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Summary U.S. market capitalization weighted indexes have outperformed in 2015. The largest U.S. capitalization stocks have melted up, and this trend forged ahead in 2015. Under the surface, the meltdown of out-of-favor assets has accelerated. Either a broader melt-up or meltdown scenario remains a probable outcome. A large cash weighting and an exposure to out-of-favor assets (a barbell approach) is an ideal portfolio strategy for this environment. “A dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy.” – Definition of “Melt Up” from Wikipedia “A rapid or disastrous decline or collapse” – Definition of “Meltdown” from Merriam-Webster “To buy when others are despondently selling and to sell when others are avidly buying requires the greatest fortitude and pays the greatest ultimate rewards.” – Sir John Templeton – 1958 Introduction I have written two articles on the stealth U.S. bear market on Seeking Alpha in 2015. In part one of this series, authored on July 9th, 2015, I examined building negative divergences in the U.S. stock market, and those divergences ultimately foreshadowed the August market sell-off. In part two , authored on December 1st, 2015, I highlighted two distinct markets under the surface of the U.S. stock market, profiling the “Winning” and “Losing” companies, and their distinctive stock prices. The conclusion of that piece suggested buying the “Losers” and selling the “Winners”, which, as a contrarian, I have openly advocated for over the last several years, with little success thus far, and a whole lot of pain. Third Avenue confirmed last week that this advice remained too early, as credit markets continued to seize up, with high-yield bond prices undercutting their August lows. As yield-chasing and bottom-fishing investors continue to be punished, the world’s central banks, with the notable absence of the Federal Reserve (who may have to shift course from their tightening rhetoric very soon), remain poised to inject further liquidity into the system. The end result is that more than any time in recent history, the markets are dually poised for a climatic melt-up or meltdown scenario. Proponents of the melt-up scenario will argue that many investors who capitulated in 2008 and 2009 remain out of the market, providing a wall of worry to climb. Advocates of the meltdown scenario believe that stock market divergences have been developing for years, setting the stage for a historic unwind, as low-conviction investors bail out of their thinking that stocks are the only game in town. Which direction will the market break, and how should investors position their portfolios? Thesis Melt-up and meltdown scenarios are equally plausible for U.S. equity investors. Thus, a barbell approach, where a high cash weighting is combined with extreme out-of-favor assets remains the best approach. QQQ> SPY> RSP> IWM In the U.S. stock market in 2015, a bigger market capitalization has correlated very positively with outperformance. This can be illustrated by looking at the performance of the PowerShares QQQ ETF (NASDAQ: QQQ ), which is designed to track the performance of the NASDAQ 100 Index, which counts five of the world’s ten largest market capitalization companies among its largest holdings, Apple (NASDAQ: AAPL ), Alphabet (NASDAQ: GOOGL ), Microsoft (NASDAQ: MSFT ), Amazon (NASDAQ: AMZN ), and Facebook (NASDAQ: FB ). These aforementioned companies are weighted more heavily in the PowerShares QQQ ETF, than they are in the S&P 500 Index, as measured by the SPDRs S&P 500 ETF (NYSEARCA: SPY ), and their weightings in the respective indexes are responsible for a large portion of the outperformance of the QQQ (up 8.06% YTD) over the SPY (down 0.35% YTD) as shown in the charts below: An equal-weighted version of the S&P 500 Index, which is represented by Guggenheim S&P 500 Equal Weighted ETF (NYSEARCA: RSP ), is disadvantaged by its lower relative weighting to the biggest market capitalization companies, and it is down over 4% in 2015. Moving further down the market capitalization spectrum, U.S. small capitalization stocks, which are prominently measured by the Russell 2000 Index, represented by the iShares Russell 2000 ETF (NYSEARCA: IWM ), are down over 5% in 2015. From the charts above, clearly the performance of the U.S. stock market in 2015, has been heavily influenced by investor flows and fund flows to larger companies, who are perceived to offer an attractive combination of safety and growth potential in a slowing global GDP world economy. AAPL, AMZN, GOOGL, FB, MSFT = Amazing It cannot be overstated how important Apple, Amazon, Alphabet, Facebook, and Microsoft have been to the performance of the U.S. stock market in 2015. These five stocks and one other, Netflix (NASDAQ: NFLX ), have accounted for the vast majority of the market capitalization gain in the S&P 500 Index, and the resilience of their stock prices in the face of broader market weakness, has kept the market capitalization indexes from showing far greater losses on a year-to-date basis. Visually, the contrast of their stock charts is stunning to see, so I have included charts of AMZN, GOOGL, and MSFT as follows: By itself, Amazon has added $150 billion dollars in market capitalization in 2015. That is amazing, especially when it was viewed as overvalued by a majority of investors entering 2015. The ominous takeaway from the dominance of a handful of stocks is that this concentrated leadership often marks the tops of bull markets, and one only has to look back to March of 2000, when six stocks accounted for the entirety of the gain of the S&P 500 Index, to see a similar, negative reference point. A Meltdown Alongside A Melt-Up? While the broad market averages bounced back strongly following their August 2015 lows, high yield bonds, as measured by the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) and iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA: HYG ), only managed a weak recovery, and have subsequently made new lows as shown in the charts below: Many analysts have attributed the unrelenting sell-off in high-yield bonds to the ongoing carnage in the commodities sector, specifically the energy market, which had extensively used high-yield financing. The fall of oil, as measured by the United States Oil Fund (NYSEARCA: USO ), seems to add credence to this thought process. Crude oil, which is down nearly 50% in 2015, after a difficult 2014, and natural gas, which is represented by the United States Natural Gas Fund (NYSEARCA: UNG ), down nearly 50% as well, which is shown in the chart below, both demonstrate how difficult the operating environment has been for energy firms. The end result is that stocks like Chesapeake Energy (NYSE: CHK ), the second largest natural gas producer in the U.S, and a major oil producer, with some of the best land acreage in the industry, has seen its shares devastated, down over 78% in 2015. Even better operators, like Antero Resources (NYSE: AR ) have lost over 50% of their market capitalization. The energy unwind has even spread to solar companies, which seemingly have the world’s political tailwinds at their back. This is best evidenced by the dramatic decline in SunEdison (NYSE: SUNE ), a company I recently authored a contrarian article on , whose shares have fallen precipitously since making their highs in July of 2015. The high-yield bond market, commodities, and a large number of dislocated stocks clearly show that there has been an ongoing meltdown, which has been partially obscured by the outperformance of a narrow group of mega capitalization technology stocks. A Fork In The Road With a large number of stocks already in their own bear markets, which can be defined as being off 20% from their highs, but the broad market indexes still far from a bear market, what is the best course of action for investors? There are two possible, probable scenarios that are as different as night and day. First, in an optimistic light, the correction in asset markets may have already run its course. If the market leadership stocks can simply tread water, any improvement in the economically sensitive, out-of-favor sectors of the market, could initiate a rotation that propels broad market indexes to new highs, climbing the proverbial wall of worry. Market analysts that reference this scenario, often recall an overvalued market getting more overvalued, similar to the NASDAQ market in 1998 to 2000. This is the melt-up scenario. The second scenario is decidedly more bearish. Its interpretation would be that the weakness in commodity prices is foreshadowing the next recession. Thus, high-yield bonds, at their current levels, could be fairly priced, not mispriced, and if that is the case, they are indicative of a fair value of 1,650 for the S&P 500 Index, which would be an 18% decline from its closing price on December 11, 2015. Under this scenario, with valuations where they are today (see the below chart from Ned Davis), the markets could gather momentum on the downside, so the ultimate sell-off could cut much deeper, hence the risk of a meltdown. (click to enlarge) The Barbell Approach On December 7th, 2015, I authored a portfolio strategy article on Seeking Alpha, which has generated a terrific commentary section, titled “Why A 90% Cash Portfolio Will Probably Outperform”. In this article, I investigated the merits of an extreme portfolio approach given the uncertain environment, where 90% of an investor’s portfolio was kept in cash, and the remaining 10% was invested in a concentrated portfolio of deep-value, distressed equities. The graphic I produced to illustrate the merits of the portfolio is replicated below: (click to enlarge) On December 7th, 2015, I also lau nched ” The Contrarian “, a p remium research service on Seeking Alpha. As part of my research service, I have several model portfolios that I am tracking with real-world transactions, so that readers can see a working example of my portfolio theory. One of the portfolios I am tracking with positions is the “90/10 Portfolio”, which I am posting an update on today. With the S&P 500 Index retreating 3.7% for the last week, the “90/10 Portfolio” was actually positive for the week. While admittedly this is a small sample size, it shows the benefit of this extremely conservative/aggressive approach. Conclusion Large-capitalization stocks are the locomotive that keeps pulling an otherwise unhealthy market train forward up a steep hill. Active managers continue to struggle, as has been the case for nearly this entire seven-year bull market, as a narrower and narrower group of stocks have led the market averages higher. The negative divergences could be signaling the start of a significant downturn, or the general apathy and frustration towards a large swath of individual stocks could signal a significant wall of worry to climb in the future. The prevailing thought in the markets is akin to this quote from Steven Roge, in the previously linked Bloomberg piece on Third Avenue, “The past few years (have not) been a good time to be a contrarian investor…Investors in that group have been trying to catch a falling knife that keeps on falling.” Reversion to the mean is one of the most powerful forces in the financial markets. Today, a reversion to the mean in the broad market indices would imply seven years of zero-to-negative returns. For out-of-favor assets, however, a ‘reversion to the mean’ trade could spark a powerful upside move that is unexpected given the current headwinds facing the out-of-favor companies. A barbell approach works in this environment. From my perspective, for the first time since 2009, it is an ideal time to be a contrarian, and today that would mean a barbell approach heavily weighted towards unloved assets, like cash, and out-of-favor equities, like commodity stocks. For more information , please peruse my research in “The Contrarian”. Scalper1 News
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