February Rebound Brings New All-Time Highs
Market Outlook
Between January 15th and February 5th, the S&P 500 suffered a 6.1% correction, its first correction of 5% or more since June 2013 and the 19th market correction of 5% or more since the current bull market started in 2009. In January’s Roadmap article, I wrote that the correction was “not the big one” but instead would prove to be the pause that refreshes, enabling the market to undertake a new bull run to all-time highs. My reasoning: the U.S. economy was gaining momentum and interest rates remained low, neither of which constituted the backdrop to the beginning of a bear market.
Although the first trading day of February started off poorly – the S&P 500 fell the most on a percentage basis since 1933 – by Friday Feb. 28th my prediction of a full recovery came true when both the large-cap S&P 500 and the small-cap Russell 2000 hit intraday and closing all-time highs. In fact, February turned out being the best period for global markets since July, with all three major asset classes (stocks, bonds, and commodities) ending up in the same month for the first time in seven months. Foreign stocks are also doing well – on Feb. 24th Great Britain’s FTSE 100 index hit a 14-year high in reaction to news that the Eurozone economic recovery is accelerating.
As small caps are wont to do, the Russell 2000 fell further during the correction (-8.4%), but – as small caps are also wont to do – the Russell came roaring back stronger. Whereas the S&P’s 6.1% decline required a 6.5% rebound to break even, Russell’s 8.4% decline required a 9.2% rebound to break even.
According to market technician Jason Goepfert, prior to the current occurrence, in each of the eight instances where the S&P 500 has dropped to a 70-day low within two weeks of hitting an all-time high, stocks were higher three months later each time and by an average of more than 8%. The rebound in 2014 has been unusually swift, recovering to hit a new high in just a little more than three weeks! Based on precedent, one can conclude two things: (1) the S&P 500 will remain above the Feb. 5th low of 1738 on May 5th (three months later); and (2) the S&P 500 should rise at least another 1.5% from its current level to match the average rebound from the low.
Other precedent from the current bull market suggests that further gains from here will be much better than a measly 1.5%. In the eight previous times that the S&P 500 dropped 5% or more from a 52-week high only to rebound to a new high, stocks were higher over the next week and month by 1% and 2%, respectively. Furthermore, stocks gained an average of 8.4% from the new bull-market high until hitting the next peak. If the S&P 500 was able to match the average 8.4% gain from this new high of 1,859, it would catapult well above 2,000.
Small caps have outperformed large caps not just for the last three consecutive weeks, but over almost every standard timeframe from one week to 10 years. See trailing returns for both SPY and IWM. This small-cap dominance is good news for further stock-market gains because it means investors are bullish and willing to take risks with their cash by buying stocks. On March 9, 2014, the U.S. stock market will celebrate the fifth birthday of the current bull market. According to Sam Stovall of Standard & Poor’s, out of the five bull markets that persisted through the fifth year, all but one survived until a sixth anniversary, averaging a tremendous return of 26%. Even better is the news for small caps, as Stovall notes:
Since 1947, the average total return for small-cap stocks usually exceeded that of the large-caps in five of six bull market years. Usually, a bull market lasts five years, and since World War II, only three bull markets completed year six, and the small-caps outscored the big stocks in two of those three.
Should the bull market continue into its sixth year, then history says (but doesn’t guarantee) that small-caps could see a late-stage surge and outpace the large-caps once again.
Small caps perform best when the economy is strengthening and there is evidence – albeit mixed – that economic growth will improve in 2014. Fourth-quarter corporate earnings were up 8.3 percent, the highest growth rate in more than two years (since Q3 2011). Sales, which are less manipulated by cost cutting and thus are a purer measure of growth, are exceeding analyst estimates by the largest margin since 2012. Q4 GDP was revised downward to 2.4% from the initial 3.2% estimate, but economists are discounting the revision because it was caused by unusual one-time events: a 16-day government shutdown and one of the coldest winters on record caused by a polar vortex and low sunspot activity.
Despite some recent slowing in U.S. economic activity, economists are hopeful that activity will pick up in the spring. At least two Federal Reserve bank presidents (Plosser of Philadelphia and Bullard of St. Louis) have voiced optimism about 2014 economic growth, predicting it will be stronger than both 2012’s 2.8% growth and 2013’s anemic 1.9% growth, rising upwards of 3%. Fed Chairman Janet Yellen’s Feb. 27th testimony before the Senate Banking Committee cheered investors because she left open the possibility of pausing further QE tapering if economic growth continues to falter in 2014. One analyst calls Janet Yellen a “structural dove” on monetary policy compared to Ben Bernanke being a “cyclical dove,” which means that QE tapering and interest-rate increases may take longer to complete under her watch.
The U.S. Congress passed a debt-ceiling extension until March 2015 (after midterm elections) and President Obama signed it. Treasury Secretary Jack Lew stated that the debt-ceiling extension combined with the earlier two-year budget deal:
will provide certainty and stability to businesses and financial markets and should add momentum to the economic growth forecasted in 2014.
Bottom line on the U.S. economy: modest economic growth with little chance of a recession near-term (at least until May) but also little chance of a super-strong recovery. According to the Congressional Budget Office (CBO), the U.S. economy will be stronger in 2013 and remain stable until 2017, after which it will struggle for the next seven years until 2024 at below-average annual growth rates thanks, in part, to job losses caused by Obamacare (pp. 117-27) and the debt burden of exploding government deficits.
James Montier at GMO is still worried about record-high corporate profit margins ready to suffer mean reversion and high asset prices (“everything is expensive right now”), but thinks that continued extreme monetary stimulus and the recently-concluded budget deal will stave off stock-market Armageddon until 2016-17. Indeed, Charles Schwab’s chief investment strategist Liz Ann Sonders says the bull market “isn’t done yet.”
When Armageddon hits, however, it won’t be pleasant. The stock market has not experienced a 10%-plus correction in more than 600 trading days and the historical average is 357 trading days. Consequently, it’s a good bet to occur sometime this year, but precisely when is impossible to predict. The recent weak economic data caused Citigroup’s Economic Surprise Index to fall below zero on February 19th for the first time in several months, and historically whenever it falls below zero the S&P 500 has a strong tendency to drop back and touch (if not go below) its 200-day moving average. With the S&P 500’s 200-day MA currently 6.7% below the index (1734.73 vs. 1859.45), the risk of at least a 6.7% correction has increased. The geopolitical standoff between the West and Russia over Ukraine may be the catalyst.
The volatility of volatility (VVIX) has risen, which suggests that investors are leaning too heavily on the bet that the S&P 500 volatility index (VIX) will continue to fall. Whenever the market drops and the VIX rises, those short VIX futures must buy-to-cover, which exacerbates the move up in the VIX. The result in greater overall stock-market volatility and 2014 is very likely to witness sharper price moves than the past few years have experienced. There is an eerie parallel between current stock-price action and the action of stocks prior to the 1929 stock-market crash. Mark Hulbert, who often dismisses these stock-chart parallels as nothing more than curve fitting, is taking this one more seriously than most because the parallel action has continued for three months after it was first discovered. Most of these curve fittings stop working immediately after being noticed.
Even if a 1929-style crash is unlikely to occur, Ukarlewitz argues that the current 2014 market looks similar to 2005, where the year also started with a down January and remained stuck in a sideways channel for many months before retesting lows later in the year. Then, as now, the CBOE total put-call ratio never rose above 1.0 during the January downswing and cyclical high-beta stocks underperformed. Prognosis: a retest of the Feb. 5th low will occur at some point in 2014. Again, Russia’s invasion of the Ukraine supports a downside retest.
I’ve discussed the presidential cycle in past OFI market briefings and the second-year of a presidential term is the worst. That said, the second year of presidential second terms is less bad than average. Based on history, the October-December period of 2013 should have been the worst quarter of Obama’s second-term. In reality, Oct.-Dec. 2013 turned out to be a very-bullish quarter so history doesn’t always repeat. Based on Hulbert’s research, although the April-June period is historically weak over all presidential second years, it actually is the second-most positive quarter during a president’s entire 16-quarter second term. In fact, the next six presidential quarters all sport positive average returns based on history (through Sep. 2015).
According to AllianceBernstein, value stocks are primed to outperform in 2014. The disparity in valuation between the top 20% of richly-priced growth stocks (as measured by price-to-book value) and the average stock is four times more expensive, which is the second-highest disparity since 1971 (the Internet bubble of the late 1990s being the highest disparity):
In the past, differences of this magnitude between the valuations of cheap and expensive stocks have heralded outsized value outperformance. Eventually, either the controversies that caused the disparity resolved themselves or cheap stocks simply became too enticing to resist.
The last time value stocks lagged expensive ones by this much in a bull market was during the late 1990s, when red-hot technology and telecom stocks left almost everything else in the dust. After that bubble popped, value stocks reclaimed the lead, scoring hefty relative gains that more than made up for previous underperformance.
Industry sectors that are currently in the cheap value camp include financials, housing-related stocks, and utilities. No wonder I have chosen two financial stocks as my Front Runner recommendations this month! In contrast, overpriced sectors include consumer cyclicals, consumer staples, medical, and technology. Even better for Roadrunner, most of the overpriced stocks are large caps, with the majority of small caps still reasonably valued:
The average market capitalization of the priciest quintile is $17.5 billion, nearly twice the size of the cheapest quintile. Half of the global market’s capitalization is now in the two most expensive quintiles.
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 12 of the 13 periods between the release of a Roadrunner monthly issue and the market close on Friday, February 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 February 28th
Start Date | S&P 500 ETF (SPY) | Russell 2000 ETF (IWM) | Advantage |
January 24th , 2013 | 27.20% | 33.42% | Small cap |
February 27th | 25.11% | 31.92% | Small cap |
March 28th | 20.77% | 25.81 % | Small cap |
April 26th | 19.57% | 27.88% | Small cap |
May 24th | 14.46% | 21.37% | Small cap |
June 28th | 17.33% | 22.47% | Small cap |
July 29th | 11.64% | 14.40% | Small cap |
September 3rd | 14.49% | 17.04% | Small cap |
October 1st | 10.60% | 9.38% | Large cap |
November 4th | 5.92% | 7.27% | Small cap |
December 2nd | 3.75% | 4.98% | Small cap |
January 6th , 2014 | 2.16% | 3.31% | Small cap |
January 30th , 2014 | 3.94% | 4.00% | Small cap |
Source: Bloomberg
Exactly half (17 out of 34) 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 11 out of 17 holdings (64.7%) outperforming and sporting an average return of 30.4%, 13.6 percentage points better than the S&P 500. In contrast, the Momentum Portfolio still hasn’t recovered from the January/February market correction and now only six of its 17 holdings (35.3%) have outperformed the S&P 500. The average return of the Momentum Portfolio is 9.3%, which trails the S&P 500 by 7.5 percentage points. Once the Momentum Portfolio reaches its maximum 20 names, I plan to sell stocks much more frequently so that only those that continue to exhibit positive momentum remain. I’m confident that more frequent trading of momentum names will allow the portfolio to outperform as intended.
Overall, 26 of 34 Roadrunner holdings (76.5%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:
Value Portfolio
(thru February 28th)
Roadrunner Stock | Start Date | Roadrunner Performance | S&P 500 ETF (SPY) | Roadrunner Outperformance? |
United Therapeutics (UTHR) | 1-24-13 | 90.75% | 27.20% | +63.55% |
Diamond Hill Investment Group (DHIL) | 1-24-13 | 73.14% | 27.20% | +45.94% |
Brocade Communications (BRCD) | 2-27-13 | 70.28% | 25.11% | +45.18% |
Gentex (GNTX) | 1-24-13 | 67.97% | 27.20% | +40.77% |
Carbo Ceramics (CRR) | 1-24-13 | 57.26% | 27.20% | +30.06% |
FutureFuel (FF) | 3-28-13 | 49.06% | 20.77% | +28.29% |
GrafTech International (GTI) | 4-26-13 | 37.39% | 19.57% | +17.82% |
U.S. Ecology (ECOL) | 9-3-13 | 28.14% | 14.49% | +13.65% |
Lydall (LDL) | 12-2-13 | 17.18% | 3.75% | +13.43% |
Stewart Information Services (STC) | 10-1-13 | 15.22% | 10.60% | +4.62% |
Fabrinet (FN) | 1-6-14 | 2.21% | 2.16% | +0.05% |
Exactech (EXAC) | 11-4-13 | 0.34% | 5.92% | -5.58% |
Stepan Co. (SCL) | 6-28-13 | 10.25% | 17.33% | -7.08% |
Weyco Group (WEYS) | 1-30-14 | -3.62% | 3.94% | -7.56% |
ManTech International (MANT) | 7-29-13 | 2.88% | 11.64% | -8.76% |
Fresh Del Monte Produce (FDP) | 5-24-13 | -3.70% | 14.46% | -18.16% |
Buckle (BKE) | 1-24-13 | 2.46% | 27.20% | -24.74% |
AVERAGES |
| 30.42% | 16.81% | 13.62% |
Momentum Portfolio
(thru February 28th)
Roadrunner Stock | Start Date | Roadrunner Performance | S&P 500 ETF (SPY) | Roadrunner Outperformance? |
G-III Apparel (GIII) | 5-24-13 | 67.04% | 14.46% | +52.58% |
HomeAway (AWAY) | 2-27-13 | 55.81% | 25.11% | +30.70% |
U.S. Physical Therapy (USPH) | 4-26-13 | 40.29% | 19.57% | +20.72% |
PriceSmart (PSMT) | 1-24-13 | 31.71% | 27.20% | +4.51% |
CBOE Holdings (CBOE) | 1-6-14 | 6.44% | 2.16% | +4.28% |
Apogee Enterprises (APOG) | 11-4-13 | 7.51% | 5.92% | +1.59% |
Western Refining (WNR) | 1-24-13 | 26.19% | 27.20% | -1.01% |
Hill-Rom Holdings (HRC) | 9-3-13 | 11.87% | 14.49% | -2.62% |
Valmont Industries (VMI) | 10-1-13 | 6.13% | 10.60% | -4.47% |
International Speedway (ISCA) | 12-2-13 | -2.43% | 3.75% | -6.18% |
Darling International (DAR) | 6-28-13 | 8.15% | 17.33% | -9.18% |
Chase Corp. (CCF) | 1-30-14 | -7.94% | 3.94% | -11.88% |
Ocwen Financial (OCN) | 1-24-13 | 2.18% | 27.20% | -25.02% |
CommVault Systems (CVLT) | 3-28-13 | -16.00% | 20.77% | -36.77% |
SolarWinds (SWI) | 1-24-13 | -15.48% | 27.20% | -42.68% |
LeapFrog Enterprises (LF) | 7-29-13 | -35.75% | 11.64% | -47.39% |
HMS Holdings (HMSY) | 1-24-13 | -27.93% | 27.20% | -55.13% |
AVERAGES |
| 9.28% | 16.81% | -7.53% |
Correlation Analysis
The Value Front Runner added this week has a low correlation with the other existing holdings. In contrast, the Momentum Front Runner doesn’t provide much diversification, but that’s understandable since it is an ETF company that does well when the stocks its funds have invested in do well. 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
WETF | |
APOG | 0.617 |
AWAY | 0.399 |
CBOE | 0.499 |
CCF | 0.436 |
CVLT | 0.467 |
DAR | 0.675 |
GIII | 0.480 |
HMSY | 0.494 |
HRC | 0.267 |
ISCA | 0.415 |
LF | 0.165 |
OCN | 0.017 |
PSMT | 0.435 |
SWI | 0.346 |
USPH | 0.570 |
VMI | 0.590 |
WNR | 0.319 |
Value Portfolio 3-Year Correlations
| WRB |
BRCD | 0.292 |
BKE | 0.215 |
CRR | 0.181 |
DHIL | 0.296 |
ECOL | 0.344 |
EXAC | 0.478 |
FDP | 0.395 |
FF | 0.363 |
FN | 0.143 |
GNTX | 0.450 |
GTI | 0.160 |
LDL | 0.321 |
MANT | 0.396 |
SCL | 0.273 |
STC | 0.172 |
UTHR | 0.414 |
WEYS | 0.251 |
As you can see above, WR Berkley provides excellent diversification benefits to the Value Portfolio, whereas WisdomTree Investments doesn’t add much diversification to the Momentum Portfolio. Based on my portfolio analysis software, the Momentum Portfolio was slightly underweight the “financial services” sector and equal-weight the “cyclical” stock type, so an asset manager like WisdomTree helped up financial exposure. Similarly, the Value Portfolio was also underweight the “financial services” sector and equal-weight the “cyclical” stock type, so a property casualty insurer like WR Berkley provided the financial flavor required to balance the other Value Portfolio holdings. Diversification by both industry sector and stock type are important investment considerations.
February marks the fourth 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.
WisdomTree is most negatively correlated with Ocwen Financial because stock investments outperform during periods of stable economic growth and low interest rates, whereas residential mortgage modification financial services outperform during troubled times for homeowners and rising interest rates. WR Berkley has a very low correlation with Fabrinet and GrafTech because Berkley’s business is focused primarily in the U.S., whereas both Fabrinet and GrafTech generate a majority of their revenues 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 Ocwen Financial and/or LeapFrog Enterprises in the Momentum Portfolio, now would be a good time to pick up some shares in them. GrafTech International in the Value Portfolio also looks like a good diversifier and is trading at a buyable price level.
Total correlation matrices are shown below:Momentum Portfolio
Value Portfolio
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