Why the Stock Market Stalled

The news on the economy keeps getting better, but the stock market has just suffered its worst decline of 2014. What’s going on? Understanding what’s happening is the key to knowing whether to go for value or momentum in the next few months.

On July 24th, the S&P 500 and Nasdaq 100 both hit another round of new all-time highs, but it’s been mostly downhill since then. As I write, the S&P 500 has rebounded a bit, but it’s too soon to say whether another substantial upswing is under way.

Risks for the second half of 2014 focus on the end of the “Goldilocks” economy – either (1) the economy slows down too much and causes corporate profits to decline; or (2) the economy heats up too much and causes a spike in inflation and  interest rates.

The current bull market is unique in history as the first one that has occurred in the absence of strong economic growth — bolstered almost entirely by extraordinarily-easy monetary policy.

Second-quarter GDP grew a surprisingly strong 4 percent.  According to economist Douglas Holtz-Eakin, however, 1.7 percent of the Q2 growth was inventory building which is unsustainable, so real economic growth was only 2.3 percent.

Most economists forecast continued economic growth for the remaining half of 2014 because:

  1. Six straight months of robust job growth, including 298,000 jobs in June and 209,000 jobs in July – the first time since 1997 that employment has grown above a 200,000-jobs pace for six straight months;
  2. July consumer confidence was the highest in nearly seven years; and
  3. The ISM manufacturing index in July was the highest in more than three years (since April 2011).

The most recent market selloff was caused by a number of factors, including the Fed’s continued QE tapering, the strong second-quarter GDP report, and the largest increase in the employment cost index since 2008. 

Rising Rates Ahead

In June, Fed Chair Janet Yellen warned of investor complacency and that junk bonds were overpriced and she followed up in July with similar overvaluation warnings for biotech and social media stocks. Unfortunately, history has not demonstrated that the Fed is a good market timer.

When Alan Greenspan labeled the stock market “irrationally exuberant” in December 1996, the market was just at the beginning of one of the strongest blow-off bull markets in history: “Investors who listened to Greenspan and got out of the market then would have been net losers even a year after the crash” in 2001.

One reason that interest rates are set to rise is because the Fed continues to taper its quantitative easing program, reducing monthly bond purchases to $25 billion from $35 billion at its July 30th meeting. The Fed is set to cease new bond purchases entirely by its October 29th policy meeting.

Keep in mind that the budget deficit has stopped shrinking, which will necessitate an increase in new bond issuance while the QE tapering continues. The result going forward will be a de facto tightening of interest rates, which isn’t good news for the stock market.

Yale economics professor Robert Shiller, whose 2000 book “Irrational Exuberance” called the top in the stock market bubble almost perfectly and who warned of a housing bubble in August 2005 almost right near that top, interestingly is not calling a stock-market top right now. Contrarian that he is, Shiller notes that the current investor worry about a market top is an indication that a top hasn’t yet formed.

It is not entirely clear why the alarms are sounding just now, after five years of general expansion in markets since they hit bottom in early 2009. Why aren’t people blithely expecting more years of expansion? The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.

No Need to Panic

So what’s the bottom line? The days of being able to ride the market upsurge without careful stock selection are over. I’m  staying invested because the Ivy Portfolio market-timing system based on the 10-month moving average remains on a “buy” signal for stocks, bonds, and real estate (the only sell is commodities). Among stocks, value stocks appear to be the only equity style that remains slightly undervalued.

Since the launch of Roadrunner on January 24, 2013, the value and momentum indices have taken turns being the outperformance leader, with momentum taking the lead early on and maintaining its leadership position until April 2014, but value has become king since April. Interestingly, both value and momentum small-cap styles outperformed the large-cap S&P 500 until April 2014.

The result of these performance-benchmark changes is that the Value Portfolio’s performance looks less impressive relative to VBR and the Momentum Portfolio’s performance looks more impressive relative to DWAS. Overall, the benchmark changes are neutral in terms of evaluating Roadrunner performance, but they provide more informative analysis of the separate portfolios.

Almost half (19 out of 40) of Roadrunner recommendations have outperformed their respective small-cap benchmarks and both the Value and Momentum portfolios have a positive average return. The Value Portfolio shows 8 out of 20 holdings (40 percent) outperforming VBR and sports an average return since inception of 19.71 percent, 4.86 percentage points better than VBR.

In contrast, the Momentum Portfolio has 11 of its 20 holdings (55 percent) outperforming DWAS and sports an average return since inception of 2.37%, 4.72 percentage points better than DWAS.

Momentum stocks are very volatile and typically have further to fall once a general stock-market correction commences. Consequently, although the improved stock-selection formula for the Momentum Portfolio is working as planned, some of the recent momentum picks have gotten hit. 

Exploring China

One of the Momentum selections that I am proudest of is Chinese Internet retailer Vipshop Holdings (VIPS), which continues to jump higher and higher, outperforming its benchmark by an impressive margin.

According to China-based iResearch, Vipshop Holdings is China’s leading online discount retailer for brands as measured by total revenues in 2013 and the number of monthly unique visitors in December 2013. The company’s business model is to offer high-quality branded products to consumers in China through flash sales on its vip.com website.

Flash sales represent an online retail format combining the advantages of e-commerce and discount sales through selling a finite quantity of discounted products or services online for a limited period of time.

The company’s U.S. initial public offering (IPO) occurred back in March 2012 at $6.50 per share. With the stock now trading at $154, price momentum has been tremendous. If you can believe the company’s financial reporting, fourth-quarter revenues were up 117 percent and earnings were up 300%. Many analysts are bullish including Zacks and Credit Suisse. Most recent price- target boost occurred on May 5th when Nomura raised its price target on the stock to $210.

In March, some insiders cashed out in a secondary offering at $143.74 per share, but new investors purchased five-year convertible bonds with a conversion price of $201.24. The stock’s all-time high price of $182 occurred on March 4th and if the stock were to revisit that level, the gain from the current $154 price would be 18.2 percent.

The company is profitable (32% return on equity), has 18% insider ownership, virtually no debt, and sports a low beta of 0.90. That’s exactly the kind of underlying quality we look for in our Momentum stocks. So far, this bet is paying off big time.