Market Outlook

The Dow Jones Industrials closed last Wednesday (April 30^th) at an all-time closing high and the S&P 500 closed last week within 10 points of its all-time closing high. It’s hard to be bearish with such positive price action by the major indices. Since the Dow Jones Transports had already closed at a new all-time high on April 23^rd, a Dow Theory buy signal was triggered when the Industrials followed suit on April 30^th. According to a Dow Theory technician: “Traders should abandon the short side of the market and trade the uptrend.”

Although the S&P 500 has yet to exceed its April 2^nd all-time closing high, the large-cap index closed April above its 10-month moving average, as did indices on European stocks, intermediate-term government bonds, REITs, and commodities. According to the Ivy Portfolio market-timing system, all five of these asset classes are currently flashing “fully invested” trading signals. 

That said, I can’t help remembering that early May marked the top of the stock market in 2011 before it suffered a 19.9% correction into October, so technical buy signals around this time of year can be false. The 2014 calendar year is a mid-term election year, which is typically the weakest of the four-year presidential cycle. According to ukarlewitz, there is some technical damage under the index surface, with market breadth deteriorating similar to what occurred near market tops in July 2011 and April 2012:

Risk/reward is skewed to the downside. In the past 10 years, there has been a sizable drop in equities during the May to July period every year except one. The sole exception came after SPX had already dropped close to 8% coming into May. When May starts at a high, like this year, there has been a drop every year.

Bear in mind that that the main trend in equities is lower until the market experiences a washout. The last four mid-term cycle lows occurred in July 2010, July 2006, October 2002 and October 1998. In each case they created the low price for the year.

Of course, mid-term election years do not always bottom in the second half of the calendar year. The market low in both 1986 and 1994 occurred prior to May 1^st.

On the economic front, first-quarter 2014 GDP growth of only 0.1% annualized marked a sharp deceleration from the 2.6% growth in the fourth quarter of 2013 and was much lower than the 1.2% growth expected by economists. The weak GDP number was discounted by many as a result of an unusually cold winter, but bond investors are worried, bidding up bond prices (lowering yields) to recession-like levels. The Federal Reserve didn’t let the weak GDP number dissuade it from continuing to taper its quantitative easing program. On April 30^th, the Fed lowered its monthly bond buying by an additional $10 billion, so that going forward monthly bond buying of $45 billion will be only a bit more than half its maximum size of $85 billion. The Fed policy statement was optimistic about the economy, noting:

Growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement.

The Fed’s optimism on the economy was arguably vindicated on Friday, May 2^nd when the April jobs report came in much stronger than expected, with the 288,000 new jobs created marking the largest gain since January 2012. The unemployment rate fell to 6.3%, the lowest level in 5 and ½ years (since September 2008).   Personal spending in March jumped the most since August 2009 and the Conference Board’s Leading Economic Index (LEI) has risen strongly for three consecutive months.

All in all, although the stock market may suffer some short-term weakness over the next few months, the bull market is probably not over. Jeremy Grantham of investment firm GMO recently wrote in his first-quarter market letter that there is a greater than 50% chance that the bull market will not end for “at least” another year or two and actually predicted another 20% in upside:

1)      That this year should continue to be difficult with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.

2)      But after October 1, the market is likely to be strong, especially through April and by then or in the  following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.

3)      And then around the 2016 election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed  can dig up.

Roadrunner Stocks Relative Performance

The selloff in small-cap stocks continued in April 2014, with the small-cap Russell 2000 losing -4.49% compared to only -0.65% for the large-cap S&P 500. April’s small-cap decline had a ripple effect that caused small caps to underperform large caps on a longer-term basis – all the way since the Roadrunner service launched on January 24, 2013. Through February 2014, the Russell 2000 had outperformed the S&P 500 in 12 out of 13 time periods (92.3%) between the release of a Roadrunner monthly issue and the release of the latest monthly issue. March 2014 was the killer, with the Russell 2000’s lead over large caps had diminished to 8 out of 14 time periods (57.1%). April’s small-cap slide just added fuel to fire — through April 2014, the Russell 2000 lost its Roadrunner lead over large caps altogether, and now has outperformed the S&P 500 in only one of 15 Roadrunner time periods (6.7%).

The small-cap selloff in March and April has not been caused by small-cap business fundamentals; rather, it is the direct result of hedge-fund selling.  Coming into 2014, hedge funds were overweight small caps and were in many cases doubling down on momentum bets with borrowed money. Unfounded fears that the U.S. economy was slowing down because of delayed consumer spending based on temporary winter weather caused many hedge funds to get “cold feet” and dump the stocks most sensitive to economic growth – i.e., momentum growth stocks and small caps. Unwinding of levered positions by hedge funds has disproportionately hurt small caps because they generally have lower trading volumes and their stock prices can get pushed down easier by selling pressure. Hedge funds have underperformed the S&P 500 over the past five years, so their selling is not a sign of market prescience but simply panic. Similarly, news that hedge funds have gone short small caps by the largest amount since 2004 is probably a good contrary indicator. Given the history of hedge-fund underperformance, since they were wrong to buy small caps on margin at the beginning of 2014, they are probably also wrong to go short small caps in April after the recent selloff. As one London-based analyst recently put it:

Small caps were disproportionately punished in April due to disappointing economic data and will rebound as lending conditions and growth improve. Longer term, if you look at their fundamentals, aside from valuations, it suggests that small caps should continue to outperform.

Total Return Thru May 1^st

Source: Bloomberg

Almost half (17 out of 38) of Roadrunner recommendations have outperformed the Russell 2000 small-cap index and both the Value and Momentum portfolios have a positive average return. The Value Portfolio continues to be the real star, with 12 out of 19 holdings (63.2%) outperforming the Russell 2000 and sporting an average return since inception of 31.74%, 18.40 percentage points better than the Russell 2000. In contrast, the Momentum Portfolio is still suffering from the March/April market correction and now only five of its 19 holdings (26.3%) have outperformed the Russell 2000.

Changing the Momentum Portfolio for the Better

The average return of the Momentum Portfolio since inception is 0.83%, which trails the Russell 2000 by 12.51 percentage points. This underperformance is unacceptable, so I will be initiating changes to the Momentum Portfolio in an effort to improve performance.

With this month’s new momentum stock recommendation, the Momentum Portfolio has now reached its maximum 20 names, so in future Roadrunner monthly issues I will replace stocks in the Momentum Portfolio every month so that only those that continue to exhibit positive momentum remain. I am also instituting new stock-selection criteria for momentum recommendations based almost exclusively on a stock’s price momentum over the preceding 10-month period between 12 months ago and 3 months ago. Academic research has found that short-term price momentum over the most-recent two-month period is actually a contrary indicator and should be ignored or even penalized when ranking the future performance potential of momentum stocks.

Bottom line: I’m confident that stock selection based on a more quantitative ranking of price momentum, combined with more frequent trading of momentum names, will allow the Momentum Portfolio to outperform the Russell 2000 as intended and provide valuable diversification to the overall Roadrunner stock universe.

Performance Scorecard

Overall, 24 of 38 Roadrunner holdings (63.2%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru May 1^st)

Momentum Portfolio
(thru May 1^st)

Correlation Analysis

Please note: As I transition the Momentum Portfolio to a new stock-selection quantitative formula over the next few months, portfolio-based correlations no longer apply to the Momentum Portfolio and I am discontinuing it. Since portfolio correlations are only important if you want to smooth out returns by intentionally including long-term stock holdings that perform differently from each other at a certain point in time (i.e., some zigging while others are zagging), a correlation analysis is irrelevant to my modified conception of a Momentum Portfolio (short-term focus). The goal of the new Momentum Portfolio will be that all short-term stock holdings move in the same positive direction at the same time. Consequently, going forward, I will only provide correlation data for the Value Portfolio (long-term focus).

The Value Portfolio Front Runner this month provides low correlation with the other existing holdings. Using a stock correlation calculator, I created a correlation matrix for the Roadrunner Value Portfolio, including this month’s recommendation. The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, AGCO provides good diversification benefits to the Value Portfolio. Based on my portfolio analysis software, the Value Portfolio was underweight the “industrial” sector and equal weight the “cyclical” stock type, so an agricultural equipment company complements the other Value Portfolio holdings with regard to sector and is neutral on stock type. Diversification by industry sector is an important investment consideration.

AGCO has a negative correlation with United Therapeutics because 74% of AGCO’s agricultural equipment is sold outside of North America to help feed youthful foreign populations, whereas United Therapeutics gets more than 90% of its revenue from treating older women in the United States.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own Exactech in the Value Portfolio, now would be a good time to pick up some shares as it is trading at a buyable price level.

A total correlation matrix is shown below:

Value Portfolio