Inside The Stock Market ...trends, cross-currents, and outlook

Small Caps lagged the S&P 500 by almost ten percentage points in 2014, but their underperformance streak technically dates back to April 2011. Nonetheless, their cumulative, 45-month underperformance in relation to the S&P 500 (now about –18%) is still modest enough that any mention of the current “Large Cap Leadership Cycle” is bound to draw a few head scratches.

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Last year was a solid one for the Group Selection (GS) Score approach, with the Attractive list delivering a total return of +13.1%—more than 500 basis points above The Leuthold Group Universe average, which gained only +7.9%.

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The recent Energy sector decline has accomplished the feat of wiping out all of the upside gains achieved during its “Third Act” played out in the 2006-2008 surge.

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For more than a quarter century, The Leuthold Group has tracked hypothetical industry group portfolios composed of the previous year’s “Dreams” (best performers) and “Nightmares” (worst performers). The former is a gauge of a simple, trend-following investment strategy, while the latter is a crude form of industry group “bottom-fishing.” Sticking with tradition, the following pages detail how the 2013 Dream and Nightmare portfolios faired in 2014, and we reveal which industries qualify in the Dream and Nightmare portfolios of 2014.

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In early October 2014, we noted the momentum reversal of Low Quality stocks and a few signs of the likelihood of transitioning to another phase of the quality cycle. The official numbers of Q4 have confirmed this.

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Extreme market viewpoints get the headlines, but it’s baked into our disciplines that we will (occasionally) be noncommittal.

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Market gains have been less broad than in 2012 and 2013; market direction and leadership have been mismatched; and quantitative factors have been choppy.

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The median S&P 500 stock is now expensive enough that we’re able to estimate its potential downside to prior bull market highs! Based on an average of four valuation measures, the median stock needs to drop about –11% to match the typical valuations at the eve of a cyclical bear market.

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Government accounting on everything ranging from the CPI, to the budget deficit, to even the unemployment rate is constantly assailed as being too rosy. So when a government report occasionally paints a less optimistic picture than the consensus one, we’re inclined to sit up and take notice (especially when we agree with it).

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The S&P 500 record median profit margin of 10.3% is now almost a full percentage point above the last cycle’s peak of 9.4% (second quarter of 2007). Trends across S&P sectors are not as uniform as one might expect, though, with only half of the ten sectors last quarter at profitability levels that exceeded their 2001-2007 expansion highs.

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The dollar’s moonshot in recent months has resuscitated a stock market leadership argument we haven’t heard for a long time.

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While we expect an eventual break in this relationship, today Emerging Market equities are following, fairly tightly, the cycle of industrial commodities—a cycle that rolled over (on a secular basis, we believe) in 2011.

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We’ve been negative on industrial commodities for some time, reflecting the persistently (and unsustainably) high levels of investment evidenced by our Global Group analyses of commodity-oriented industries.

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Last month’s tactless comments from MIT health care economist Jonathan Gruber contained an (accidental) investment nugget we’ve alluded to several times in the last three years (and, no, it does not relate to the “stupidity of the American voter” or investor).

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With the quantitative horsepower now available at the fingertips of even the most technophobic portfolio manager, there’s little tolerance for any model that finds itself out of sync. But “broken” models (and especially value-based ones) have an eerie way of reasserting their relevance just after they’ve been finally tossed to the trash heap.

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The price of crude oil staged a dramatic change of fate in the past few months, and the bottom is still nowhere in sight.

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We remain positioned with below-average net equity exposure in tactical portfolios for now. We’re inclined to think there may be more trouble ahead for the stock market.

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Considering the Major Trend improvement, new bull market highs (Nov. 6th) on the S&P 500, DJIA, and DJ Transports, we present a list of talking points we’d use if forced to make a bullish stock market case.

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The renewed embrace of risk hasn’t extended to the sector level. After resisting decline in late September through mid-October, defensive sectors have matched the rebound in Cyclicals, almost point for point.

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