Market Outlook

Another week, another all-time closing high for the S&P 500. With the market close on Friday, September 5^th, the S&P 500 has risen for five consecutive weeks – the longest win streak of 2014. For the year, the S&P has risen 9.9%, including 3.8% in August alone, which was the best monthly gain since February and the best-performing August in 14 years (since 2000). All three Dow Jones stock indexes (industrials, transports, and utilities) are moving higher together, which is a bullish sign.

Fears of wage-cost inflation and geopolitical turmoil in Ukraine and Gaza that caused a small stock-market correction in late July/early August — when stocks quickly dropped 4.3% over a two-week period — have evaporated, with stocks quickly reversing course back up in bungee-jump fashion, hitting new all-time highs. Ceasefires in both Ukraine and Gaza have reduced concern, as well as recent economic data indicating a “Goldilocks” environment that is not too hot and not too cold, which should simultaneously promote corporate earnings growth and prevent the Federal Reserve from raising short-term interest rates.

Positive economic news in the U.S. includes:

• Second-quarter U.S. GDP growth revised up to 4.2% from the initial 4.0% estimate.
• ISM services index in July rose to 58.7, the highest level since December 2005.
• Consumer confidence in August rose, with its index of current economic conditions hitting its highest level since July 2007.
• Purchases of durable goods (e.g., airplanes, cars, and heavy machinery designed to last at least three years) rose 22.6% in July over June, the largest one-month sequential percentage gain on record (since 1992).
• U.S. auto sales in August reached an annual pace of 17.5 million vehicles, the highest since January 2006.

All of this economic strength has caused the Economic Cycle Research Institute’s (ECRI) Future Inflation Gauge to hit a 71-month high reading, which is somewhat worrisome. One person who doesn’t appear worried is Fed Chairman Janet Yellen, who stated in her August 22^nd Jackson Hole speech:

Underutilization of labor resources still remains significant. Given this assessment, it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase program ends, especially if projected inflation continues to run below the 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

This labor “slack,” however, could be a mirage and caused by “pent-up wage deflation” where employers kept wages abnormally high during the recession to maintain employee morale, so that the wage level during the economic recovery is now normal and doesn’t need to be raised. If this is the case, the current lack of wage increases should not be construed as evidence of labor slack, but simply a lull in wage increases that could explode higher if the economic recovery continues. As Yellen herself warned:

If downward nominal wage rigidities created a stock of pent-up wage deflation during the economic downturn, observed wage and price pressures associated with a given amount of slack or pace of reduction in slack might be unusually low for a time. If so, the first clear signs of inflation pressure could come later than usual in the progression toward maximum employment.

As a result, maintaining a high degree of monetary policy accommodation until inflation pressures emerge could, in this case, unduly delay the removal of accommodation, necessitating an abrupt and potentially disruptive tightening of policy later on.

(emphasis added).

ECRI says that Yellen’s focus on real wage growth as a sign of increasing inflationary pressures is misplaced because rising inflation can occur without real wage growth. In fact, rising inflation can neutralize nominal wage growth and cause real wage growth to remain stagnant – precisely because inflation is occurring! By the time the Fed realizes that the lack of real wage growth has nothing to do with inflation, the genie will be out of the bottle and the amount of monetary tightening necessary to tame the inflation beast could be draconian and painful. Philadelphia Fed Bank President Charles Plosser has voiced similar concerns to ECRI on the riskiness of judging inflation by wages. Needless to say, the stock market would not react well to an abrupt monetary tightening and a severe market correction would become a certainty.

The stock market rally continued last week precisely because the August jobs report was weaker than expected, with only 142,000 new jobs – less than the 225,000 expected. In addition, the job numbers for June and July were revised down by 28,000. In this case, bad news for the economy is good news for the stock market because it signifies less chance that wage inflation will ignite anytime soon and force the Fed’s hand to raise short-term rates.

Also helping to keep U.S. interest rates low is the much-weaker economic news elsewhere in the world:

1. GDP in both Germany and Italy contracted by 0.2% in the second quarter.
2. China loan growth slowed “dramatically” in July
3. GDP in Japan contracted by a severe 6.8% in the second quarter, as the monetary and fiscal stimulus program known as “Abenomics” appears doomed to fail in its quest to extract Japan from its massive debt burden.
4. Baltic Dry Index of shipping rates dropped to an 18-month low in July and was the lowest July index level in 28 years (since 1986).

On September 4^th, the European Central Bank (ECB) became so worried about a resumption of recession and deflation that it surprised analysts by cutting interest rates (51 out of 57 economists surveyed had predicted no rate cut) after ECB President Mario Draghi had stated previously that no further rate cuts were possible after June’s rate cut. In addition, the ECB initiated a quantitative easing program that will purchase asset-backed securities (ABS) and “covered” bonds (general obligation debt with ABS collateral) from European banks in an amount that could total $650 million over three years. The ECB stopped short of authorizing the purchase of government bonds, but most analysts now expect such an expansion of the European QE program to be inevitable. Capital inflows into U.S. debt markets to escape the low and declining rates available in the European Union will put downward pressure on U.S. rates despite the improving economic news in the U.S. In addition, declining U.S. productivity is causing economists to downgrade the long-term growth potential of the U.S. economy.

The combination of strengthening U.S. economic growth and continued low interest rates caused by economic weakness elsewhere in the world is a powerful combination for continued U.S. stock-market gains. In fact, Morgan Stanley recently predicted that the S&P 500 could rise an additional 50% to 3,000 over the next five years (by 2020)! Over the intermediate term, positive momentum should continue to propel the S&P 500 higher. Between August 8^th and September 3^rd, the S&P 500 closed above its 5-day moving average for 18 consecutive trading days, which is very rare and historically bullish.

That said, there typically is some autumn stock-market weakness in mid-term election years and historically the worst-performing month of the year is September, so a temporary interruption to the current bull-market rally remains a strong possibility in the weeks immediately ahead. The stock market has not suffered a 10% correction in more than two years (more than 563 trading days), which is longer than double the average length between corrections, but not unprecedented (eight periods have been even longer).

In fact, since 1928 whenever stocks have risen by more than 3% in August and also made a new all-time high, September was up just one time out of nine occurrences. More recently, six of the past seven times stocks rose more than 3% in August, September turned out to be a losing month for stocks (but the most recent example in 2009 was positive):

One concrete catalyst for a stock decline in September could be the Federal Reserve Open Market Committee Meeting on September 16-17, where the policy statement could see a significant change in language towards faster interest-rate hikes. After September, however, the market is likely to continue rising because positive momentum has been so great until “something” gives, either higher interest rates or lower corporate profits. In other words, that “something” may be unknown but it will be a negative event, whatever it turns out to be. Risk is high for a 50% drop given that the current long-term valuation of the stock market is more expensive than at any other time in market history except 1929 and 2000. But, as Yale economics professor Robert Shiller recently noted, statistically speaking there have not been enough data points at these high valuation levels to conclude definitively that another crash is likely.

In conclusion, people have worried about a market correction for years, but any declines have been short-lived and the market has kept climbing. Anyone that cashed out prematurely has missed out on enormous capital gains. Although caution and prudence are always warranted, investing is a marathon, not a sprint, and long-term investors should remain invested at all times because market timing is impossible.

Bottom line: 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).

Roadrunner Stocks Relative Performance

Small caps have not recovered as quickly as large caps from the April/May stock swoon, but most recently since the early-August market correction, small-cap stocks have started to outperform the S&P 500 yet again – only this time its small-cap momentum leading the way! Small caps have now outperformed the large-cap S&P 500 a majority of the time, in 10 of the 19 Roadrunner time periods.  

Total Return Thru September 2^nd

Source: Bloomberg

More than half (22 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 26.14%, 5.48 percentage points better than VBR. In contrast, the Momentum Portfolio has 14 of its 20 holdings (55%) outperforming DWAS and sports an average return since inception of 17.80%, 11.98 percentage points better than DWAS.

The improved stock-selection formula for the Momentum Portfolio really showed its tremendous effectiveness last month, with three of the four new Momentum recommendations scoring double-digit gains in less than a month: BitAuto Holdings (43.15%), Marcus & Millichap (27.99%), and EQT Midstream (16.16%).

Performance Scorecard

Overall, 30 of 40 Roadrunner holdings (75.0%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru September 2^nd)

Momentum Portfolio
(thru September 2^nd)

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, I only provide correlation data for the Value Portfolio (long-term focus).

The Value Portfolio Front Runner this month – RPC Inc. (RES) — 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 RPC Inc. (RES). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, RPC Inc. provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, the Value Portfolio was seriously underweight both the “energy” sector (caused by the previous deletion of Carbo Ceramics and the classification of its replacement, Gulf Island Fabrication (GIFI) as “industrial”) and seriously underweight the “hard asset” stock type, so an energy service company that is classified as both “energy” and “hard asset” helps diversify in regards to both industry sector and stock type.

Value Portfolio Composition After Fabrinet is Sold

 Source: Morningstar

RPC Inc. has a very low correlation with U.S. Ecology (ECOL) because energy service firms engaged in fracking activity do well when environmental regulations are lenient and don’t impede drilling efforts, whereas an environmental cleanup company gets more work when environmental regulations are more stringent.  

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own Sanderson Farms (SAFM) or GrafTech International (GTI) in the Value Portfolio, now would be a good time to pick up some shares as both are currently trading at a buyable price level.

A total correlation matrix is shown below:

Value Portfolio