Market Outlook

The stock market continues to hit new all-time highs, seemingly on a daily basis. Positive momentum is at an extreme, but has been for quite a while. All bets on a market pullback have been money losers. The volatility index (VIX) is at multi-year lows, averaging 13.77% during the first half of 2014 (lowest average level since 2006), which signifies investors have no fear that the good times won’t continue for the foreseeable future.

One of the few warning signs that the market may be topping was negated on July 1^st when the small-cap Russell 2000 finally hit a new all-time intraday high after suffering a 9.3% correction and underperforming the large-cap S&P 500 since hitting its last all-time on March 4^th. Whereas the S&P 500 has continued to hit new all-time highs each month in 2014, the negative divergence of the Russell 2000 since March had technicians worried, but you can now throw that concern out the window! The Dow Jones industrials and transportation indices also hit new highs simultaneously on July 1^st, so a fresh Dow Theory “buy signal” was also triggered. As one market commentator put it: “There’s nothing more bullish than both averages closing at all-time highs on the same day.”

More evidence of the extreme positive market momentum:

1. Both the S&P 500 and the Nasdaq Composite completed a sixth straight quarter of gains on June 30^th, a streak not seen in more than 14 years for the Nasdaq and 16 years for the S&P 500.
2. Six indices comprising stocks, bonds, and commodities all rose during the first half of 2014, the first time all six have risen simultaneously in 21 years (since 1993): (1) U.S. stocks, (2) foreign developed-market stocks, (3) foreign emerging market stocks, (4) 10-year U.S. Treasury bonds, (5) commodities composed of agriculture, energy, and industrial metals, and (6) gold. This simultaneous phenomenon is unusual because:  “stocks and most commodities tend to rise in good times, while bonds and gold often benefit from economic weakness and market distress. “
3. CBOE put-call ratio is at 0.49, the lowest ratio in 3 ½ years (since early 2011), which signifies extreme investor bullishness.
4. S&P 500 has not closed up or down by at least 1.0% in more than 50 days – the longest period of stagnation since 1995.
5. S&P 500 has not suffered a 10% correction in more than two years.
6. S&P 500 has not touched its 200-day moving average since November 2012. 
7. The current market’s positive momentum has “shredded prior precedents.”
8. Wharton finance professor Jeremy Siegel states that the Dow Jones Industrials could hit 20,000 by the end of this year. Keep in mind, however, that he was bullish at the end of 2007 also and that prediction was dead wrong.

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.

On the negative side, first-quarter GDP was revised down to negative 2.9%, the worst quarterly economic contraction in five years (since 2009). The original estimate of Q1 2014 growth back in April was positive 0.1%, which was then revised down to negative 1.0% in May, and then revised down again in June to negative 2.9%. The massive downward revision of 3.0% over the entire three-estimate cycle was the largest downward revision since revision records began to be kept in 1976. Granted, winter weather was very cold in parts of the U.S., but such a dismal Q1 economic performance cannot be explained away by regional weather. According to financial blogger Zero Hedge:

US GDP has never fallen more than 1.5% except during or just before an NBER-defined recession since quarterly GDP records began in 1947.

Housing is a substantial part of the U.S. economy (18% of GDP) and money manager Jeffrey Gundlach is recommending that investors sell short homebuilders because declining affordability is causing a housing market downturn. Recent housing data does not look bearish, however. In addition, economic growth forecasts for the remainder of 2014 have been cut by:

1. The World Bank
2. The International Monetary Fund (IMF)
3. The U.S. Federal Reserve

The European Central Bank (ECB) recently cut its benchmark interest rate to 0.15% from 0.25% (including a negative interest rate for banks) and may institute a bond-buying quantitative-easing program. This suggests desperation and the ECB must be worried about accelerating economic weakness.  

On the positive side, the first-quarter economic contraction may have been an anomaly and most economists forecast resumed economic growth for the remaining three quarters of 2014:

1. Five straight months of robust job growth, including 288,000 jobs in June. First time since the late 1990s that employment has grown above a 200,000-jobs pace for five straight months.
2. Corporate earnings growth is expected to accelerate in the second quarter and hit double-digits in the third and fourth quarters.
3. June auto sales were highest in eight years and ISM manufacturing remains strong.
4. Fed Chairman Janet Yellen doesn’t care about inflation and is solely focused on promoting U.S. economic growth.
5. Standard & Poor’s has upgraded its economic forecast for the United Kingdom.
6. China’s manufacturing activity in June hit a six-month high, leading economists to proclaim the worst of the economic slowdown is over.

With interest rates remaining low and the uncertain future direction of the economy on the head of a pin, the market continues to rise until “something” gives, either higher interest rates or lower corporate profits. In other words, that “something” may be unknown but it will be a negative event, whatever it turns out to be. So, risk is high and warning signs are flashing:

1. Stock trading volume is “dead.” Almost nobody is buying and sellers have their hands on the sell button but waiting for a trigger.
2. The largest buyers of stocks are the corporations themselves, which have a notoriously bad record of buying at market tops. The smart money (hedge funds, corporate insiders, and institutional investors) are currently net sellers.
3. Merger & acquisitions (M&A) activity is at a seven-year high. Historically, extremes in M&A are correlated with market tops.
4. Margin debt is declining, which historically signals increased investor risk aversion and results in a subsequent decline in equity prices.
5. Corporate profit margins are at all-time highs and primed to revert back down to their long-term average level.
6. The Bank for International Settlements stated that stock markets are “euphoric” and “detached from reality” thanks to the unsustainable easy-money policies of global central banks.
7. Based on the Q Ratio (market price divided by asset replacement cost), the market is 80% overvalued.
8. Market cap to GDP ratio of 114.5% is nearly two standard deviations above its mean and is higher than at any other market peak of the past 45 years except the Internet bubble of 2000. 

In conclusion, people have worried about a market correction for years, but any declines have been short-lived and the market has kept climbing. Anyone that cashed out prematurely has missed out on enormous capital gains. Although caution and prudence are always warranted, investing is a marathon, not a sprint, and long-term investors should remain invested at all times because market timing is impossible. As Citigroup CEO Charles Prince said in 2007:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.

Roadrunner Stocks Relative Performance

Small-cap stocks staged an amazing comeback during the May-June period, and the small-cap Russell 2000 hit a new all-time high in the process. The long winter of discontent is over for small caps, and the Russell 2000 has now outperformed the S&P 500 in seven of the 17 Roadrunner time periods (after having underperformed the S&P 500 in all 16 time periods at the end of May). Quite the turnaround that should continue in the months ahead.

Total Return Thru July 1^st

Source: Bloomberg

A majority (21 out of 40) of Roadrunner recommendations have outperformed the Russell 2000 small-cap index and both the Value and Momentum portfolios have a positive average return. The Value Portfolio continues to be the real star, with 13 out of 20 holdings (65.0%) outperforming the Russell 2000 and sporting an average return since inception of 30.12%, 10.82 percentage points better than the Russell 2000. In contrast, the Momentum Portfolio – which is in the process of being reformulated – has only eight of its 20 holdings (40.0%) outperforming the Russell 2000 and lags the benchmark by a modest 3.30% on average.

One reason for the improved performance of the Momentum Portfolio is that my new stock-selection criteria has already proven itself, with Vipshop Holdings (VIPS) and Matador Resources outperforming their Russell benchmark by a whopping 32.95% and 8.48%, respectively. Another reason the Momentum Portfolio’s relative performance has improved: some of the biggest laggards (CVLT, HMSY, OCN, LF) hurting portfolio performance were sold last month.

Performance Scorecard

Overall, 32 of 40 Roadrunner holdings (80.0%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru July 1^st)

Momentum Portfolio
(thru July 1st)

Correlation Analysis

Please note: The goal of the new Momentum Portfolio will be that all short-term stock holdings move in the same positive direction at the same time. Consequently, going forward, I will only provide correlation data for the Value Portfolio (long-term focus).

The Value Portfolio Front Runner this month – Sanderson Farms (SAFM) — 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 Sanderson Farms (SAFM). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, SAFM provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, the Value Portfolio was seriously underweight the “consumer defensive” sector (caused by the deletion of Fresh Del Monte Produce) and overweight the “aggressive growth” stock type, so a poultry food processor helps diversify in regards to industry sector but hurts on stock type.

Sanderson Farms has a very low correlation with AGCO because a company that benefits from low feed prices for its chickens gets hurt when crop prices rise and farmers are more likely to purchase farm equipment from AGCO.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own AGCO, Fabrinet, and/or W.R. Berkley 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

New Feature: Best Buys

 Perhaps the most important tenet of investing is diversification. The best performance results will occur if you buy all 40 stocks in the the Value and Momentum portfolios. On the other hand, I realize that some members of the Roadrunner service have limited funds and want to “pick and choose” among the portfolio holdings. For this reason I now label five stocks in each portfolio “best buys”, which means they are the stocks you should buy first with whatever funds you have available for small-cap stock investing. All of the stocks in the two portfolios are companies I admire and would be happy to own at the right price, but my criteria for the best buys is as follows:

• Current stock price is less than than the “buy below” price
• Safety rating is 3 or above
• Financial performance is improving
• Growth prospects are above average and experiencing a near-term catalyst