings or forward guidance from Apple, AT&T, Boeing, and Yahoo!.
• Fears of continued QE tapering by the Federal Reserve.

On the positive side, both the S&P 500 and the Nasdaq Composite rebounded from the bad start to hit all-time highs later in January. The stock market has not experienced a 10-percent or greater correction in more than 410 days, which suggests that one is due and could happen at any time. Bullish investors that believe in the Super Bowl indicator are despondent because neither the Seattle Seahawks nor the Denver Broncos are an original NFL team, so it is a lose-lose situation regardless of who wins. Optimists argue that the Seahawks are an NFC team, so the market will do well in 2014 if they win, ignoring the distinction between an original NFL team and any NFC team.

The global economy appears to be stabilizing and even strengthening on average, with the World Bank recently forecasting (page 17):

an acceleration in global growth from 2.4 percent in 2013 to 3.2 percent this year, 3.4 percent in 2015, and 3.5 percent in 2016

Most of the economic growth is expected in the developed “rich” countries, with growth in the emerging markets (e.g., Brazil, China, India, Mexico) expected to continue but slow down over the next few years. The United Kingdom reported its best economic growth since 2007.

U.S job growth in December was disappointing, but Chicago Fed Bank president Charles Evans remains optimistic:

Taking a broader perspective, payroll employment growth averaged more than 200,000 jobs per month between August and November and the unemployment rate has fallen to 6.7 percent. According to surveys of consumer sentiment, household confidence is recovering from the drop that occurred during last fall’s fiscal policy debates. These improvements in the job market and sentiment are helping to boost consumer spending, which has increased at a very solid 4-1/2 percent annualized rate over the past three months.

Another $10 billion per month in QE tapering (down to $65 billion from $75 billion) was announced on January 29th — Ben Bernanke’s final meeting as Fed chairman before Janet Yellen takes the helm on February 1st. Recent stock-market weakness since the January 15th all-time high in the S&P 500 may be related to investor nervousness over further QE tapering. The Fed statement recognized that job and housing data was “mixed,” but remained optimistic about the overall economy, focusing on improvements in household spending and business fixed investment. Lastly, the Fed noted that the fiscal restraint of lower government spending “is” coming to an end — more definitive than the “may” used in the December statement.

The global economy appears to be strengthening on average, with the World Bank recently forecasting (page 17):

an acceleration in global growth from 2.4 percent in 2013 to 3.2 percent this year, 3.4 percent in 2015, and 3.5 percent in 2016

Wharton finance professor Jeremy Siegel continues to beat the drums for a 10% or greater extension of the bull market, making positive statements on January 17th and again on January 28th. Although he concedes that a stock-market correction could occur at any time and it is foolish to attempt to predict short-term market movements, the fact remains that corporate earnings are strong, the U.S. economy will grow in 2014, interest rates will remain low, and stock valuations remain moderate.

Bottom line: According to Ukarlewitz, “the trend is up, but it’s flattening” and “a break in the equity rise is growing increasingly likely.” Despite the selling in January, the S&P 500 has still not fallen below the December low of 1,767.99 — but it’s gotten very close (1,770.45). If it takes out the December low:

There is reason to suspect that a larger 7-10% correction is in store, to at least 1650 to 1710. That would match the corrections in April and September 2012 and May 2013. If that is the case, the S&P 500 will not see a new high for at least 3 months and probably more than 6 months.

At the end of December, bullish sentiment has hit extreme levels (26-year high) that historically has signaled a likelihood in the intermediate term that the S&P 500 will at least fall back down to its 200-day moving average, which is currently at 1,715 (3.3% below the current index level of 1,774).

Roadrunner Stocks Relative Performance

Since the Roadrunner service launched on January 24, 2013, the small-cap Russell 2000 has outperformed large caps. In fact, the Russell 2000 has outperformed the large-cap S&P 500 in 11 of the 12 periods between the release of a Roadrunner monthly issue and the market close on Tuesday, January 28, 2014. This small-cap outperformance vindicates my January 2013 prediction in the article entitled Small Caps: The Time to Invest is Now.

Total Return Thru January 28^th

Start Date	S&P 500 ETF (SPY)	Russell 2000 ETF (IWM)	Advantage
January 24th , 2013	22.27%	28.26%	Small cap
February 27th	20.26%	26.81%	Small cap
March 28th	16.09%	20.94 %	Small cap
April 26th	14.94%	22.93%	Small cap
May 24th	10.02%	16.67%	Small cap
June 28th	12.78%	17.73%	Small cap
July 29th	7.31%	9.97%	Small cap
September 3rd	10.06%	12.51%	Small cap
October 1st	6.32%	5.15%	Large cap
November 4th	1.81%	3.12%	Small cap
December 2nd	-0.27%	0.92%	Small cap
January 6th , 2014	-1.80%	-0.69%	Small cap

Source: Bloomberg

A majority (18 out of 32) 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 16 holdings (62.5%) outperforming. In contrast, the Momentum Portfolio had a rough month of January and now only eight of its 16 holdings (50.0%) having outperformed the S&P 500. After outperforming last month, the average return of the Momentum Portfolio fell back below the S&P 500 by an average of 2.37%.

Overall, 23 of 32 Roadrunner holdings (71.9%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru January 28^th)

Roadrunner Stock	Start Date	Roadrunner Performance	S&P 500 ETF (SPY)	Roadrunner Outperformance?
United Therapeutics (UTHR)	1-24-13	102.29%	22.27%	+80.02%
Gentex  (GNTX)	1-24-13	78.57%	22.27%	+56.30%
Diamond Hill Investment Group (DHIL)	1-24-13	72.180%	22.27%	+49.91%
Brocade Communications (BRCD)	2-27-13	68.15%	20.26%	+47.89%
GrafTech International (GTI)	4-26-13	49.43%	14.94%	+34.49%
FutureFuel (FF)	3-28-13	38.82%	16.09%	+22.73%
U.S. Ecology (ECOL)	9-3-13	32.03%	10.06%	+21.97%
Carbo Ceramics (CRR)	1-24-13	35.58%	22.27%	+13.31%
Stepan Co. (SCL)	6-28-13	14.93%	12.78%	+2.15%
Lydall (LDL)	12-2-13	0.46%	-0.27%	+0.73%
Fabrinet (FN)	1-6-14	-2.53%	-1.80%	-0.73%
ManTech International (MANT)	7-29-13	5.59%	7.31%	-1.72%
Stewart Information Services (STC)	10-1-13	4.56%	6.32%	-1.76%
Exactech (EXAC)	11-4-13	-1.68%	1.81%	-3.49%
Fresh Del Monte Produce (FDP)	5-24-13	-1.51%	10.02%	-11.53%
Buckle (BKE)	1-24-13	0.16%	22.27%	-22.11%
AVERAGES		31.06%	13.05%	18.01%

  

Momentum Portfolio
(thru January 28^th)

Roadrunner Stock	Start Date	Roadrunner Performance	S&P 500 ETF (SPY)	Roadrunner Outperformance?
G-III Apparel (GIII)	5-24-13	69.45%	10.02%	+59.43%
U.S. Physical Therapy  (USPH)	4-26-13	39.45%	14.94%	+24.51%
HomeAway (AWAY)	2-27-13	37.98%	20.26%	+17.72%
Western Refining (WNR)	1-24-13	32.62%	22.27%	+10.35%
Apogee Enterprises (APOG)	11-4-13	10.36%	1.81%	+8.55%
Valmont Industries (VMI)	10-1-13	8.45%	6.32%	+2.13%
Ocwen Financial (OCN)	1-24-13	23.91%	22.27%	+1.64%
CBOE Holdings (CBOE)	1-6-14	-1.45%	-1.80%	+0.35%
International Speedway (ISCA)	12-2-13	-0.46%	-0.27%	-0.19%
Hill-Rom Holdings (HRC)	9-3-13	9.03%	10.06%	-1.03%
PriceSmart (PSMT)	1-24-13	20.45%	22.27%	-1.82%
Darling International (DAR)	6-28-13	7.34%	12.78%	-5.44%
CommVault Systems (CVLT)	3-28-13	-7.20%	16.09%	-23.29%
HMS Holdings (HMSY)	1-24-13	-14.97%	22.27%	-37.24%
LeapFrog Enterprises (LF)	7-29-13	-36.89%	7.31%	-44.21%
SolarWinds (SWI)	1-24-13	-27.05%	22.27%	-49.32%
AVERAGES		10.69%	13.05%	-2.37%

 

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

	CCF
APOG	0.519
AWAY	0.413
CBOE	0.379
CVLT	0.338
DAR	0.401
GIII	0.359
HMSY	0.512
HRC	0.198
ISCA	0.612
LF	0.389
OCN	0.162
PSMT	0.211
SWI	0.474
USPH	0.300
VMI	0.483
WNR	0.405

 

Value Portfolio 3-Year Correlations

	WEYS
BRCD	0.140
BKE	0.466
CRR	0.411
DHIL	0.301
ECOL	0.353
EXAC	0.530
FDP	0.277
FF	0.456
FN	0.481
GNTX	0.523
GTI	0.110
LDL	0.298
MANT	0.507
SCL	0.344
STC	0.341
UTHR	0.214

As you can see above, both Chase and Weyco provide decent diversification benefits to the Momentum Portfolio and Value portfolios. Based on my portfolio analysis software, the Momentum Portfolio was slightly underweight the “industrials” sector and “cyclical” stock type, so a manufacturer of tapes and laminates like Chase was a good stopgap. In contrast, the Value Portfolio was underweight the “consumer cyclical” sector and the “cyclical” stock type, so a footwear manufacturer like Weyco provided the perfect complement to the other Value Portfolio holdings. Diversification by both industry sector and stock type are important investment considerations. January marks the third straight month I have bulked up on cyclical stocks. Part of this action is based simply on the fact that small and mid-cap stock indices typically have a 50% weighting to cyclical sectors. Beyond index-weighting considerations, however, the global economy is strengthening and cyclical stocks are timely right now.

Chase is most negatively correlated with Ocwen Financial because industrial materials and services outperform during periods of strong economic growth and low interest rates, whereas residential mortgage modification financial services outperform during troubled times for homeowners and rising interest rates.. Weyco has a very low correlation with GrafTech because consumers buying shoes involves a small-ticket purchase, whereas steel production is associated with big-ticket construction projects and industry.

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

Total correlation matrices are shown below:

Momentum Portfolio

Value Portfolio