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STA Weekly Market Report – Is The Honeymoon Over?

Week of February 6, 2017

INSIDE THIS EDITION:

Is The Honeymoon Over?
Chart Of The Week “Corporate Earnings Update”
Weekly Technical Comment
401k Plan Manager
Weekly Snapshot of Global Asset Class Performance
Features Articles & Interviews

Upcoming STA Community Event
STA Wealth Management, Co-sponsored by Fidelity Investments 
“How Will the Trump Administration Affect  Your Retirement?”

Thursday, February 23rd, 2017
6:00 – 8:00 pm
Seated Is Limited, Register Here

Is The Honeymoon Over?

In last week’s report, we discussed a theme entitled “Opportunity Within Volatility”.  As we learned in 2016, events can change and it can be dangerous to follow the herd. In volatility, there are always going to be opportunities when assets are mispriced. This is likely to be the case again this year in the third phase since the U.S. Presidential election. More on market phases later.

Stock market volatility as measured by the Volatility Index (VIX) briefly declined to 2014 levels last week.  Despite the best gain in two months on Friday, the major averages for the week were little changed and the market is bobbing and weaving around its highs.

Maybe we’re seeing a bit of an “end of the honeymoon” theme here because there are things happening now that were not occurring at all in the aftermath of the U.S. election – stock markets are consolidating, small-caps are no longer outperforming, the U.S. dollar is retreating and bond yields have stopped rising.  However, some fundamental improvements in stocks and our technical analysis keeps us invested.

As we have written, this has been very much a policy driven rally (or “expected” policy…). I think you can observe this market in three phases since the election on November 8.  Phase 1: Trump Rally or Surge. Phase 2: Consolidation (we are experiencing this phase currently). Phase 3: Volatility.  Again, this volatility will create opportunities.

Chart of the Week: Stories of Emerging Market

Investing in emerging markets (EM) has been tough for the last five years. The Chart of the Week looks at the historical performance of developed market stocks compared to emerging market stocks (Figure 1). While developed markets have gained more than 50%, emerging markets have been mostly range bound and more volatile. The fears of a commodity price collapse and a hard landing of the Chinese economy may still linger, even after a strong recovery in emerging market stocks since February, 2016. We believe, however, that emerging markets represent growth that is difficult to find in developed economies. Across emerging markets, positive momentum is building – we have improving economic growth, ongoing economic reform, and a revival in corporate fundamentals. Reflation and supportive fiscal policies in developed countries are another positive for emerging markets, as they demand emerging market products ranging from raw materials to manufactured goods.

Figure 1. Historical performance of DM and EM stock markets.

Source: Bloomberg. Indexes are normalized as of 02/08/1999
*Click to Enlarge

The fundamental driver for emerging market financial assets is the emerging market growth premium, the difference in economic growth between emerging and developed economies. When this gap widened from 2000 to 2008 (Figure 2), capital flowed to emerging markets, driving emerging markets to historical highs in 2007 (Figure 1). Thereafter, growth in emerging markets decelerated (Figure 2). A narrower emerging market growth premium drove capital back to developed economies as investment opportunities became scarce. This trend, however, recently reversed as emerging market economies are reaccelerating (Figure 2). Furthermore, emerging market manufacturing PMI has trended positively since early 2016 (Figure 3). Sitting above 50, the current emerging market PMI reading suggests manufacturing sectors are expanding and business sentiment is optimistic.

Figure 2. Emerging market growth turning around.

*Click to Enlarge

Figure 3. EM manufacturing sentiment turns positive.

Source: Bloomberg
*Click to Enlarge

Together with a more stable oil price, the strong positive correlation between oil and emerging market currencies has been significantly weakened, suggesting that emerging market stocks may become less volatile as corporate earnings in commodity exporters are less sensitive to commodity price movements (Figure 4).

Figure 4. Disconnect between oil and emerging market currencies

Source: Bloomberg
*Click to Enlarge

Trump’s immigration and trade policies are a threat to emerging markets, as we observed a meaningful outflow from emerging market equity funds in November (Figure 5). The outflow, however, was quickly halted and emerging market stocks have recovered to pre-election levels, suggesting investor sentiment is strong enough to ignore potential headwinds down the road.

Figure 5. Capital outflew Emerging Markets after US election.

Source: Bloomberg
*Click to Enlarge

While positive macroeconomic conditions are drivers for corporate earnings growth and stock returns in the long term, valuations tell the story of how future growth has been priced in. An overvalued stock market not only dampens future returns but also leaves stocks vulnerable to shocks if growth falls short of expectations.

Currently, emerging market stocks are attractive from a valuation standpoint (Figure 6). P/E ratio differences between emerging market and developed markets have widened over the last 5 years, indicating that emerging markets are traded at a discount. The cheap valuations for emerging market stocks may be attributed to past underperformance, the vivid memories of deep recessions in Russia and Brazil, and continuous concerns over Chinese currencies, a stronger US dollar, and the possibility of trade wars under a new US administration. However, we think valuations are attractive enough to take on some of these risks.

Figure 6. Valuation of EM stocks remains attractive.

Source: Bloomberg *Click to Enlarge

Emerging market bonds also present investment opportunities. Even after the strong rally in emerging market bonds in the first half of 2016 and rising yields in developed countries in the second half of 2016, emerging market bonds still trade at a discount, as measured by bond yield multiples (Figure 7).

In the last five years, emerging market hard-currency bonds have consistently outperformed US bonds (Figure 8). Although emerging market bonds are more volatile and thus riskier, their consistent outperformance is likely to compensate investors who have a longer investment horizon. Furthermore, the moderate correlation between emerging market and US bond returns provides additional diversification benefits for a bond portfolio mainly composed of US bonds.

However, we do see “animal spirits” on the rise after the recent rebound in commodity prices, recovery of Russian and Brazil from recession, and stabilization of the Chinese currency. The HY-IG spread for emerging market bonds has tightened sharply (Figure 9), so investors are less compensated for taking incremental credit risk in the emerging market bond space. Thus we favor high quality emerging market bonds over their lower-rated counterparts.

Figure 7. Compared to their peers in G7 countries, emerging market bonds are still attractive.

Source: Bloomberg
*Click to Enlarge

Figure 8. Emerging market hard-currency bonds: outperformance but higher volatility.

Source: Bloomberg *Click to Enlarge

Figure 9. Credit spread between investment grade and high yield emerging market bonds has decreased.

Source: Bloomberg *Click to Enlarge

While emerging markets offer attractive investment opportunities in 2017, we are fully aware of the risks, including a stronger US dollar and potential trade conflicts (Figure 10 and 11), that may rise unexpectedly and could have a negative impact on emerging market performance.

The divergence of global central bank policies and a US fiscal policy shift could strengthen the US dollar and thus present renewed downward pressure on emerging market assets. However, a sharply rising greenback, as we had in 2014-2015 (Figure 10), is not our base scenario.

Many emerging market economies are part of a global supply chain that heavily depends on global trade activities. After experiencing fast growth from 2003 to 2007, global trade growth has decelerated. This has slowed the recovery of global economies after the financial crisis and softened demand in developed countries (Figure 11). We also see rising protectionism which increases risk for emerging markets. However, an improving economic picture in developed countries and a growing middle class in emerging markets are likely to offset these risks.

Figure 10. Strong US dollar is a headwind for emerging market stocks and bonds.

Source: Bloomberg
*Click to Enlarge

Figure 11. Slowdown in global trade.

*Click to Enlarge

In sum, the prospects for emerging markets looks brighter in 2017, supported by improving economic fundamentals, fiscal health, and growth potential. These make emerging market stocks and bonds less vulnerable to potential headwinds such as higher interest rates in developed economies, commodity price volatility, and protectionist trade policies. Nevertheless, investors need to be mindful of these risks and be tactical as emerging market investments tend to be more volatile and subject to price correction when sentiment changes.

Weekly Technical Comment

Dow Jones Index Retest 50-Day Line…

The stock uptrend has stalled after last week’s move into new highs. The daily bars show the Dow Industrials heading down to a possible retest of its January lows and its 50-day moving average. That would be the first serious test of the market’s uptrend since the November 8 election.

*Click to Enlarge

S&P 500 May Be Stalling

The stock market’s major technical trend is still up, and the charts show no signs of a major top. Shorter-term momentum indicators, however, show some stalling that may lead to nothing more than a short-term pullback or a period of relatively choppy action over the short- to intermediate-term. The chart below shows the S&P 500 hitting a record high last week. Short-term momentum indicators like the RSI (Relative Strength index) and MACD, however, have failed to confirm that upturn. The box on top of the chart show the two MACD lines turning negative in late December, and remain so. The last time that happened in August (and April), the market underwent a pullback lasting two to three months. The last market upturn in early November coincided with an upturn in the MACD lines. Current weakness in short-term momentum indicators may simply be signaling a period of relatively choppy trading within the context of a major uptrend. It would take a price drop below the 50-day line and the early January intra-day low (2233) to signal the start of a downside correction.

*Click to Enlarge

Healthcare is Week’s Strongest Sector

A month ago, I wrote about healthcare being the week’s strongest sector. And here we are again writing about the same thing. Why that may be noteworthy is that healthcare has been one of the market’s weakest sectors over the past year. The daily bars in price chart, however, offer some encouragement. The two converging trendlines drawn on the Health Care SPDR (XLV) have the appearance of an “ascending triangle” which is usually a bullish pattern. [The ascending triangle is identified by a flat upper line and a rising lower line]. Biotechs and pharmaceutical stocks rebounded this week. But bigger gains have come from medical equipment and supplies, as well as healthcare providers.

*Click to Enlarge

Weekly Snapshot of Global Asset Class Performance

*Click to Enlarge

Sector Relative Rotation Model

The Sector Relative Rotation Model shows what sectors of the S&P 500 are strengthening and what sectors are weakening relative to the index. In other words, what is driving returns versus detracting from them.

The chart below (updated through February 7, 2017) indicates relative strength (relative to the S&P 500 Index). Materials are leading relative to the S&P 500. No sectors are currently lagging.  Financials, Energy, Industrials, Technology, and Small Cap Stocks indicate weakening, with Healthcare, Utilites, Consumer Staples, and REIT stocks indicating improvement in the model.  Keep in mind while this model is helpful to analyze sector strength in the S&P 500, it is one tool and should be used with a comprehensive investment discipline.

*Click to Enlarge

*Click to Enlarge

Note: There are four quadrants on the chart:

  • Leading (Green) – strong relative strength and strong momentum
  • Weakening (Yellow) – strong relative strength but weakening momentum
  • Lagging (Red) – weak relative strength and weak momentum
  • Improving (Blue) – weak relative strength but improving moment

Upcoming Events:

You are cordially invited to attend an exclusive presentation

Business Transitioning
Strategic Considerations for Business Owners
and Entrepreneurs

February 16, 2017
4:00 pm – 6:00 pm
With reception to follow

The Live Oak Room
at the Norris Conference Center
in CityCentre
816 Town & Country Blvd.
Houston, TX 77024

Seating will be limited. Direct inquiries to Mintie at
mpickel@selmanmunson.com or 713.400.1552
by Friday, February 10.


Featured Articles & Interviews

Getting Your Finances Ready for Year-End
Written By: Scott Bishop, Director of Financial Planning

Checklist for 2016 Year-End Tax Planning
Written By: Scott Bishop, Director of Financial Planning

If you have any questions, please feel free to email me at luke@stawealth.com.

Luke

STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Michael Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)


Disclaimer:

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.

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