Market Outlook

Until last week’s Greece-induced market upset, “boring” was the best word to describe the stock market. In the second quarter of 2015, the S&P 500 moved in a range of just 4.22%. Going back 65 years, only the fourth quarter in 1993 had a tighter range. The first six months of 2015 were almost as historic, trading in just a 7.77% range; only the first halves of 1992 and 1993 had tighter trading ranges in the past 65 years. Through the close of trading on Friday, June 26^th, the S&P 500 had made a weekly move of less than one percent (up or down) for nine consecutive weeks, the longest stretch of calmness in 22 years (since August 1993). The streak in 1993 lasted 12 weeks and stocks subsequently broke out to the upside and rallied 3.62% through year end, so the current period of stagnation in 2015 is not necessarily a red flag warning of an impending market correction.  On the other hand, when looking at the average price moves subsequent to the last nine such narrow-range occurrences, six and 12-month returns have been modestly negative at -3.82% and -1.93%, respectively. Based on five-year rolling returns, the stock market is overbought whereas based on 15-year rolling returns, the stock market is oversold. A mixed picture depending on the time frame you choose. It’s fair to say that – based on history — the stock market may remain in a narrow range for another year. Sideways trading patterns persist for much longer than you might expect. As Urban Carmel puts it:

Long periods where the S&P trades sideways in a range is not unusual. There have been at least 15 similar situations in the past 35 years, about one every two years. Some of these have lasted as long as two years. Most of these have resolved with the S&P moving higher. We’ve been in a trading range for 7 months; settle in, this could go on much longer.

Perhaps Jeffrey Hirsch has it right when he wrote recently that a 10% market correction is likely in the short term but it will be followed by a continuation of the “resilient” bull market. Any correction will probably wait until August, since July is historically a strong month for stocks. Although the streak ended yesterday (Monday July 6th), the S&P 500 ETF (SPY) had previously closed below where it opened for 10 consecutive trading days, which is extremely rare and signals a one-week bounce is likely. Wharton finance professor Jeremy Siegel continues to blow his bullish horn, arguing that stocks are not significantly overvalued. Looking forward, 5.5 to 6 percent annual real returns are easily achievable. Tack on 2% annual inflation, and nominal annual stock returns could hit 8 percent, which would be much better than what is available collecting meager yields in bonds.

The stock market’s narrow trading range marks a standoff between the bulls looking at improving economic growth and corporate earnings versus the bears looking at the Federal Reserve on the cusp of starting a new cycle of raising interest rates. The standoff has resulted in stocks significantly underperforming the typical third year of the presidential election term, which historically is the strongest of the four-year cycle. So far in 2015, the Dow Jones Industrials and S&P 500 are both underperforming their average performance during the third years of the presidential cycle by -10% and the Nasdaq is underperforming its average by even a greater amount at -17%. Based on history, such underperformance continues for the remainder of the year with no “catch up” to historical norms and full-year returns end around flat.

The second quarter was not only calm but also a downer for the S&P 500 – its first quarterly decline in the past ten quarters. The Dow Jones Industrials fell 0.9% during the quarter, its worst quarterly performance since the fourth quarter of 2012. Bonds, which often trade inversely with stocks, fell in tandem with stocks during the second quarter, with ten-year U.S. Treasuries dropping in price (yields rising) by the most since the end of 2013 and marking the first quarter of rising yields in the past six quarters.

Greece is a wild card, especially now that Greeks have voted a resounding “OXI” (i.e., no) on Sunday July 5^th to European Central Bank demands for austerity measures (lower government spending and higher taxes) in exchange for a third round of bailout funds worth $67 billion. Earlier, on Monday June 29^th, U.S. stocks suffered their worst one-day drop of 2015 on fears of a Greek debt default, which occurred on Wednesday July 1^st when Greece did not pay back $1.7 billion owed to the International Monetary Fund (IMF). With Greeks adding insult to injury with the July 5^th referendum “no” vote on the following Sunday, stocks on Monday July 6^th are set to re-test the lows of the prior week with another Monday free-fall. The ECB may blink in the face of the Greek no vote and an IMF report stating that Greece will never be able to pay off its current 310 billion Euro debt load. According to the IMF, forgiving $53 billion Euros of Greece’s debt would make it possible for the country to repay the remaining 257 billion Euros owed to European banks. The ECB may determine that it is preferable to forgive 53 billion Euros than it is to face default on Greece’s entire debt load of 310 billion Euros. Greece also appears conciliatory, forcing its finance minister Varoufakis to resign, even though he supported the winning no vote in the referendum, because he called the European creditors “terrorists” and Germany wanted him gone. If a deal will happen, it will likely occur before the next drop-dead date of July 20^th, when Greece is due to repay $3.5 billion Euros of debt to the ECB.

This second consecutive Monday stock-price drop on July 6^th could be the double-bottom buying opportunity investors have been waiting for as Greece is a small country that doesn’t really affect the U.S. economy. Small-cap stocks are focused on the domestic U.S. economy and are thankfully insulated from most of the financial shenanigans occurring overseas. In contrast, large-cap multinational stocks can be significantly affected due to the fact that a large portion of their revenues is generated overseas. This difference in foreign vulnerability is one of the great advantages of small-cap investing. I suppose things could get worse if a Greece exit from the Euro caused a contagious loss of confidence in weaker Eurozone countries like Portugal, Spain, and Italy, but the chance of such a contagion appears remote and in any event would not affect small caps as much as large caps. Mark Hulbert has studied market history and determined that foreign financial crises have only short-term market effects:

Sovereign debt crises like the one Greece has been suffering from in recent years are not particularly rare, and more often than not following past such crises, the stock market rose.

I hope Hulbert is right because another debit crisis closer to home is the possible bankruptcy of Puerto Rico thanks to a $72 billion debt load.

The silver lining of a Greece debt default and a Grexit (Greece exiting the Euro) would be that the destabilization in Europe would cause the Federal Reserve to delay its first rate hike until 2016 because:

scared investors will flood into the dollar, sending the greenback through the roof. That itself would become a seriously dampening factor to the U.S. expansion. As well, it is an inflationary factor. If it were actually to materialize, the safe haven demand for the dollar could cause the Fed to pause.

With the U.S. economy rebounding from the first-quarter GDP contraction (revised upward to only -0.2% from the previous -0.7% estimate), New York Fed President William Dudley says that a September rate hike is “very much in play” if second-quarter GDP growth comes in at 2.5% or higher, but that Greece or lesser second-quarter GDP growth would cause the Fed to wait until December or later. According to the Atlanta Fed’s “GDP Now” forecast, second-quarter GDP growth is set to come in at only 2.2%, which is below Dudley’s 2.5% threshold for a September hike. The June jobs report was below expectations and included downward revisions in the two previous months, and Fed futures prices are now predicting that the first Fed rate hike won’t occur until January 2016, whereas Wall Street economists continue to predict a September 2015 liftoff.

Lastly, I would like to emphasize that small-cap stock investing works best from a long-term perspective over many full business and political cycles. Any short-term market correction will be inconsequential over the long term. In fact, one of the benefits of small-cap investing is that their higher volatility allows the purchase of shares at significant discounts during market corrections, which quickly morph into large profits when the inevitable market recovery occurs. As financial theorist William Bernstein recently wrote:

The greater volatility of small stocks allowed for a greater number of shares to be bought at lower prices. The reason is the paradoxical nature of the small-value strategy: higher volatility than a conventional 100% S&P 500 strategy and, thus, more opportunity to buy at much lower prices. The excess returns of both small size and value strategies, of course, come with a double cost. Small value stocks have much greater volatility and, thus, far greater emotional demands on the investor.

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 and foreign stocks (sells are bonds, real estate and commodities).

Roadrunner Stocks Relative Performance

Small-cap  stocks are the comeback kids! Whereas last month small caps had outperformed large caps in only nine of the 27 Roadrunner time periods, or 33% of the time, this month small caps have come roaring back and have now outperformed large caps 61% of the time (17 of 28 time periods). As I predicted last month, investors have shrugged off the weak Q1 GDP figure as a statistical anomaly as evidence accumulates that the U.S. economy is growing faster in the second quarter.  Small caps have rebounded strongly because they are much more economically sensitive than large caps.

Of the 17 periods of small-cap outperformance, all ten of the most recent time periods have seen small caps outperform. Simply put, small caps are hot! The value style of small cap has outperformed seven times and the momentum style ten times, which demonstrates the diversification benefits of investing in both the value and momentum equity styles. Small-cap value has outperformed over longer time periods, whereas momentum has been the outperformance 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.

Nine of the past ten time periods have seen small-cap momentum outperform both large caps and small-cap value, so we are currently in a momentum “sweet spot.”

Comparative Index Total Return

(Thru June 26th)  

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 positive 20%-plus average returns. The Value Portfolio shows 9 out of 20 holdings (45%) outperforming VBR and sports an average return of 23.44%, 6.23 percentage points better than VBR. In contrast, the Momentum Portfolio has 13 of its 20 holdings (65%) outperforming DWAS and sports an average return of 43.35%, blowing away DWAS by an astounding 30.03 percentage points. When individual momentum stocks outperform an index, they REALLY outperform!

Performance Scorecard

Overall, 30 of 40 Roadrunner holdings (75%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio

(thru June 26th)

Momentum Portfolio

(thru June 26th)

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 – Weis Markets (WMK) — 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 Weis Markets (WMK). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, Weis Markets provides decent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting trucking firm Werner Enterprises, the Value Portfolio was equal-weight the “consumer defensive” sector and also severely underweight the “slow growth” stock type. Weis Markets is both a consumer defensive stock and classified as slow growth, so adding this stock helps diversify the portfolio in one important way.

Value Portfolio Composition After Werner Enterprises is Sold
But Before Weis Markets is Added

Source: Morningstar

Weis Markets has a very low correlation with Rayonier Advanced Materials (RYAM) and Diamond Hill Investment (DHIL) because grocery stores sell food, a consumer staple that is insensitive to economic growth, whereas basic materials and money management are economically sensitive industries that benefit from stronger economic growth. 

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own semiconductor manufacturer Lattice Semiconductor (LSCC), energy equipment firm Gulf Island Fabrication (GIFI), 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