Market Outlook

2013 is now in the history books and what a great year it was! Both the Dow Jones Industrials and the S&P 500 closed out 2013 at all-time record highs and December marked the fourth consecutive month of gains for all three major stock indices (Dow, S&P, and Nasdaq). The annual return numbers for 2013 were as follows:

Dow Jones Industrials: 26.5% (best since 1995)

S&P 500: 29.6% (best since 1997)

Nasdaq Composite: 38.3% (best since 2009)

2013 was the fifth best year in the history of the S&P 500 index since its inception in 1957. In addition, 2013 marked the fifth year in a row where the Dow Jones Industrials has gained more than 5%. In the past 115 years, the Dow has never gained more than 5% six years in a row.

The U.S. economy is set to go into overdrive in 2014 for the first year of above-trend economic growth (3%-plus) since 2007. In fact, Deutsche Bank thinks GDP estimation risk is on the upside (up to 4%), not the downside.  Fourth-quarter 2013 US GDP was up a very strong 4.1%. U.S. housing prices in October rose the most year-over-year in more than seven years. The global economy appears to be stabilizing and even strengthening on average. The Eurozone’s economic recovery is choppy, with third-quarter GDP numbers falling back a bit from the strength seen in the second quarter – France and Italy’s economy both dropped 0.1%, but Spain is hot and Germany continued to grow (albeit at a decelerating 0.3%).

The divided U.S. Congress is showing increased signs of cooperation and bipartisanship, reaching a two-year budget deal (first time since 1986) that in 2014 will cut in half the fiscal drag on the economy previously scheduled by automatic budget cuts under sequestration. The Federal Reserve’s surprise December 18^th decision to begin tapering its $85 billion per month quantitative easing (QE) program by $10 billion is in response to both the budget deal and the Fed’s increased confidence that the economy is doing better. Long-term interest rates should rise modestly in 2014, but not too much since short-term rates remain anchored at zero until at least 2015. 

Higher long-term interest rates in developed markets (U.S., Western Europe, and Japan) combined with a peak in large-cap corporate profit margins may slow down S&P 500 returns to a single-digit gain 2014 after two double-digit years of returns in 2012 and 2013, but some hope profit margins can stay at peak levels longer than expected. Four factors will keep the market aloft: (1) stronger earnings (page 12), (2) the end of the “fear trade” resulting in retail investors rotating out of fixed income and into stocks, (3) increased M&A activity (after two down years in 2012 and 2013) as companies gain confidence in the recovery and stop hoarding cash, and (4) low energy prices (thanks to the U.S. fracking revolution) boosting consumer spending.

Wharton finance professor Jeremy Siegel said on Nov. 29^th that the market is 10% to 15% undervalued and “this bull market has definitely more to run.” Brian Belski, chief investment strategist at BMO Capital Markets, goes so far as to say that a new secular bull market began in 2011 and could last 15-20 years. On the other hand, Henry Blodget argues that stocks are at least 40% overvalued and likely to generate sub-par returns over the next decade.

2014 will be the second year of the presidential cycle, which is historically the weakest market year of the four-year cycle – up on average only 4.0 percent since 1901. The upcoming year should favor: (1) U.S.-led developed-markets outperformance based on a strengthening of the U.S. Dollar and Euro, (2) economically-sensitive industry sectors such as industrial capital goods, technology, real estate, and retail, and (3) small-cap stocks which outperform during accelerating economic growth.  Japanese stocks could perform well again in 2014, but U.S.-based investors may not benefit much because of a declining Yen.

Volatility should increase in 2014 because 2013 was abnormally quiet, with only one peak-to-trough downdraft of less than 6%. The average year experiences four market pullbacks of greater than 5% with at least one major pullback of 15.8%. With QE tapering, the stock market will react more forcefully to economic data, which could be a negative reaction if economic growth stalls or strengthens too much. Additional stock-market gains in 2014 require a “goldilocks” scenario of moderate economic growth near 3% that neither hurts corporate earnings nor spurs inflationary concerns. The first two trading days of 2014 have seen back-to-back losses for the first time since January 2005. You may recall that in 2005 stocks continued to decline into April, falling 6.3 percent. Two other pieces of stock-market trivia reach different conclusions about 2014:

1. Since 1927, the S&P 500 has made its year-to-date high on the final trading day of the year 11 times. Over the next year, the stock index finished higher 10 out of 11 times. (bullish)
2. In 20 of the past 26 years, the Dow Jones Industrials Average has moved in the same direction for the entire year that it moved on the first day. (bearish)

Gold is in a death spiral (biggest annual drop since 1981) as less Fed money-printing combined with no signs of inflation reduce the shiny metal’s attractiveness as insurance against U.S. dollar debasement. A lack of inflation means that maintaining some fixed-income exposure – despite the poor performance of bonds in the second half of 2013 — makes sense.

Emerging markets were terrible laggards in 2013 (along with commodities and the Japanese Yen), and may continue to underperform in 2014 because rising interest rates will reduce the capital inflows from the developed world many developing economies rely upon. Higher U.S. rates reduce the attractiveness of investing abroad. Commodity exports from developing countries could suffer based on a credit crunch and continued economic slowdown in China, a large importer of emerging-market goods.

On the other hand, the bearish view on emerging markets is a crowded trade, so contrarians could interpret this bearishness as a bullish sign. Developed economies currently appear healthier than emerging economies, but a recent IMF report reminds us that public debt in developed countries is at 200-year highs, is not sustainable, and will result in a painful restructuring at some point in the not-too-distant future. Stock-market gains and “painful restructuring” don’t mix.

Another crowded trade: fund managers are very bearish on defensive industry sectors such as electric utilities, REITs, and MLPs, but this could also be a contrary indicator, especially combined with analyst fundamental models finding such conservative stocks undervalued. It may be time to start rebalancing your portfolio by selling a small portion of  economically-sensitive, high-beta stocks that have done so well in 2013 and bulking up on the low-beta laggards (at least for the start of 2014). Market timing doesn’t work, but rebalancing does.

Bottom line: “The trend in U.S. indices remains strong” with no near-term warnings that a stock-market correction is near. The cumulative NYSE advance-decline line has hit an all-time high, confirming the new all-time high in the S&P 500. Bullish sentiment, however, has hit extreme levels (26-year high) that historically has signaled a likelihood in the intermediate term that the S&P 500 will fall back down to its 200-day moving average, which is currently at 1,685 (9% below the current index level of 1,841). Another indication that increased stock-market volatility is the one certainty in 2014.

Roadrunner Stocks Relative Performance

Since the Roadrunner service launched on January 24^th, the small-cap Russell 2000 has outperformed large caps.  In fact, the Russell 2000 has outperformed the large-cap S&P 500 in 10 of the 11 periods between the release of a Roadrunner monthly issue and the market close on Tuesday, December 31^st: This small-cap outperformance vindicates my January prediction in the article entitled Small Caps: The Time to Invest is Now.

Total Return Thru December 31^st

Source: Bloomberg

A majority (19 out of 30) of Roadrunner recommendations have outperformed the S&P 500 and both the Value and Momentum portfolios have a double-digit positive average return. The Value Portfolio continues to be the real star, with 9 out of 15 holdings (60.0%) outperforming, but the Momentum Portfolio isn’t far behind with eight of its 15 holdings (53.3%) having outperformed the S&P 500. The average return of the Momentum Portfolio has finally surpassed the S&P 500, showing outperformance (1.06%) for the first time since I started tracking this metric in the May issue of Roadrunner.

Overall, 26 of 30 Roadrunner holdings (86.7%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru December 31^st)

 Momentum Portfolio
(thru December 31^st)

Correlation Analysis

The two Front Runners added to the portfolios this week have 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 daily measuring periods over three years:

Momentum Portfolio 3-Year Correlations

Value Portfolio 3-Year Correlations

As you can see above, both CBOE Holdings and Fabrinet provide excellent diversification benefits to the Momentum Portfolio and Value portfolios. Based on my portfolio analysis software, the Momentum Portfolio was slightly underweight the “financial services” sector and “cyclical” stock type, so an options exchange like CBOE Holdings filled the gap well. In contrast, the Value Portfolio was underweight the “technology” sector and equal-weight the “cyclical” stock type, so a contract manufacturer of electrical components like Fabrinet complements the other portfolio holdings. Diversification by both industry sector and stock type are important investment considerations. December marks the second straight month I have bulked up on cyclical stocks. With the global economy potentially strengthening in 2014, increasing the amount of cyclical exposure in both portfolios right now in late 2013 makes a lot of sense!

CBOE Holdings is most negatively correlated with Darling International because risk management for common stocks and volatility benefits from economic and business uncertainty, whereas animal rendering and food-waste recycling businesses perform better when the energy and agriculture markets are growing in a stable manner. Fabrinet has a negative correlation with Brocade Communications because Brocade’s data-storage products for corporate computer networks face completely separate supply/demand characteristics from those faced by Fabrinet’s consumer electronics assemblies.

Looking at the correlation matrices below, the best diversifiers are those with a lot of red shadings. If you don’t already own SolarWinds or Apogee Enterprises in the Momentum Portfolio and/or Fresh Del Monte in the Value Portfolio, now would be a good time to pick up some shares in them. The best diversifiers in the Value Portfolio, however, are trading above their buy-below prices (BRCD, CRR, UTHR).

Total correlation matrices are shown below:

Momentum Portfolio

Value Portfolio