Market Outlook

Investor sentiment reached extremely bearish levels in September after the S&P 500 closed below its declining 10-month moving average at the end of August, thus signaling to some a bear market similar to those of 2000 and 2008. Although past 10-month moving average cross-unders have resulted in “false positives” that didn’t result in subsequent bear market, these false positives had never occurred when the 10-month moving average had been declining at the time of the cross-under.

Well, there is a first for everything, and it appears that the most recent 10-month moving average cross-under in August 2015 is yet another false positive. With a huge 8.3% rally in October, the fifth-largest October rally ever, the S&P 500 has once again risen above its 10-month moving average to close out a month after just two short months below. As this chart shows, the 2015 quick recovery looks similar to the whipsaw fakeouts in 1998, 1999, 2010, and 2011, with the 1998 example the closest fit of all. Interestingly, after the 1998 fakeout, stocks went on a rip-roaring rally for more than a year, gaining 13.1% alone in the fourth quarter. In fact, none of the four prior fakeouts resulted in a resumed stock-market decline within the first 11 months after the fakeout. It’s difficult to argue stocks are starting a bear market in a month where the Nasdaq-100 hit an all-time closing high.

Also bullish: whenever stocks have risen 5% or more in October and are positive year-to-date (like this year), the rest of the year has been up 83% of the time by an average of 5.2%.Also positive fourth quarters after 4% October gains and 8% October gains, although November tends to be flat after 8% October gains (like this year) and strong after 5% October gains. Insiders are net sellers again after brief buying binge at the August/September lows and investor sentiment has improved along with the huge October rally, which suggests from a contrarian perspective that the bulk of the recovery gains for this year may have already taken place. The rally is up against strong resistance levels from early August and Jeffrey Saut sees a trading top during the first week of November that will cause a mild retracement of recent gains, but this retracement will end during the first half of December and result in a year-end rally.

The Federal Reserve’s Wednesday October 28^th policy statement mentioned the upcoming December 16^th meeting by name as a possible time for the first interest rate hike. This initially rattled investors, because it meant that a rate hike in December was a real possibility, but stocks shook this worry off and ended higher on Wednesday as investors reconsidered and decided that the economy is strengthening and could handle a rate hike. Based on interest-rate futures prices, the odds of a December rate hike increased from 30% probability before the Fed policy statement was released to 60% afterwards — the highest probability for any Fed meeting since 2007. Although a first rate hike won’t have much effect on the economy, investors have an excessive fear about it and consequently every economic data point between now and the December 16^th meeting (including two employment reports) will have magnified importance in gauging the likelihood of a December rate hike, which will result in increased stock-market volatility between now and December 16^th. Whatever the Fed decides on December 16th, investors will be relieved at the reduced uncertainty and a Santa Claus rally during the second half of December into year-end is a good bet.

Concurrent with the stock-market rally off the August/September lows has been a massive reduction in the S&P 500 volatility index (VIX), from a peak reading of 53.29 on August 24^th to a low of 12.80 on October 28^th. According to Dana Lyons, since 1986 there have been 13 instances of the VIX dropping from a reading over 37 to under 20, and each time the stock market has made a double-digit percentage move over the following 12 months. What is interesting, however, is that this big percentage move can be either up (eight times) or down (five times). The deciding factor as to whether the move is up or down appears to be whether the VIX stops its decline at the 15 level or whether it drops below 15. The good news this time around is that the VIX has dropped below 13, which suggests that the upcoming big move will be up. Since 1950, whenever stocks have risen more than 5% in October (like this year), the S&P 500 has never dropped between the following November to April time period. In fact, the average gain is 13%, double the average gain during the Nov.-April period.

Retail sales, personal consumption, employment, and car sales, have continued to grow steadily throughout 2015, which makes the August market correction unrelated to the real performance of the U.S. economy and more a reflection of foreign worries involving China and Greece. Hedge fund manager David Tepper recently stated that any indication that China’s economy has stabilized could be the “magic formula” trigger for a continued U.S. market rally that would allow stocks to catch up with the economy’s strong fundamentals. On the other hand, an end to fears about China would cause the Federal Reserve to raise rates much faster, which could mute any continued rally.

Good news for small-cap stocks: recent small-cap underperformance vis-a-vis large-cap stocks has pushed the ratio of the large-cap S&P 500 divided by the small-cap Russell 2000 up close to 1.8, which has historically marked the end of small-cap underperformance and the beginning of small-cap dominance. With more than 50% of small-cap stocks still down 20% or more, they have a lot of catching up to do. Historically, the period between December and February favors the Russell 2000 over the S&P 500. Get ready for a rip-roaring small-cap rally into year-end and beyond!

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 – Rackspace Hosting (RAX) — 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 Rackspace Hosting (RAX).

Value Portfolio 3-Year Correlations

As you can see above, Rackspace Hosting provides decent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting digital marketer Harte-Hanks, the Value Portfolio was underweight the “technology” industry sector and overweight the “aggressive growth” stock type. Rackspace Hosting is both technology and aggressive growth, so adding this stock helps diversify the portfolio in one important way (industry sector).

Value Portfolio Composition After Harte-Hanks is Sold
But Before Rackspace Hosting is Added

Source: Morningstar

Rackspace Hosting has a very low correlation with specialty chemical manufacturer Stepan Co. (SCL) and Sanderson Farms (SAFM) because Internet services are a growth industry in any economic climate, whereas cyclical chemical producers only outperform in strong economies and consumer-staple chicken processors do best in slow economies. 

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