Market Outlook

The worst recent stock-market prediction goes to TV pundit and newsletter editor Dennis Gartman, who panicked during the market dip in mid-October and recommended selling everything because allegedly a new bear market was starting. Second place goes to Nick Colas, chief market strategist at ConvergEx, who said that a V-shaped market bottom was “unlikely.”

I don’t mean to beat up on these guys, because market timing is difficult for anyone, but they were dead wrong, and anyone who sold stocks because of them missed out on a huge rally. In fact, the stock market has experienced a dramatic V-shaped market bottom and roared back in a breathtaking and relentless upward climb to new all-time highs. From September 19^th to October 15^th, the S&P 500 dropped 9.8 percent on an intraday basis – not enough to qualify as a 10-percent correction, but the closest thing to one in three years (since October 2011).  Reasons for the sharp but short-lived decline include investor fears that the Federal Reserve would end its bond-buying quantitative easing (QE) program at its October 29^th meeting (it did) at the same time that the U.S. economy was slowing down, as evidenced by September economic data concerning negative retail sales (first month-over-month decline since January) and negative producer prices (first month-over-month decline in 13 months).

Stocks began to rally on October 17^th with strong economic reports in housing and consumer confidence, combined with strong earnings from economic-bellwether industrial stocks General Electric (GE) and Honeywell (HON). The rally party continued on October 21^st when the major stock indices experienced their best one-day gains of the year, thanks to strong Apple earnings and news that the European Central Bank (ECB) initiated a new round of bond-buying monetary stimulus. Ten days later on October 31^st, the Bank of Japan (BOJ) followed suit with its own surprise announcement of additional quantitative easing.

Overall, third-quarter earnings from S&P 500 companies was very strong, with 77 percent beating analyst estimates, the highest percentage of any quarter since 2010. However, the magnitude of the Q3 beats was relatively low, and Q4 earnings estimates are coming down fast, which suggests that Q3 earnings growth could be a peak and that future quarters will be less strong. One reason earnings growth may weaken is the tremendous strength in the U.S. dollar, which hit a 7-year high against the Japanese Yen. A strong dollar hurts the foreign-exchange earnings of U.S. multi-national corporations.  

On October 29^th, in between the Oct. 21^st ECB and October 31^st BOJ announcements on increased monetary stimulus, the U.S. Federal Reserve issued its policy statement announcing the end of its QE program. Important to remember is that the expansion in the Fed’s balance sheet from $700 million before QE started to $4.5 trillion today will remain at its elevated levels for the foreseeable future (maturing bonds will be reinvested), so the end of new bond buying does not end accumulated QE stimulus at all. Changes to the October policy statement focused on recognition of stronger economic conditions, including “solid job gains and a lower unemployment rate” and “substantial improvement in the outlook for the labor market.” In addition, the Fed kept the “considerable time” phrase intact regarding the continuation of its zero-interest-rate-policy and emphasized that a decision to raise short-term rates would be dependent on future economic data.

The October jobs report of 214,000 new jobs marked the ninth-consecutive month of more than 200,000 jobs – the longest streak since 1995. Although the headline number was below the 231,000 forecast, job gains in the prior two months were revised up by 31,000 collectively and the unemployment rate fell to 5.8 percent, a six-year low. Overall, the October jobs report was a sign of continued strength.

From a fundamental perspective, the stock market rally since the October 15^th low is based on the fact that U.S economic strength is continuing to trend higher while interest rates are likely to remain low because of the economic weakness and monetary easing occurring in Europe and Japan. The current economic situation could be the best of both worlds for future stock-market gains – growing corporate earnings combined with low interest rates. Financial blogger Barry Ritholtz believes that the 13-year secular bear market from 2000-13 is now over and in 2014 we have entered a decade-long secular bull market. It’s difficult for me to consider the huge bull-market recovery from March 2009 through 2013 to be part of a bear market, but Ritholtz defines a new bull market as requiring the indices to hit new all-time highs. In any event, the Republican takeover of the U.S. Senate bodes well for stock-market performance over the next two years because whenever a Democrat is President and Republicans control both houses of Congress, the stock market has risen on average by 15.1 percent per year — more than any other political combination.

Technically, the price momentum in the stock market is so strong that it is virtually unprecedented and suggests a continued move up. As Urban Carmel points out:

After dropping to a 6 month low in mid-October, SPX has since risen more than 10% in two weeks. The bounce has been at a torrid pace. The S&P 500 has traded more than 0.5% above its 5-dma for 10 days in a row in the past two weeks. In the prior 75 years, this has only happened twice before, both at bear market lows (1982 and 2002). In other words, a rare rip higher, that has only happened after multi-year bear markets, just occurred after a mild, four week drop. It’s incredible and completely unexpected.

Strong momentum does not stop on a dime: “This type of strength usually does not mark an uptrend high; the momentum normally carries the market higher.” But even an uptrend destined to continue can pause and there are short-term technical signs that the current market is overextended and likely to stagnant or fall:

• The percentage of American Association of Individual investors (AAII) that are bearish is only 15%, a 9-year low. Whenever the AAII bull ratio (bull/bear) is above 50% one week after the S&P 500 hits a 6-month low (like now), the median return of the market over the next 3, 6, and 9 months has been negative.
• Retail equity investments in bullish Rydex funds is at a 9-year high
• Nine times over the past 20 years the S&P 500 has experienced a series of 12 daily “higher lows” in a row (like now). Seven of those times stocks struggled and lost ground over the next several weeks.
• McClellan Oscillator closed above 80% twice in the same trading week. Historically, when this occurs, the S&P 500 subsequently falls by a minimum of 4% (median of 7%, average of 11%).
• Between September 19^th and November 7^th, defensive industry sectors of utilities and consumer staples have been market leaders. Such defensive leadership historically occurs during periods of economic slowdown and risk aversion, which is not bullish for future market gains. The economic forecasting firm Jerome Levy (which predicted the 1929 crash) estimates that there is a 65 percent probability of a global recession in 2015.
• The percentage of stocks at new 52-week highs has continuously narrowed for 18 months. According to Lowry Research:

“The U.S. Market appears to be in the latter stages of an old bull market extending back to the March 2009 low. One of the first signs of an old bull market occurs when the % of stocks rising to New 52-week highs begins to diminish, showing that fewer stocks are participating in the bull market. In the U.S., this warning sign began to develop in May 2013, and has persisted to the present time since hitting a peak in May 2013.

The 88 year history of the Lowry Analysis shows that erosions of this type, lasting 6 months or longer, have only been found in old bull markets – much like yellow and red leaves are found only in Autumn. Further, we can find no cases in the past 88 years in which a 6 month or longer contraction in New Highs ever reversed itself and set the stage for additional years of  bull market.”

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 I mentioned in last month’s September Roadrunner issue, rebalancing one’s portfolio by adding more small caps made sense because their underperformance had made them cheaper and a better value. Furthermore, reversion to the mean suggested a bounce back. Sure enough, cued by my comments, the month of October saw small-cap stocks finally awaken from their underperformance malaise and sprint ahead of the large-cap S&P 500 by more than 400 basis points:

Source: Bloomberg

In fact, one indication that the mid-October stock-market correction was coming to an end was the fact that the small-cap Russell 2000 started to rise on October 14^th — two days before the S&P 500 bottomed on October 16^th. Small caps have a long way to go to catch up, however, with the S&P 500 still having outperformed the Russell 2000 in 20 out of the 21 Roadrunner time periods. Small caps should continue their incipient October outperformance in future months, however, based on historical positive seasonality.
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Comparative Index Total Return Thru November 6^th   

Source: Bloomberg

More than half (23 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 11 out of 20 holdings (55%) outperforming VBR and sports an average return since inception of 29.22%, 11.15 percentage points better than VBR. In contrast, the Momentum Portfolio has 12 of its 20 holdings (60%) outperforming DWAS and sports an average return since inception of 16.10%, 12.96 percentage points better than DWAS.

Performance Scorecard

Overall, 27 of 40 Roadrunner holdings (67.5%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru November 6^th)

Momentum Portfolio
(thru November 6^th)

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 – Alliance Fiber Optic Products (AFOP) — 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 Alliance Fiber Optic Products (AFOP). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, Alliance Fiber Optic Products provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting consumer cyclical Buckle, the Value Portfolio was slightly underweight the “technology” sector and slightly overweight the “cyclical” stock type, so a communications equipment company helps diversify in regards to industry sector but not stock type. With more than half of the company’s revenues coming from North America and the U.S. economy getting stronger, I’m okay with additional cyclical exposure.

Value Portfolio Composition After Buckle is Sold
But Before Alliance Fiber Optic Products is Added 

Source: Morningstar

Alliance Fiber Optic Products has a very low correlation with Exactech (EXAC) because people who need joint replacements are an older demographic and less likely to need the high-speed Internet for gaming and watching movies that younger people crave.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own medical-device company Exactech (EXAC) or poultry-processor Sanderson Farms (SAFM) 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