Market Outlook

U.S. GDP in the first quarter was revised down to a -0.7% contraction from the original estimate of 0.2% growth. This marks the third time in the six-year economic recovery from the 2008-09 recession that GDP has shrunk. Reasons for the decline include: (1) bad winter weather hurting consumer spending, (2) a strong U.S. dollar hurting exports to an extent some call a collapse, and (3) a West Coast port strike. Since both winter weather and the port strike are over, and the U.S. dollar quickly sunk to a four-month low in May after breaking a nine-month winning streak, many economists believe that the first-quarter GDP decline was a one-time event and that growth will rebound in the second quarter similar to 2014 when GDP rebounded 4.6% in the second quarter after a first-quarter decline. Indeed, there appears to be a “residual seasonality” problem in first-quarter GDP reporting that causes the first-quarter to almost always be the weakest quarter of the year. The Commerce Department plans to adjust GDP numbers by July 30^th to better account for seasonality factors.

There is evidence that the first-quarter slowdown may be caused by more than a seasonality quirk in U.S. data. Canada’s economy also contracted in the first-quarter – and by the worst annualized amount (-0.6%) in nearly six years.  China also grew by the least amount (7.0%) in six years during the first quarter and Japan remains moribund. On the other hand, the Eurozone experienced positive first-quarter growth thanks to the introduction of the European Central Bank’s quantitative easing program and German stocks advanced during the first quarter by the largest percentage in 27 years (since the DAX index was created in 1988).

Any U.S. economic rebound in the second quarter may be muted since some data points since the end of the first quarter remain weak. For example, Chicago business activity in May fell to 46.2, which is contractionary. Readings below 46.2 have historically signaled recession. In addition, May consumer sentiment hit a six-month low. On the other hand, April job growth was strong at 223,000, the four-week moving average of jobless claims is near a 15-year low, and contracts to purchase existing homes in April hit a nine-year high. All in all, the leading economic indicators (LEI) remain positive but “the growth of the LEI does not support a significant strengthening in the economic outlook at this time.”

The current economic malaise is a far cry from the strong economic growth experienced during the second and third quarters of 2014 when growth hit 4.6% and 5.0%, respectively – the strongest growth in a decade. Everyone was hoping that strong growth was signaling that the U.S. economy was finally ready to break out to the upside and leave its anemic behavior, but it now looks like mid-2014 was a fake out, which is common during “stop-and-go” economic periods. Former U.S. Treasury Secretary President Lawrence Summers speculates that the U.S. economy is suffering from a “secular stagnation” that promises below-average growth and low interest rates for many years to come. Goldman Sachs is skeptical, however.

Small-cap stocks do best in very-strong economic upswings, so a secular stagnation scenario would be less than ideal for small-cap investments. However, U.S. small caps and foreign stocks are due for an outperformance streak against the large-cap S&P 500 because the S&P 500 is extended and needs to pause. In 2014, the large-cap Russell 1000 outperformed the small-cap Russell 2000 by 8.35%, the largest margin since 1998. The S&P 500 outperformed the MSCI EAFE (foreign index) by 18.59%, the most since 1997. Enough is enough. In the first quarter of 2015, the Russell 2000 index “posted the strongest first-quarter 2015 of any U.S. market segment” and European stocks were even stronger. Put these two outperformance themes together and 2015 may turn out to be the year of the international small cap.

Federal Reserve Chairman Janet Yellen stated on May 22^nd that a rate hike would occur this year despite the recent weak economic data. According to NY Fed President William Dudley, what’s important for the markets is not whether an initial rate hike occurs, but that any future rate hikes are done gradually and take into account the market’s reaction to each hike, pausing for a time if the market reaction is overly negative. Earlier on May 6^th, Yellen said that stock valuations “generally are quite high” and that bond yields “could see a sharp jump” when the first rate hike occurs. Some scary talk, but Yellen isn’t known for prescient financial predictions, just as Alan Greenspan in December 1996 was premature by more than three years in saying that the stock market was exhibiting irrational exuberance.

According to S&P’s Sam Stovall, Yellen will be proven wrong despite the currently high earnings multiples because corporate earnings growth will “shift into overdrive” in the next 12 months, thereby enabling the S&P 500 “to close 2015 at an all-time high and eclipse the 2300 mark by year-end 2016.” The “Rule of 20,” which sums the price-to-earnings (P/E) ratio with the consumer price index (CPI), is currently below 19 versus 22 at bull market tops since 1948, implying that stocks are not overpriced. Jeffrey Saut of Raymond James is even more bullish, convinced that we are in a secular bull market that will take the S&P 500 to 4300 by 2023-24.

Merger mania (primarily in the cable and tech sectors) has some analysts worried about an overheated market, with the $37 billion takeover of semiconductor manufacturer Broadcom – the biggest tech takeover ever – by a Singapore company a prime example of insider smart money selling out at the top. On the other hand, U.S. equity funds are experiencing the largest investor outflows since 2009, with April experiencing the largest monthly outflow since July 2014, which suggests that retail dumb money is selling out. The only U.S. shareholders that aren’t selling U.S. stocks are the U.S. companies themselves, with April marking the largest amount of stock buyback announcements in a single month in history. Based on these mixed signals, I think the market can move higher because there appears to be a wall of worry among retail investors that refutes the contrarian idea of fading extreme bullishness – clearly everybody who wants to buy has NOT already bought.

From a technical perspective, signs are pointing to a 10% correction mid year, but for stocks to recover into year-end and notching another gain. The correction signal is the curious divergence between the Dow Jones Industrials, which hit new highs in May, and the Dow Jones Transports, which have struggled at six-month lows. According to Jason Goepfert, this is the first time in 100 years that such a wide divergence between the industrials and the transports has occurred. According to Mark Hulbert, in the past 14 instances where such a divergence has occurred, five have resulted in serious bear markets averaging a 25.7% decline. A one-third chance is less than half, but substantial enough to mention. According to Urban Carmel, June could act as a corrective catalyst:

The trend in US equities remains higher. But momentum is very weak and breadth suggests the uptrend is running on fumes. This is the set up as we enter June, one of the weakest months of the year for equities.

On a much more bullish note, the first half of 2015 is shaping up to be the narrowest trading range (6.15% high to low) in the history of the Dow Jones Industrial Average (dating back to 1896):

Since 1896 there’s been 19 times that the Dow has traded in a range of less than 10 percent high to low. Thirteen of those 19 times the Dow went on to gains in the second half of the year, and only three times of those 19, the Dow closed negative. The average year-to-date return of those 19 occurrences is positive 8.25 percent.

Low volatility is often interpreted as investor complacency and a contrarian bearish signal, but history says otherwise!

Another technical study found that in the 39 years where the S&P 500 has gained both year-to-date through May and in the month of May itself (like this year), stocks have averaged a 7.percent subsequent gain through the end of the calendar year, which is actually better than the average year. Even in the nine instances where stocks were more overvalued on a P/E basis than they are currently, stocks averaged a 4.3% subsequent gain through year end.

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, foreign stocks, and bonds (sells are real estate and commodities).

Roadrunner Stocks Relative Performance

Thanks entirely to one day’s trading on April 30^th, when small caps lost more than twice as much on a percentage basis as large caps due to fears of an economic slowdown, the historical outperformance of small caps during Roadrunner’s existence took a severe beating. Whereas last month small caps had outperformed large caps 62% of the time (16 of 26 time periods), now small caps have outperformed in only nine of the 27 Roadrunner time periods, or 33% of the time. The good news is that the weak Q1 GDP figure is a statistical anomaly and the U.S. economy should grow much faster in coming quarters. Consequently, once these unfounded economic fears dissipate, small caps should come roaring back because they are much more economically sensitive.

Of the nine periods of small-cap outperformance, the value style of small cap has outperformed two times and the momentum style seven times, which demonstrates the diversification benefits of investing in both the value and momentum equity styles. Small-cap value outperformed over longer time periods, whereas momentum has been an outperformance star over the more-recent time periods.

As I explained in the initial January 2013 Roadmap article entitled Your Destination to Profits, the best long-term investment results will be achieved from a diversified portfolio consisting of both value and momentum stocks. A 50-50 allocation to value and momentum is the “holy grail” of investing.

Seven of the past nine time periods have seen small-cap momentum outperform large caps, so we are currently in a momentum “sweet spot.”

Comparative Index Total Return Thru May 22nd  

Source: Bloomberg

More than half (21 out of 40) of Roadrunner recommendations have outperformed their respective small-cap benchmarks and both the Value and Momentum portfolios have positive 20%-plus average returns. The Value Portfolio shows 8 out of 20 holdings (40%) outperforming VBR and sports an average return of 22.30%, 3.87 percentage points better than VBR. In contrast, the Momentum Portfolio has 13 of its 20 holdings (65%) outperforming DWAS and sports an average return of 37.08%, blowing away DWAS by an astounding 25.63 percentage points. When individual momentum stocks outperform an index, they REALLY outperform!

Performance Scorecard

Overall, 28 of 40 Roadrunner holdings (70%) have generated positive absolute returns. Below, each Roadrunner portfolio lists the best relative performers in descending order:

Value Portfolio
(thru May 22nd)

Momentum Portfolio
(thru May 22nd)

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 – MSC Industrial Direct (MSM) — 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 MSC Industrial Direct (MSM). The time frame for the correlations was daily measuring periods over three years:

Value Portfolio 3-Year Correlations

As you can see above, MSC Industrial Direct provides excellent diversification benefits to the Value Portfolio. Based on my portfolio analysis software, after deleting real estate financer Stewart Information Services, the Value Portfolio was severely underweight the “industrial” sector and was modestly underweight the “cyclical” stock type. MSC Industrial Direct is both an industrial and cyclical, so adding this stock helps diversify the portfolio in two important ways.

Value Portfolio Composition After Stewart Information Services is Sold
But Before MSC Industrial Direct is Added

Source: Morningstar

MSC Industrial Direct has a very low correlation with Sanderson Farms (SAFM) because industrial tools are economically sensitive and a pure play on stronger growth, whereas poultry is a relatively inexpensive food —  a consumer staple — which is eaten by people in any economic environment. MSC Industrial Direct also has a low correlation with Rayonier Advanced Materials (RYAM) because cigarette filters are not only a consumer staple but an addictive one, and thus impervious to economic weakness.

Looking at the correlation matrix below, the best diversifiers are those with a lot of red shadings. If you don’t already own poultry-processor Sanderson Farms (SAFM), energy services firm RPC Corp. (RES), or cigarette-filter manufacturer Rayonier Advanced Materials (RYAM) 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