Market Outlook

It took more than 15 years, but the Nasdaq Composite finally closed at a new all-time closing high last Thursday (April 23^rd). Most analysts view this new record as a technical breakout that should have some legs. According to Urban Carmel, the breakout is near-term bullish but it may not last long because of seasonality and excessively bullish investor sentiment:

NDX looks very bullish: a big weekly gain to new highs and seemingly strong momentum. The February breakout continued higher nearly 4%; optimistically, that could be the set up now as well. New price highs are usually bullish as all investors are in a profitable position and not in need of selling.

We don’t like to be cautionary when price is bullish, but the reality is that prior moves to new highs have failed in the past year and several measures of breadth, sentiment and volatility suggest that is likely to be the case again now. Recall that, over time, the November-April period produces average gains of 7.5% while May-October has average gains of 0%. In other words, what has traditionally been the bullish half of the year is now coming to an end.

According to Mark Hulbert, the average recommended equity exposure by short-term market timers tracked by the Hulbert Stock Newsletter Sentiment Index (HSNSI) stands at 72.9%, one of the highest levels ever seen:

Over the past decade, there have been only two occasions when the HSNSI was higher than it is today, and on both occasions the market proceeded to fall:

• End of 2013/beginning of 2014: The Dow Industrials fell more than 1,000 points in a month’s time, or 7.3%.

• February 2015: The Dow Industrials fell 600 points, or 3.2%.

The Nasdaq price-to-earnings (PE) ratio is around 21 today compared with almost a 200 PE ratio 15 years ago. Fears of an “earnings recession” due to a strong U.S. dollar and low oil prices have been overblown as first-quarter earnings have been better than expected. According to Factset Research:

With 40% of the companies in the S&P 500 reporting actual results for Q1 to date, the percentage of companies reporting actual EPS above estimates (73%) is equal to the 5-year average, while the percentage of companies reporting actual sales above estimates (47%) is well below the 5-year average.

So far, Q1 earnings are down 2.8% year-over-year, but that is much better than the 4.6% decline expected. Still, if earnings are down in the first quarter, it would be the first time in 2 ½ years (since Q3 2012). History shows that stocks continue to rise during earnings recessions as long as there is no accompanying economic recession.

In an April 27^th note entitled “We are Full of Bull,” Morgan Stanley equity strategist Adam Parker says the time to buy stocks is “right here right now.” Parker provides three reasons for his expectations of “meaningful appreciation”:

• US economy will accelerate in the 2nd and 3rd quarters.
• Analyst earnings estimates are too low and will be adjusted higher.
• Investor sentiment remains cautious. Market tops don’t occur until there is excessive optimism.

As for valuations, Parker admits that the S&P 500’s forward PE ratio of 17 is one-standard deviation above its historical long-term average and eventually will revert to its long-term average, but this fact has “zero predictive value” in the short term (i.e., next couple of years).

The March employment report was weak, producing only 126,000 jobs which was half the amount expected and broke the 12-month streak of gains above 200,000. New York Fed President William Dudley recently stated that economic growth would slow to 1% in the first quarter from 2.2% in the final three months of 2014. Most economists believe that the current economic slowdown is temporary, but it will give the Federal Reserve pause and the first interest-rate hike will likely be postponed until the September 17^th policy meeting.

Even when the first rate hike occurs, the Fed is not going to ratchet up rates quickly with additional rate hikes. According to Fed Governor Jerome Powell, the Fed wants to get short-term rates above zero but is in no hurry to raise much above zero, saying “the precise timing of liftoff is less important than the path of subsequent additional rate increases.” Bond king Jeffrey Gundlach expects long-term interest rates to remain low which will keep the Fed from raising short-term rates much. Let’s hope he’s right because the stock market’s current elevated price level is very dependent on continued low rates. According to Norway’s $890 billion sovereign-wealth fund, the investment risks stemming from monetary policy have never been greater, meaning that stocks would fall hard if interest rates rise more than a little.

On the negative side, stocks typically sputter in the three months following a first rate hike, falling two thirds of the time. Value investor Howard Marks does not see stock valuations as “compelling” and future stock returns should be mediocre, but he also doesn’t see valuations as dangerously excessive.   

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, foreign stocks, bonds, and real estate (only sells are foreign stocks and commodities, but foreign stocks will switch to a buy at the end of April).

Roadrunner Stocks Relative Performance

Small caps have outperformed in 16 or the 26 Roadrunner time periods, or 62% of the time. Of the 16 periods, the value style of small cap has outperformed seven times and the momentum style nine times, which demonstrates the diversification benefits of investing in both the value and momentum equity styles. Small-cap value has been the star over the longer time periods, whereas small-cap momentum has been the star over the more-recent time periods.

As I explained in the initial January 2013 Roadmap article entitled Your Destination to Profits, the best long-term investment results will be achieved from a diversified portfolio consisting of both value and momentum stocks. A 50-50 allocation to value and momentum is the “holy grail” of investing.

My takeaway: Ten of the past 11 time periods have seen small caps outperform large caps, so we are currently in a small-cap “sweet spot.”

Comparative Index Total Return Thru April 17^th  

 Source: Bloomberg

More than half (21 out of 40) of Roadrunner recommendations have outperformed their respective small-cap benchmarks and both the Value and Momentum portfolios have positive 20%-plus average returns. The Value Portfolio shows 9 out of 20 holdings (45%) outperforming VBR and sports an average return of 21.98%, 2.92 percentage points better than VBR. In contrast, the Momentum Portfolio has 12 of its 20 holdings (60%) outperforming DWAS and sports an average return of 34.12%, blowing away DWAS by an astounding 21.97 percentage points. When momentum stocks outperform, they REALLY outperform!

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 April 17^th)

Momentum Portfolio
(thru April 17^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 — SJW Corp. (SJW) — 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 SJW Corp. (SJW). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, SJW Corp. provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting biofuels manufacturer FutureFuel, the Value Portfolio was severely underweight the “defensive” sector and had zero utility exposure. On the other hand, SJW exhibits “aggressive growth” characteristics, which is already the second-heaviest stock type in the portfolio, so adding a utility company provides a huge benefit for sector diversification, but doesn’t do anything for stock-type diversification.

Value Portfolio Composition After FutureFuel is Sold
But Before SJW Corp. is Added

Source: Morningstar

SJW Corp. has a very low correlation with RPC Corp. (RES) because water is a consumer staple that is in demand regardless of the business cycle whereas oil services are highly cyclical and sensitive to economic growth. SJW also has a low correlation with Exactech (EXAC) because water usage declines with age whereas joint replacements increase with age.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own poultry-processor Sanderson Farms (SAFM), energy services firm RPC Corp. (RES), or cigarette-filter manufacturer Rayonier Advanced Materials (RYAM) 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