Market Outlook

On Friday September 19^th, the last day of September options expiration week, the S&P 500 experienced yet another all-time intraday high of 2019.26. But then . . . the week after September expiration occurred. The S&P 500 fell 1.4 percent for the week of Sep. 22^nd through Sep. 26^th, which was the worst weekly decline in almost two months. Thursday alone, stocks fell 1.6 percent, which was the worst one-day decline since July 31st.

The following week of Sep. 29^th through Oct. 3^rd saw stocks suffer an even scarier intra-week drop of 2.9 percent before recovering most of the week’s losses on Friday thanks to a strong U.S. jobs report. European stocks had it even worse, on Thursday (Oct. 2^nd) suffering their worst one-day drop in 15 months after the European Central Bank (ECB) backtracked on its quantitative-easing (QE) monetary stimulus plans in reaction to Germany’s opposition.

Besides the ECB backtrack on QE, reasons for last week’s market decline included:

Bearish seasonality may also have played a role. 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 now was a predictable time for a temporary interruption in the current bull-market rally to occur. The stock market has not suffered a 10% correction in more than two years (more than 575 trading days), which is longer than double the average length between corrections, but not unprecedented (eight periods have been even longer).

The S&P 500 fell 1.6% in September, so the month held true to historical bearishness. The small-cap Russell 2000 index performed much worse in September, down 6.2%, but should be bottoming. Over the past three years, every few months the stock market experiences a dip of a few percentage points, only to climb to new highs afterwards.

According to ukarlewitz, the extreme oversold readings in technical indicators suggests that the bearish trend is coming to an end:

The bottom-line is this: if the pattern of the past two years is still driving the market’s playbook, then a re-test of recent highs is on the way. Enough extremes in shorter term measures of market stress have been reached in the past two weeks to mark a washout.

But price declines may continue for another one to two weeks before reversing:

The key missing element is time. The down cycles have become increasingly short. This one was less than 2 weeks. One reason to expect a larger sell off is that that has been a pattern during mid term election years. As an example, in the past four mid-term years, SPX has sold off by 8%, 16%, 20% and 34%; from its high to its eventual low has taken 2-6 months.  

In the past six months, the largest correction was 4.6% and took just 10 days. Another reason is that SPX will have traded above its lower Bollinger band for 22 months by the middle of this coming week. That is four months longer than even the powerful 1995-96 period.

The S&P 500 Volatility Index (VIX) is also flashing a bearish signal. As one market strategist noted:

Right now the VIX high for the year was in February: 21.44 on February 3. If you go back 25 years to the beginning of the VIX, it’s never topped out in February. October is typically a very high volatility month.

I do expect that we get a pullback that rolls through the first half of October. It’s seasonally right. We’ve had a lot of complacency.

A few other warning signs:

• Junk bond yields are rising, which signals an increase in risk aversion that historically has caused a stock-market correction.
  
  
• Small-cap stocks have severely underperformed large-cap stocks and this performance divergence usually resolves in favor of large caps following small caps down – on average by 18%.
  
  
• Foreign U.S.-dollar denominated debt in Asian emerging markets has soared from $300 billion to $2.5 trillion over the last decade and now equals 15% of the region’s GDP, which is higher than the 10% ratio that existed prior to the 1997 Asian financial crisis. A rising U.S. dollar makes these debts much more difficult to repay in local Asian currency.
  
  
• Structural illiquidity in the global bond market could cause interest rates to skyrocket if institutional investors decide it’s time to reduce their fixed-income allocation.

Joe Terranova of CNBC is calling for a 500-point down day in the Dow Jones Industrials sometime in the next month. Sounds scary, but that would amount to only a 3% decline and bring the Dow back to the price levels it traded at back in early August. Steve Miller of TastyTrade.com forecasts a similar 50-point (2.5%) decline in the S&P 500 over the next couple of weeks. Even the Washington Post is getting worried, advising readers to have a stock-market “exit strategy.” A large option trader recently sold an October put spread on the Nasdaq-100 index at the 3,625 put strike, which is a $101 million bet that the Nasdaq won’t fall more than 9% by options expiration on October 17^th. Not exactly a bullish bet, but definitely a bet that any market decline will be contained.

Longer term, however, risk is high for up to a 50% drop given that net free credit balances in margin accounts are at an all-time low, meaning that any stock-market decline will become magnified because there is no cash to prevent margin calls and selling stocks will be the only method for satisfying margin calls.

If there is market weakness over the next month or so, the odds of a market rally into year-end are very good because U.S. economic news is positive with no recession in sight. Positive economic news in the U.S. includes:

• September non-farm jobs increased 248,000 which beat analyst expectations and the unemployment rate fell to 5.9%, the lowest it has been in more than six years (since July 2008). On the other hand, the labor participation rate hit a 36-year low , the jobs growth included  the return of 20,000 striking workers, and average hourly earnings were stagnant.
  
  
• Second-quarter U.S. GDP growth revised up to 4.6% from a revised 4.2%, which itself was higher than the initial 4.0% estimate. The 4.6% figure marks the strongest economic growth in almost three years.
  
  
• U.S. dollar index rose to its highest level in more than four years.
  
  
• New home sales in August surged to more than a 6-year high.

Three Federal Reserve bank presidents have warned against raising rates too quickly, stating that the strength in the U.S. dollar would lower inflationary pressures through lower import prices. Economic weakness in China, Japan, and the Eurozone will all continue to prop up the U.S. dollar and limit U.S. economic growth, with Chinese weakness the biggest negative  influence.

The U.S. is the strongest world economy, but its growth potential is limited as long as the rest of the world is mired in stagnation and retraction. Indeed, on Wednesday October 7th the IMF cut its global economic growth forecast, which initially caused the S&P 500 to plunge, only to reverse course and spike higher after minutes of the Federal Reserve’s October meeting were released showing member concern about weakening economic activity and a consensus not to raise rates until the economy was stronger. On Thursday October 8th the stock market plunged by the most since April after investors realized that the Fed minutes didn’t really say anything new. Volatility and wild swings are the new reality.

Rising U.S. interest rates also have a limited runway given that Eurozone bond yields are the lowest they have been since the 15^th century. Ironically, European stocks may a better investment than U.S. stocks because things are so bad over there that investors have overreacted and dumped European stocks en masse, resulting in super-cheap valuations.

At the Federal Reserve Open Market Committee Meeting on September 17, the policy statement retained the “considerable time” language concerning how long after the bond-buying quantitative easing (QE) stops in late October will the Fed wait before raising short-term interest rates. There had been a lot of speculation that this language would be removed, so its retention was a pleasant surprise for investors and stocks rallied on the news. But the latest “dot plot” of interest-rate projections by Federal Reserve open-market members was higher than in June, signifying a growing hawkishness to raise rates in the future. An initial rate hike would unsettle markets in the short term, but stocks actually rise in the intermediate term if interest-rate hikes are mild because economic growth and corporate profits are also rising.

The fourth quarter of midterm election years is historically very strong. Even better, when the historically- weak May through October period acts against its nature and is a bullish period, the odds of this bullishness continuing in the following three months of November through January is over 90% and with an average positive return of more than 5%. Furthermore, a Dow Theory buy signal was triggered in late-September that suggests stock prices will rise further, perhaps by 20%. Value investors should also take heart in knowing that the greatest value investor of them all, Warren Buffett, took advantage of the recent market downdraft to buy stocks, telling CNBC: “The more the market goes down, the more I like to buy.”

Bottom line: For now, I would stay invested because the Ivy Portfolio market-timing system based on the 10-month moving average remains on a “buy” signal for U.S. stocks, bonds, and real estate (sells are foreign stocks and commodities).

Roadrunner Stocks Relative Performance

As mentioned above, September’s 6.2% decline in small-cap stocks was brutal and wiped out all small-cap outperformance since the launch of Roadrunner in January 2013. In fact, the large-cap S&P 500 has now outperformed the small-cap Russell 2000 in all 20 Roadrunner time periods. Sooner rather than later, reversion to the mean in the relative performance of large and small stock indices will result in small caps roaring back, but for right now . . . ouch.

So far in 2014, U.S. small caps have underperformed large caps by -4% to +7.5% — an 11.5% gap.

There would be no need for asset allocation if you could predict which asset class was going to outperform in the upcoming quarter. The key to successful investing is diversification and maintaining fixed allocation percentages to large caps, small and mid caps, foreign equities, real estate, commodities, bonds, etc.

Because the performance of different asset classes vary over a certain period of time, to maintain fixed allocation percentages requires rebalancing, where you buy more of the underperforming asset classes and sell a portion of the outperforming asset classes. Rebalancing has proven to increase annualized returns thanks to the concept of “reversion to the mean.” All equity asset classes have very similar long-term annualized returns, so if you buy an equity asset class after a period of underperformance, the equity asset class is more likely to “bounce back up” to its long-term mean in the future and if you sell an equity asset class after a period of outperformance, the equity asset class is likely to “fall back down” to its long-term mean. Rebalancing is a form of value investing, buying what is cheap and selling what is expensive.

Since U.S. small caps have underperformed so far in 2014, rebalancing requires that you INCREASE your U.S. small-cap investments later this fall to capture the mean-reversion bounce-back and benefit from the long-term outperformance of small-cap stocks (more than 2% annual return advantage over large caps). According to Jeffrey Hirsch of the Stock Trader’s Almanac, positive seasonality for small-cap stocks is just around the corner:

In a typical year the smaller fry stay on the sidelines while the big boys are on the field. Then, around late November, small stocks begin to wake up and in mid-December, they take off. 

Beyond reversion to the mean and seasonality, small caps should also outperform in the future because of the likelihood of rising interest rates. History shows that small caps outperform large caps in a rising interest-rate environment. In addition, the business of most small caps is focused on the domestic economy, with little exposure to foreign economies and currency exchange rates. With the U.S. economy the strongest in the world and both Europe and Asia weak, U.S. small caps should perform better in the future than large-cap multinationals whose exports suffer from weak foreign demand, made worse by a strengthening U.S. dollar.

Total Return Thru October 3^rd  

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 double-digit average return. The Value Portfolio shows 9 out of 20 holdings (45%) outperforming VBR and sports an average return since inception of 19.65%, 6.80 percentage points better than VBR. In contrast, the Momentum Portfolio has 13 of its 20 holdings (65%) outperforming DWAS and sports an average return since inception of 10.85%, 13.25 percentage points better than DWAS.

Performance Scorecard

Overall, 21 of 40 Roadrunner holdings (52.5%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru October 3^rd)

Momentum Portfolio
(thru October 3^rd)

Correlation Analysis

Please note: The goal of the 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 – Vishay Precision Group (VPG) — 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 Vishay Precision Group (VPG). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, Vishay Precision Group provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, the Value Portfolio was seriously underweight both the “technology” sector (caused by the previous deletion of Fabrinet) and seriously underweight the “slow growth” stock type, so a scientific & technical instrument company helps diversify in regards to both industry sector and stock type.

Value Portfolio Composition After Graftech International is Sold

Source: Morningstar

Vishay Precision Group has a very low correlation with both U.S. Ecology (ECOL) and United Therapeutics (UTHR) because a technical instrument company does well when environmental regulations are lenient and don’t impede or increase the costs of manufacturing, whereas an environmental cleanup company gets more work when environmental regulations are more stringent.  As for United Therapeutics, there is simply no relationship between the manufacture of technical instruments and the treatment of pulmonary arterial hypertension.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own Weyco Group (WEYS) or Gulf Island Fabrication (GIFI) 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