Market Outlook

2014 marked the sixth consecutive positive year for U.S. stocks and the third consecutive year that the S&P 500 gained a double-digit percentage total return:

• 2014: 13.7%
• 2013: 32.4%
• 2012: 16.0%
• 2011: 2.1%
• 2010: 15.1%
• 2009: 26.4%

With large-cap stocks in five out of the last six years generating double-digit gains, is there any speculative juice left to push stocks higher again in 2015? Wall Street equity strategists remain bullish, with the consensus predicting an 8.2% gain this year and not a single person among the ten surveyed predicting a down year. Six of the ten strategists expect another double-digit gain in 2015. From a contrarian perspective, this bullish sell-side indicator is a bit worrying although these strategists were also bullish last year and were proven correct. Other contrarian signs of excessive bullish sentiment are:

1. Best-performing investment newsletters of 2014 currently recommend portfolios that are 3.32 times riskier than the overall stock market – one of the highest levels ever over the past 30+ years. According to Mark Hulbert:

What makes this trend so alarming is that the stock market has been near a major top whenever the top performers’ risk levels were at or close to current levels. In 2006, for example, the last calendar year prior to the 2007-2009 bear market, it rose to slightly higher than current levels: 3.85 times riskier than the market versus last year’s 3.32 times. In 1999, the last calendar year prior to the bursting of the dot.com bubble, the comparable level was 2.58.

2. Individual investors are allocating 68.5% of their investment portfolios to stocks, which is the highest percentage in more than seven years (since June 2007).

3. Speculators in S&P 500 futures are more net long now than at any point since the peak of the Internet bubble in 2001, making the S&P 500 “one of the most crowded trades in the world.” Goldman Sachs predicts a market “pullback” sometime in mid-to-late February as this crowded S&P 500 trade is unwound.

Historically, four consecutive years of double-digit gains is rare, with only one example since 1975: the four-year period of 1995 through 1998. Even then, the fourth-year double-digit gain in 1998 was tortured and occurred only after investors suffered a severe 22% drawdown between July and October. So, even if 2015 is going to be another good year, it will probably be a highly-volatile ride that will have unpleasant moments. Fasten your seat belts!  

According to Jeff Hirsch of the Stock Trader’s Almanac, the stock market is providing mixed signals for 2015. On the one hand, 2015 is a year ending in the number “5” and every year ending in “5” since 1885 has been bullish, with one qualifier: in 2005, the Dow Jones Industrial Average was down 0.6%, but the S&P 500 was up 3%. The average gain in “5” years has been a huge 28.2%. Furthermore, 2015 is a pre-presidential election year, “which is by far and away the best year of the 4-year cycle.” Since 1939, when the Dow Jones Industrials fell 2.9% in the face of the beginning of World War II, there have been 18 pre-presidential election years and they have all been positive. In fact, the best three quarters of the entire 4-year cycle are midterm Q4 and the pre-election Q1–Q2, during which stocks average a 50% gain from intraday low to intraday high. This time around, Jeff Hirsch is expecting only a 20-30% gain given elevated market valuations and the end of the Federal Reserve’s quantitative easing. The midterm Q4 low was 1820.66 on October 15^th and so far the rebound high was 2093.55 on December 29^th, which is a 15% gain from the low. To achieve a 20% to 30% gain from the 1820.66 low would require the S&P 500 to reach a level between 2185 and 2367. With the S&P 500 currently trading at 2045, this analysis suggests that the index could gain anywhere between 6.8% and 15.7% between now and the end of June 2015.

On the other hand, the Santa Claus rally failed to materialize this year, which is defined as the final five trading days of December plus the first two trading days of January. Between the close on December 23, 2014 and the close on January 5^th, the S&P 500 fell 3.0%. According to the Stock Trader’s Almanac, “If Santa Claus should fail to call, bears may come to Broad & Wall.” 

The lack of a Santa Claus Rally has often been a preliminary indicator of tough times to come. This was the case recently in 2000 and 2008. A 4.0% decline in 2000 foreshadowed the bursting of the tech bubble and a 2.5% loss in 2008 preceded the second-worst bear market in history. There have been several instances in which a Santa Claus Rally preceded bad years or markets, so some caution is in order. This was the case in 2011, although the market did manage to recoup most of its losses to finish the year flat.

In the 22 years since 1994, the Santa Claus rally has failed to materialize five times (1994, 2000, 2005, 2008, 2015). In the prior four instances, the S&P 500 fell three times over the following year (-1.5%, -10.1%, -38.5%) and rose once by only 3.0%. Let’s hope that 2015 does not follow the latest precedent of 2008, which was a very bad year.

Past is not necessarily prologue, however. The current market environment is unique, comprised of:

1. Accelerating U.S. economic strength.
2. Slowing but stable Chinese economic growth (the world’s second-largest economy, while projected to slow to a 7.2% growth rate in 2014 and 6.8% in 2015, is still strong relative to most of the world). Housing bust could be a black swan, however.
3. European and Japanese economic weakness which will result in further foreign fiscal and monetary stimulus.
4. 55% decline in global oil prices to below $50.

A growing U.S. economy means growing corporate profits, which helps support higher stock prices. Evidence of a strong U.S. economy includes:

• U.S. GDP growth and real final sales growth (GDP growth minus changes in inventories) in the third quarter of 2014 were both revised up to 5.0% annualized, the fastest rate of growth in 11 years.
• Year-over-year industrial production growth of 5.2% was the highest in 4 years and, coming six years into the recovery, “was arguably the most impressive report since 2000.”
• Employment growth in 2014 was the highest since the year 1999, but wages remains stagnant.

Although the 55% crash in oil prices since last June has understandably caused energy stocks to crash, it is important to remember that the energy industry comprises only 8% of total stock market value and that non-energy stocks should actually benefit from the lower oil price because it acts like a $125 billion tax cut. In fact, a recent study by Societe Generale found that whenever oil prices fall 30% or more in less than a six-month period, “the only asset that systematically increases is U.S. equities.” Since 1970, oil prices have fallen 30% or more in less than six months on seven different occasions. Over the following year, U.S. stocks have risen an average of 18%. The industries that historically benefit most from collapsing oil prices include cars, auto parts, food and retail. Ironically, despite this bullish research, Societe Generale predicts that U.S. stocks will drop 1% in 2015. Go figure. The one scenario where an oil-price collapse would be bearish instead of bullish for stocks is if it was caused not by a supply glut but by demand weakness resulting from a recessionary economy. Goldman Sachs CEO Lloyd Blankfein recently warned that the oil prices may be signaling deflationary pressures. Bond king Jeffrey Gundlach is also worried about deflation and predicts that the 10-year U.S. Treasury yield could actually continue to fall in 2015 and actually re-test its July 2012 all-time low yield of 1.38%. On January 6th, the iShares 20+ year Treasury Bond ETF (TLT) exceeded its July 2012 price high.

Societe Generale’s rationale for a U.S. market decline is partly due to its fears that the U.S. Federal Reserve will start to raise interest rates in 2015. Fed minutes of the December 17^th policy meeting were released on January 7^th and appeared slightly dovish, emphasizing that the Fed would be “patient” and flexible depending on future economic data, which alleviated investor concerns that Yellen’s December press conference statement that an interest-rate hike wouldn’t occur for “a couple of meetings” meant that the first hike would occur at the April meeting. In fact, Chicago Fed president Charles Evans and Minneapolis Fed President Narayana Kocherlakota don’t expect a rate hike until 2016 thanks to the oil-price decline and stagnant wages, whereas futures traders are betting that a rate hike won’t occur until September.

A similar contradiction can be seen with hedge-fund manager David Tepper. He was quoted on CNBC predicting that 2015 would be a “good year” similar to 1999 that sees stock-market gains of at least 8-10%, and yet he is returning upwards of 20% of his hedge fund’s $20 billion assets to clients. Typically, a hedge-fund manager only returns capital to clients if he is pessimistic about future investment returns.

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). As of Monday, January 12th, the S&P 500 remains 58 points above its 10-week moving average (2044 vs. 1986).

Roadrunner Stocks Relative Performance

Small-cap stocks have now outperformed the S&P 500 in each of the last three consecutive Roadrunner time periods – with small-cap momentum leading the way! Overall, small caps have outperformed the large-cap S&P 500 in only 5 of the 23 Roadrunner time periods since January 2013, but reversion to the mean suggests that small-cap outperformance is likely in 2015.  The reasons:

• Small-cap stocks are cheaper now. At the start of last year they traded at a 27% premium (based on P/E ratio) relative to the S&P 500 index, and now they’re back in line with the historical average of around a 15% P/E premium.

• The U.S. economy is picking up steam, which benefits small-cap stocks more, because generally they’re more exposed to the domestic economy.

• The strong U.S. dollar will stay strong in 2015, and a strong dollar hurts large-cap stocks, which receive a substantial portion of their revenues in foreign currencies.

• Merger and acquisition (M&A) activity is red-hot at seven-year highs, which benefits small caps because they are the targets, not the acquirers, and targets get acquired at premium prices.

• Oil prices should remain low, which reduces costs and raises profit margins for many small caps.

Small-cap stocks have outperformed the S&P 500 for three consecutive monthly periods – only this time its small-cap momentum leading the way! Small caps have now outperformed the large-cap S&P 500 in only 5 of the 23 Roadrunner time periods. 

Comparative Index Total Return Thru January 5^th   

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 11 out of 20 holdings (55%) outperforming VBR and sports an average return since inception of 24.38%, 8.49 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 16.31%, 12.18 percentage points better than DWAS.

Performance Scorecard

Overall, 26 of 40 Roadrunner holdings (65%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru January 5^th)

 Source: Bloomberg

Momentum Portfolio
(thru January 5^th)

 Source: Bloomberg

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 – Rayonier Advanced Materials (RYAM) — 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 Rayonier Advanced Materials (RYAM). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, Rayonier Advanced Materials provides limited diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting biotechnology firm United Therapeutics, the Value Portfolio was overweight the “basic materials” sector and equal-weight the “cyclical” stock type, so adding another cyclical basic- materials company doesn’t do anything for diversification. However, deleting United Therapeutics helped reduce the portfolio’s severe overweight to the “Aggressive Growth” stock type, so it is important to remember that portfolio diversification can be improved in two different ways: (1) adding low-correlation stocks; and/or (2) deleting high-correlation stocks.

Given Rayonier Advanced Materials’ undervaluation, growth prospects, and consumer-defensive orientation, I’m okay with additional basic-material and cyclical exposure right now at a time when interest rates are low and U.S. economic growth is accelerating (42% of sales are in the U.S.). Sometimes short-term “tactical” asset allocation that results in overweights trumps long-term “strategic” asset allocation based on equal-weights.

Value Portfolio Composition After United Therapeutics is Sold
But Before Rayonier Advanced Materials is Added

Source: Morningstar

Rayonier Advanced Materials has a very low correlation with Harte-Hanks (HHS) and Brocade Communications (BRCD) because materials used in consumer defensive products (e.g., cigarette filters, drugs) outperform during modest economic growth, whereas corporate purchases of marketing services and computer systems are more economically sensitive.

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), poultry-processor Sanderson Farms (SAFM), or data-transfer tech play Silicon Image (SIMG) 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