Market Outlook

At the close of trading on Friday, December 12th, the S&P 500 suffered its worst one-week decline in 2 1/2 years (since May 2012) on fears that collapsing oil prices and weakening Chinese growth indicates a global economic slowdown that will soon affect the U.S. economy. Market hate negative surprises and the collapse in oil prices could be viewed as a black swan event. So far in December, the S&P 500 is down 3.2%, which is not an unusual December drawdown in mid-month (average drawdown is -3.7%)  but would be very unusual if it persisted through the end of the month since December is historically the strongest month of the year and closes higher 82% of the time. In fact, the volume of declining stocks to advancing stocks on the New York Stock Exchange was 16:1 on Wednesday Dec. 10th. This type of washout has happened during the month of December only 14 times in the past 40 years and in 13 of those 14 years (93% of the time) stocks finished the year higher.

If a 93% win rate isn’t good enough, there is another statistic with a 100% win rate: Since 1986, the S&P 500 Volatility Index (VIX) has traded more than 34% above it 1-month low on 52 separate days in December. From the close of each those days through the end of the year, the S&P 500 has been positive each time without exception. On December 9th, the VIX closed 41% above its one-month low and the S&P 500 closed at 2,059.82, which is 2.9% above last Friday’s Dec. 12th close of 2,002.33.

What a difference one week makes!  On Friday December 5th, both the S&P 500 and the Dow Jones Industrials had hit new, all-time highs, marking the seventh consecutive week of gains since the mid-October low. Even the Nasdaq Composite, which has yet to exceed its Internet bubble-high of 5,049 from nearly 15 years ago in March 2000, needed only a 6.2% gain from its current level to break through and join the other major indices in the all-time high club.

The bull market in U.S. stocks continues thanks to unprecedented monetary stimulus outside of the United States in both Asia and Europe. On November 21st, the ECB emphasized the need to prevent deflation and the Bank of China (BOC) shocked global investors by cutting interest rates for the first time in more than two years. The BOC move could be a sign of desperation, given that Chinese economic growth is expected to increase “only” 7.4 percent, which would constitute the slowest annual growth in 24 years (since 1990). The yield on China’s 10-year government bond suffered its worst one-day decline in six years on the news as bond investors priced in less inflation and Chinese stocks rallied, reaching their highest level in more than three years (since Aug. 2011). The Chinese stock-market rally occurred in the face of a slowing economy, which is a fundamental disconnect (since weaker growth means lower corporate earnings) and analysts are puzzled, concluding that stocks are rallying solely due to a mysterious investor “frenzy.” Historically, frenzies don’t end well and Tuesday December 9th, when the Shanghai Composite suffered its largest one-day percentage decline since August 2009 , may be the start of further downside.

The Chinese economic slowdown may be long-lasting and, along with the U.S. fracking revolution and OPEC overproduction, are primary causes of the recent five-year-low in crude oil prices under $58 a barrel, which may not end soon and which may, along with other commodities, have entered a 13-to-15-year secular bear market. Unlike retail investors, corporate insiders are not panicking and, in fact, are buying energy stocks at the fastest pace since 2012.

Allianz chief economic adviser Mohamed El-Arian recently warned that the strong U.S. dollar may cause a sharp increase in stock-market volatility because the vast majority of investors do not hedge their equity portfolios against currency exchange rates: “When you have very sharp moves in the currency markets, something breaks.” The global investment strategist for the huge TIAA-CREF pension fund also predicts an increase in volatility as investors have not fully absorbed the fact that both short-term and long-term interest rates are likely to rise in 2015. From a technical standpoint, traders have been crowding into SVXY, the inverse-volatility index ETF, which suggests complacency and Deutsche Bank worries that a sudden unwinding of the low-volatility trade could cause a short squeeze in VIX futures that would result in VIX futures spiking much higher than they otherwise would.

On November 19th, the minutes of the October meeting were released and revealed that Fed members were concerned that economic weakness in foreign countries could hurt the U.S. economy, but concluded that the effect on the U.S. economy would be “quite limited.” The bond market appears to disagree, with both the 7-10 Year U.S. Treasury ETF (IEF) and the 20+-Year U.S. Treasury ETF (TLT) near their 52-week price highs (i.e., yields are near lows), which is probably due to foreign investors bidding up U.S. bond prices and chasing yield in reaction to declining interest rates in Asia and Europe and the appreciating U.S. dollar. I don’t U.S. bond prices can go much higher, however, because U.S. inflation is perking up and the Fed is likely to raise short-term interest rates in 2015, but history demonstrates that rising short-term rates do not cause long-term rates to rise by anywhere near the same magnitude. Somewhat troubling is the under-performance of high-yield “junk” corporate bonds (HYG), which are falling off a cliff thanks largely to the fact that energy companies comprise 15% of the junk-bond market. Junk bonds have historically been a leading indicator of where stocks are headed:

Prices for high-yield bonds are a great coincident—and sometimes leading—indicator for stocks because they are just above equities on the risk scale. When investors feel less comfortable about the world, they cut junk bonds from their portfolio first and then stocks second.

The November jobs report of 321,000 new jobs marked the 10th-consecutive month of more than 200,000 jobs – the longest streak since 1995. The headline number far surpassed the 230,000 forecast, and job gains in the prior two months were revised up by 44,000 collectively and the unemployment rate held steady at 5.8 percent, a six-year low. Overall, the November jobs report was a sign of continued strength:

It is time to retire clichés about the “slow but steady” recovery in the job market. The recovery has found its footing; there is no longer anything “slow” about it. Crucially, employers are paying workers more: Average weekly earnings rose 2.4 percent from a year earlier, their fastest pace in a year.

Third-quarter U.S. GDP growth was revised significantly higher to 3.9 percent annualized growth compared to the prior estimate of 3.5 percent. Combined with second-quarter GDP growth of 4.6 percent, this marks the strongest two-quarter U.S. GDP growth rate in more than a decade (since December 2003). As one economist put it: “economic growth is strong and getting stronger by the day.”

Wharton finance professor Jeremy Siegel calculates that the S&P 500 could rise an additional 10 percent to 2,300 before becoming fairly valued. But Siegel also believes that a 10% correction will occur sometime in 2015. He doesn’t recommend selling stocks now, however:

People say, ‘Doesn’t that mean I should wait for that?’ The answer is, ‘No,’ because if it’s up 15 percent and then goes down 10 percent, you’re still better off buying today. You don’t know when that’s going to come.

James Paulsen, chief investment strategist of San Francisco-based Wells Capital Management, also is wary of 2015 and would underweight U.S. stocks next year because the U.S. will be raising interest rates while other countries will be lowering them:

Good [economic] news is becoming bad news on Wall Street because it pushes the Federal Reserve closer to hiking interest rates. I think there’s got to be better bets in 2015 in markets that have underperformed the U.S. the last couple of years and that I think are likely to bounce in 2015.

Through November 28th, the S&P 500 had closed above its five-day moving average for 30 consecutive trading days. This degree of relentless low-volatile market momentum has never before occurred in history. The previous record of 27 consecutive trading days occurred in 1928  and the stock market subsequently doubled in value before crashing in 1929. All five other times — 1979, 1986, 1991, and 1996 (twice) — that the S&P 500 remained above its five-day moving average for 21 consecutive trading days or more, stocks were up over the next 12 months by a minimum of 11 percent. Lowry’s agrees, stating that the advance/decline line of large and mid-cap stocks recently hit all-time highs, thereby confirming the all-time price highs in the associated indices:

Perhaps the best investment news of the Thanksgiving week is that, while a bear market is eventually coming, many large-cap and mid-cap stocks are still healthy, solid participants in an old, but still spry bull market – far too early for a heavily defensive investment strategy. During the past week, the Advance-Decline lines for our [Operating Companies Only] large-cap and mid-cap segments rose to new bull market highs. Thus, while the market will become increasingly more selective over time, there are still many good opportunities for further gains in large-caps and mid-caps in the months ahead.

Although its true that declining oil prices historically have led to declining stock prices, the economy is simply too strong for oil prices to remain at such such low levels for very long. Urban Carmel (i.e., ukarlewitz) puts it this way:

Assuming the world is not on the precipice of a major recession, the price of oil should make its way higher to at least $80 over the next year. [That’s more than 30% above today’s $58 close].

Technical warning signs for a stock-market correction may be playing out right now, however, and could bode for a little more downside before the traditional Santa Claus rally at the end of the year:

• The stock market is showing a bearish megaphone chart pattern (higher highs, lower lows), which historically has signaled a 10-percent correction.
  
• During the third week of November, the S&P 500 exceeded its weekly upper bollinger band, which acts as an impenetrable ceiling 97.5% of the time. Historically, whenever the market’s rubber band gets stretched so tight, stock prices recoil back down over the next several weeks.
• Corporate profit margins are at record highs, which may be unsustainable.  If reversion to the mean were to occur, corporate earnings could fall. No evidence of reversion, yet, however.
• Junk-bond weakness, although it may be caused by the oil crash alone and not risk aversion in the overall economy.

Bottom line: For now, I would stay invested because the Ivy Portfolio market-timing system based on the 10-month moving average remains on a “buy” signal for U.S. stocks, bonds, and real estate (sells are foreign stocks and commodities). Even after this week’s market carnage, the S&P 500 remains 39 points above its 10-week moving average (2002 vs. 1963).

The value of following the 10-month moving average was proven once again in the current commodity crash. If you had cashed out of commodity-related stocks — including energy stocks — when the PowerShares commodity ETF (DBC) closed below its 10-month moving average at the end of July, you would have saved yourself a 20%-plus price decline.

Roadrunner Stocks Relative Performance

Small-cap stocks continue to underperform as the collapse of oil prices has investors rushing to the relative safety of large caps. Small caps have now outperformed the large-cap S&P 500 in only one of the 22 Roadrunner time periods, but the rubber band of small-cap underperformance has been stretched too thin and small caps should come roaring back. 

Comparative Index Total Return Thru December 5^th   

Source: Bloomberg

More than half (23 out of 40) of Roadrunner recommendations have outperformed their respective small-cap benchmarks and both the Value and Momentum portfolios have a positive double-digit average return. The Value Portfolio shows 11 out of 20 holdings (55%) outperforming VBR and sports an average return since inception of 29.22%, 11.15 percentage points better than VBR. In contrast, the Momentum Portfolio has 12 of its 20 holdings (60%) outperforming DWAS and sports an average return since inception of 16.10%, 12.96 percentage points better than DWAS.

Performance Scorecard

Overall, 27 of 40 Roadrunner holdings (67.5%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru December 5^th)

Momentum Portfolio
(thru December 5^th)

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 – Harte-Hanks (HHS) — 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 Harte-Hanks (HHS). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, Harte-Hanks provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting industrial conglomerate Lydall, the Value Portfolio was underweight the “consumer cyclical” sector and completely devoid of the “high yield” stock type, so a dividend-paying marketing company helps diversify in regards to both industry sector and stock type. 

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

Source: Morningstar

Harte-Hanks has a very low correlation with United Therapeutics (UTHR) and Exactech (EXAC) because people who suffer from pulmonary arterial hypertension or need joint replacements are an older demographic that is not the focus of marketing campaigns that typically target the younger 18-49 demographic.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own medical-device company Exactech (EXAC) or agricultural equipment company AGCO Corp. (AGCO) in the Value Portfolio, now would be a good time to pick up some shares as both are currently trading at a buyable price level.

A total correlation matrix is shown below:

Value Portfolio