Market Outlook

Stock-market momentum has been historic, with the S&P 500 starting off 2013 with seven-consecutive up weeks for the first time since 1967.  But since a more than 5-year high of 1,530.94 was reached on February 19, the S&P 500 has fallen 2.8 percent and a stock-market correction of 5-8 percent may have begun. With Monday’s price plunge the worst of 2013,  the index closed below its 10-week moving average for the first time since last December, which opens the door to a test of the 40-week moving average around 1,430.

The Volatility Index (VIX) jumped an astounding 34.0 percent (14.17 to 18.99) on Monday February 25  — the largest one-day percentage gain since a 35.4 percent jump on August 4, 2011. Back then, a short-term bottom was not reached for an additional three trading days and an intermediate-term low was not reached for two months.

Back in August 2011, investors were worried about the U.S. government failing to extend the debt ceiling, which resulted in Standard and Poor’s downgrading the credit rating of U.S. government debt. The current political situation is different but somewhat similar as it also involves Washington political paralysis over automatic spending cuts (i.e., sequestration) that are scheduled to take effect on March 1 and which could push the economy back into recession. It looks like sequestration will occur, as there are no signs of progress towards a compromise.

Besides the impending March 1 sequestration, two other reasons why the stock market may be starting a correction include:

• Federal Reserve minutes from its January policy meeting revealed that many members were worried that the Fed’s current “quantitative easing” (QE) policy of purchasing $85 billion worth of mortgage and Treasury securities monthly may be unwise and deserves to be re-evaluated. (But Bernanke reiterated the Fed’s commitment to continued QE in Congressional testimony on Feb. 26^th ).
• Wal-Mart said that February sales were a “total disaster” caused by higher payroll taxes. Weak consumer spending (70 percent of the U.S. economy) may signify a new recession is coming.
  • Chaotic Italian elections that have resurrected the political power of Silvio Berlusconi in the Italian Senate threaten to jeopardize the European austerity plan aimed at staving off a Eurozone government debt crisis.

After a correction, the bull market should continue for a several more months. Technical weakness in safe-haven gold bullion suggests that neither hyperinflation nor a recession is likely. Furthermore, recent U.S. economic data has exhibited strength, including January new home sales at more than five-year highs and home prices over the past 12 months rising by the largest percentage in six years.

According to stock-market research firm Birinyi Associates, since 1962 the stock market has gone for 500 or more trading days without a 10% correction five separate times. Based on these instances, stocks averaged another 9.2% gain over the next six months and a 13% increase over the ensuing one-year time frames. Furthermore, the current streak of 505 days without a correction is not that extreme historically – three of the five instances of 500-plus days didn’t actually end up suffering a 10% correction until the streaks had continued to run for 1127, 1673, and 2553 days, respectively.

Roadrunner Stocks Are Outperforming the S&P 500

Between January 24 and February 26, the S&P 500 has risen 0.41 percent. Five Roadrunner stocks have outperformed this figure and five have underperformed, but the outperformers have gained on average much more than the underperformers have lost on average. The result is that the Roadrunner value and momentum portfolios are both outperforming:

Jan. 24 through February 26

Was it possible at the January 24 launch of Roadrunner Stocks to know which of the ten recommended stocks would do the best? I don’t think so; otherwise I would have simply recommended that everyone put all of their money into Western Refining. The future is unknowable in advance and that’s why hedging one’s bets through diversification is so important. Intelligent stock picking focuses on collective outperformance of the portfolio as a whole, not bets on individual stocks outperforming.

Diversification is the Key to Success

In January’s Road Map article entitled Your Destination for Profits, I argued in favor of allocating a portion of your equity portfolio to small and mid-cap stocks. Smaller stocks perform differently than large-cap stocks – sometimes outperforming in the short term and always outperforming in the long term – so one should own them to take advantage of this outperformance when it occurs.

But the concept of asset allocation has many layers and does not stop at diversifying the market capitalization. Within the small-cap equity segment, it is equally important to diversify your investments. The key to investment success is “moderation in all things;” choosing a combination of moderate risk and moderate reward that has the best chance of achieving significant wealth accumulation. The means to this end is asset allocation. Keep in mind that asset allocation maximizes your chance of success but does not guarantee it. If the world goes to Hell, no asset class would be safe.  As former Federal Reserve Chairman Paul Volcker once said: “You cannot hedge the world.”

Spread the Money Around

The first step in asset allocation is following the old proverb” don’t put all of your eggs in one basket.” No matter what the investment, something can go wrong. If you put all of your money in a single investment and it goes bad, you could lose everything. As I wrote in The Great Investment Truth, large losses must be avoided at all costs because they can irreparably devastate your wealth.  Consequently, rather than put your money in a single stock, put it in a minimum of 20 different stocks and preferably more. According to a November 2012 research paper (page 14), the number of U.S. stocks needed to achieve proper diversification is between 40 and 70. With proper diversification, if a stock goes under, the detrimental impact on your overall wealth will be minimal and manageable:

Asset Allocation Includes Equity Style Diversification

Diversifying the number of investments you own is only the first step of asset allocation, however. Although some risks are specific to an individual security, other risks affect entire industries. Let’s say back in 2006 you bought 20 housing stocks instead of only one. Would your numerical diversification have saved you from the housing crisis of 2008? Nope. When a crisis hits an entire industry, all of the stocks in that industry can go down together. Owning a portfolio of 20 stocks where each stock declines 40 percent is no better than owning  a single stock that goes down 40 percent. Effective equity diversification requires that some stocks zig up while others zag down. Minimizing downside volatility by canceling out the inevitable down moves with up moves is critical to generating wealth in the long term. 

Consequently, a second step in asset allocation is to diversify the types of investments you own, not just the number.  This entails investing not only in different industries, but different geographies and styles (e.g., growth vs. value). A 2006 study found that more than 100% of investment returns comes from asset allocation; active management (i.e., choosing individual securities within an asset class that you judge to be superior to others) on average actually loses money.

Every type of investment has its own unique profile, performing well during some economic scenarios and performing poorly in others. As economic conditions change, the relative performances of different investments change. Provided the world does not go to Hell, some investment type will always be performing well based on the economic scenario in place at a given time. By diversifying among many types of investments, you increase the odds that you will benefit from the investment type that does well in whatever the current economic environment proves to be. 

If you take a look at historical equity style returns, this constant style rotation becomes clear. For example, in the 10-year period between 2003 and 2012, small-cap growth stocks outperformed in five years and small-cap value stocks outperformed in five years. Ignoring foreign small-caps would have been a mistake, because. foreign small-cap stocks outperformed both U.S. small-cap growth  and U.S. small-cap value in six of the ten years. 

Market Timing Doesn’t Work

Of course, if you knew in advance which equity style would perform the best, there would be no need for asset allocation; you would simply put all your money in the equity style primed to perform best. But in real life, nobody knows the best-performing equity style in advance. The ability to market time successfully over a long period of time is impossible, which is why diversification is important. 

Low Correlations Are the Holy Grail of Asset Allocation

The key to finding asset classes that complement each other with zig-zag returns is to know how their returns correlate with each other. Correlation ranges from +1.0 (moving in lockstep with each other) to –1.0 (moving in diametrically opposite directions). Mixing assets with a +1.0 correlation together provides no diversification benefits, whereas adding assets with a –1.0 correlation together provide perfect diversification. The more diversification, the less downside volatility occurs, and the more wealth is created over time.

It’s pretty rare to find stocks with a negative correlation, so the best you can reasonably hope for is a low positive correlation under 0.5. For example, if you look at the middle correlation matrix in this link covering the period between 1990 and 2008, you’ll see that the lowest correlation of 0.27 is between tech stocks and energy stocks, as well as between tech stocks and utility stocks.

Diversification in the Roadrunner Portfolios

When selecting new stocks to add to the Value and Momentum portfolios, I am not looking simply  for the stock that offers the highest potential return, but also for the stock whose correlation with the rest of the portfolio holdings is lowest.  Reducing volatility is so important to wealth generation that you can actually increase your portfolio’s overall expected rate of return by adding a stock with a below-average rate of return! Wow.

The two Front Runners added to the portfolios this week have very low correlations with the other existing holdings. Using a stock correlation calculator, I created correlation matrices for both Roadrunner portfolios, including this month’s recommendations. The time frames for the correlations were weekly measuring periods over 2 years, 8 months for HomeAway (i.e., since its IPO in June 2011) and over five years for Brocade:

Momentum Portfolio Correlations

As you can see above, HomeAway provides fabulous negative correlation with each of the five other Momentum portfolio stocks. The short time period probably exaggerates the negative benefits somewhat, but it’s impressive nonetheless. Correlation between most of the other portfolio holdings are on the high side, which is to be expected given that momentum stocks are all going up together in a virtual straight line.

Value Portfolio Correlations

Both Brocade and United Therapeutics are “strange birds” that provide excellent diversification benefits to the overall Value Portfolio, whereas Carbo Ceramics/Gentex and Buckle/Diamond Hill are virtual clones of each other. Stocks from seemingly unrelated industries can sometimes exhibit strong correlations that are not intuitive.

The ultimate goal is to allocate different monetary weights to each portfolio holding so as to maximize the overall portfolio’s Sharpe Ratio (return divided by volatility), but that requires a portfolio optimizer calculator and knowledge of each stock’s expected annual return and expected annual standard deviation of returns. We’ll come back to this topic at a later date.

For now, an understanding and appreciation of equity-style diversification and low stock correlations is more than enough to chew on.