Market Outlook

Just when you thought the stock market had flashed the all-clear sign for higher highs, this week the S&P 500 suffered its worst weekly decline in more than two years (since June 2012). On Thursday July 24th, the S&P 500 and Nasdaq 100 both hit another round of new all-time highs, but it was all downhill after that . The volatility index (VIX), which on July 3rd dropped to 10.28% — its lowest level since 2007 — skyrocketed 27 percent on Thursday July 31st and closed the week up 34 percent to 17.03%.

One of the few warning signs that the market may be topping was the relative underperformance of the small-cap Russell 2000. After hitting a new all-time high on July 1st,  the Russell  2000 fell 5.1% by July 16th — the same date that the the Dow Jones industrial and transportation indices hit new all-time highs simultaneously, triggering a fresh Dow Theory “buy signal” The Russell 2000 was the tell, not Dow Theory.

Risks for the second half of 2014 focus on the end of the goldilocks economy – either (1) the economy slows down too much and causes corporate profits to decline; or (2) the economy heats up too much and causes a spike in inflation and  interest rates.

The current bull market is unique in history as the first one that has occurred in the absence of strong economic growth — bolstered almost entirely by extraordinarily-easy monetary policy.

Second-quarter GDP grew a surprisingly strong 4.0%.  According to economistDouglas Holtz-Eakin, however, 1.7 percent of the Q2 growth was inventory building which is unsustainable, so real economic growth was only 2.3 percent, leaving annualized GDP growth at less than 2 percent. Most economists forecast continued economic growth for the remaining half of 2014 because:

1. Six straight months of robust job growth, including 298,000 jobs in June and 209,000 jobs in July. First time since 1997 that employment has grown above a 200,000-jobs pace for six straight months.
2. July consumer confidence was the highest in nearly seven years.
3. ISM manufacturing index in July was the highest in more than three years (since April 2011).
4. U.S. corporate earnings growth accelerated in the second quarter to 6.7%. However, the growth is largely caused by unsustainable “buybacks and financial engineering.”
5. European corporate earnings growth is expected to be even stronger in the second quarter — up double digits.

This past week’s market sell-off was caused by a number of factors, including the Fed’s continued QE tapering, the strong second-quarter GDP report, and the largest increase in the employment cost index since 2008, which follows the script entitled “good economic news is bad news for stocks” since a stronger economy and less monetary stimulus will probably cause inflation and interest rates to rise. Dallas Federal Reserve bank president Richard Fisher didn’t allay rate concerns when he stated that the strengthening U.S. economy had caused the Fed’s timetable raising short-term rates to be “moved forward significantly” from June 2015 to early 2015. An Argentina credit default and a Portuguese bank failure stirred fears that a global financial crises may re-emerge, with geopolitical instability in the Middle East and the Ukraine further upsetting investors.

In June, Fed Chairman Janet Yellen warned of investor complacency and that junk bondswere overpriced and she followed up in July with similar overvaluation warnings for biotech and social media stocks. NYU finance professor Aswath Damodaran criticized Yellen for offering valuation advice, arguing that the Fed has no expertise in stock valuation, especially in new-era tech sectors. History has not demonstrated that the Fed is a good market timer. When Alan Greenspan labeled the stock market “irrationally exuberant” in December 1996, the market was just at the beginning of one of the strongest blow-off bull markets in history: “Investors who listened to Greenspan and got out of the market then would have been net losers even a year after the crash” in 2001. Damodoran notes that the equity risk premium (expected excess return of stocks over U.S. Treasury bonds) is higher today than in 2006, which is the exact opposite of what normally occurs at stock-market tops.

Yellen may have no valuation expertise, but her June market call on junk bonds appears prescient — July is shaping up to be the worst month for junk bonds in nearly a year and junk bonds are often a leading indicator for stocks. Goldman Sachs may be taking its cue from the junk-bond selloff and the resulting rise in interest rates, recently downgrading its view of the stock market to neutral for the next three months because “global acceleration in economic growth is largely behind us and geopolitical risks are elevated.” Of course, Goldman may simply be placing a bet on the well-known seasonal tendency of the stock market to decline between August and October.  

Besides junk bonds, another reason that interest rates are set to rise is because the Fed continues to taper its quantitative easing program, reducing monthly bond purchases to $25 billion from $35 billion at its July 30th meeting. The Fed is set to cease new bond purchases entirely by its October 29th policy meeting. The tapering that began in December 2013 has not as of yet caused interest rates to rise because the federal budget deficit shranksimultaneously, which allowed the lower demand to be met with lower new supply. But the budget deficit has stopped shrinking which will necessitate an increase in new bond issuance while the QE tapering continues. The result going forward will be a de facto tightening of interest rates, which isn’t good news for the stock market.

Yale economics professor Robert Shiller, whose 2000 book “Irrational Exuberance” called the top in the stock market bubble almost perfectly and who warned of a housing bubble in August 2005 almost right near that top, interestingly is not calling a stock-market top right now. Contrarian that he is, Shiller notes that the current investor worry about a market top is an indication that a top hasn’t yet formed:

It is not entirely clear why the alarms are sounding just now, after five years of general expansion in markets since they hit bottom in early 2009. Why aren’t people blithely expecting more years of expansion? The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.

Permanent worry-wart Jeremy Grantham isn’t sounding an alarm yet either, stating that the stock-market bubble won’t play out until the S&P 500 hits 2,250, a level that is 13.7% higher than where the index is sitting right now. The final blow-off will be driven by an unprecedented number of mergers & acquisitions, spurred on by a continuation of the Fed’s commitment to a zero interest rate policy (ZIRP) until mid-2015 and an “early cycle” economic recovery that has a couple of more years left to run. Grantham’s pessimism has not disappeared, however, it has only been delayed. Once the S&P hits 2,250 the market will become “very dangerous indeed” with a significant risk of a crash similar to 1987.

Options trader Mark Cook predicts a 20 percent market decline within 12 months based on his TICK indicator (NYSE advance/decline) turning negative and “radically” diverging from rising stock prices in the second quarter of 2014. The last two times it happened were in the first quarter of 2000 and the third quarter of 2007 — just before bear markets.

Bottom line: You could panic like this guy, but I would stay invested because the Ivy Portfolio market-timing system based on the 10-month moving average remains on a “buy” signal for stocks, bonds, and real estate (only sell is commodities). Among stocks, value stocks appear to be the only equity style that remains slightly undervalued.

Roadrunner Stocks Relative Performance

After a brief reprieve in June from relative underperformance in early 2014, small-cap stocks have started to underperform the S&P 500 yet again since hitting a new all-time high on July 1^st. Small caps have now outperformed the large-cap S&P 500 in only three of the 18 Roadrunner time periods.

New Portfolio Performance Benchmarks

I’ve decided to change the benchmark for the small-cap Value and Momentum Portfolios from the generic Russell 2000 ETF (IWM) to two narrowly-tailored small-cap indices that more accurately reflect the two portfolios’ equity styles. For the Value Portfolio, I will start using the Vanguard Small-Cap Value ETF (VBR) and for the Momentum Portfolio I will start using the PowerShares DWA SmallCap Momentum ETF (DWAS).

Since the launch of Roadrunneron January 24, 2013, the value and momentum indices have taken turns being the outperformance leader, with momentum taking the lead early on and maintaining its leadership position until April 2014,  but value has become king since April . Interestingly, both value and momentum small-cap styles outperformed the large-cap S&P 500 until April 2014:

Source: Bloomberg

The result of these performance-benchmark changes is that the Value Portfolio’s performance looks less impressive relative to VBR and the Momentum Portfolio’s performance looks more impressive relative to DWAS. Overall, the benchmark changes are neutral in terms of evaluating Roadrunner performance, but they provide more informative analysis of the separate portfolios.  

Total Return Thru August 1^st

Source: Bloomberg

Almost half (19 out of 40) of Roadrunner recommendations have outperformed their respective small-cap benchmarks and both the Value and Momentum portfolios have a positive average return. The Value Portfolio shows 8 out of 20 holdings (40%) outperforming VBR and sports an average return since inception of 19.71%, 4.86 percentage points better than VBR. In contrast, the Momentum Portfolio has 11 of its 20 holdings (55%) outperforming DWAS and sports an average return since inception of 2.37%, 4.72 percentage points better than DWAS.

Momentum stocks are very volatile and typically have further to fall once a general stock-market correction commences. Consequently, although the improved stock-selection formula for the Momentum Portfolio is working as planned, some of the recent momentum picks have gotten hit. One pleasant exception is Chinese Internet retailer Vipshop Holdings (VIPS), which continues to jump higher and higher, outperforming its benchmark by a massive 41 percent.

Performance Scorecard

Overall, 20 of 40 Roadrunner holdings (50.0%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru August 1^st)

Momentum Portfolio
(thru August 1st)

Correlation Analysis

Please note: 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 – Silicon Image (SIMG) — 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 of Silicon Image (SIMG). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, Silicon Image provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, the Value Portfolio was seriously underweight the “technology” sector (caused by the deletion of ManTech International) and overweight the “cyclical” stock type, so a semiconductor manufacturer helps diversify in regards to industry sector but hurts on stock type.

Silicon Image has a very low correlation with Sanderson Farms because high-definition video cards are located in luxury consumer devices that are bought in good economic times by rich people who can afford steak, whereas the chicken processed by Sanderson Farms sells best in more defensive economic conditions.

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

A total correlation matrix is shown below:

Value Portfolio