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STA Weekly Market Report – How Quickly Things Can Change

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Week of January 9, 2017

INSIDE THIS EDITION:
How Quickly Things Can Change
Chart of the Week “US Stock Market Valuations”
Weekly Technical Comment
Weekly Snapshot of Global Asset Class Performance
401k Plan Manager
Features Articles & Interviews

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How Quickly Things Can Change

If 2016 taught us anything, it is how quickly things can change and how dangerous it can be to follow the herd.  Anyone who owned risk assets or stocks at the start of the year underperformed significantly as concerns over Brexit, a Chinese economic hard landing, declining oil prices, and the solvency of European banks mounted, ultimately to pushing valuations of more defensive yield stocks into bubble territory by the summer.

In the last several months of the year a rotation into the cyclical stocks and Financials, and out of the Consumer Staples, Utilities and other bond proxies took hold and became the dominant theme for the back half of the year.

The market started this year on a good note as both the Dow and the S&P 500 hit record highs on Friday. Although the Dow never touched 20,000 it still rose 1.07 percent last week. The smaller cap Russell 2000 advanced 0.76 percent. We saw more than three stocks advance for every one that fell and we saw more than thirteen times as many stocks hit new highs as new lows. Technology and Healthcare stocks did well while Energy and Utility stocks lagged. Retail department store stocks like Macy’s and J.C. Penney had an especially bad week.

While the market has been moving higher, we are seeing a rise in overall risk. Where sentiment readings had been favorable for stocks, the pace of the advance has been too rapid and some settling of prices is to be expected. We have performed a review of the market’s performance after an election where the party in the White House changes. The market usually rallies from the time of the election until shortly after the inauguration and then undergoes a bit of a correction. Now that Congress is back in session, many new bills will be considered and a changing landscape may cause investors to take pause. Little is known of Mr. Trump’s governing approach and surprises, as many companies have already found, rarely settle well with investors.

Chart of the Week: US Stock Market Valuation with the Shiller P/E ratio

In last week’s report, we discussed the valuation of the US stock market by comparing current price-earnings (P/E) ratios to historical levels (insert hyperlink of last week report). With the Schiller P/E at 27.68, the current market looks to be either moderately or significantly expensive, depending on how far back we look into history (Figure 1). Generally, the market has experienced a bit of overvaluation on average over the last four decades (Figure 1). We believe that it is important to understand the drivers of this persistently overvalued market. If these drivers are secular trends and thus sustainable, investors might be wise to put “hard-earned” cash to work with the expectation of decent future returns; if these drivers are more transitory, then the opposite is true and investors should be more cautious as market valuations have shown the tendency to reverse to the mean level.

Figure 1. Valuation of US stock market with Shiller P/E ratio.

Source: STA Wealth Management; data source: http://www.econ.yale.edu/~shiller/data.htm.
*Click to Enlarge

Academic research that study factors that affect P/E ratios predicts a positive relationship with anticipated earnings growth and a negative relationship with expected rates of return for stocks. This implies a negative relationship with risk and nominal interest rates. These relationships are summarized in Figure 2.

Figure 2. Fundamental drivers of P/E ratios.

Source: STA Wealth Management
*Click to Enlarge

By intuition, lower interest rates make bonds less attractive than stocks. As a result, in low rate environments, investors are willing pay higher prices for stocks and push P/E ratios higher. From an equity valuation standpoint, lower interest rates discount future earnings at a lower rate and thus make stocks worth more today.

Persistent lower interest rates have been the major secular driver for higher P/E ratios. The yield on the 10 year US Treasury bond has steadily declined from more than 15% in the early 1980s to 2.45% by the end of 2016 (Figure 3). Lower interest rates have been partially caused by long-term economic trends including aging demographics and stagnant productivity growth (Figure 4). Also contributing to lower interest rates has been accommodative financial policy enacted since the financial crisis. While we expect the Fed to raise rates, albeit slowly, the secular trend we have observed will likely place a cap on how far and how quickly the Fed can tighten monetary conditions.

Figure 3. Lower interest rates are a secular driver for higher P/E ratios

Source: ONLINE DATA ROBERT SHILLER. http://www.econ.yale.edu/~shiller/data.htm *Click to Enlarge

Figure 4. US trend economic growth and neutral rate, 1961-2016.

*Click to Enlarge

2016 represented an inflection point for the economic outlook. The first half of the year started with all signs pointing to an increased probability of a US recession, as a hard landing of the Chinese economy became more possible, and the oil and commodity markets remained mired in a slump. Since July, the economic backdrop has changed and is decidedly more positive as we have seen global growth reaccelerate, global deflationary pressures abate, and a more stable outlook for emerging markets emerge.

The Bloomberg Economic Surprise Index, an index of aggregated economic indicators, has beat economist forecasts since mid-November (Figure 5). Prior to the recent shift, leading economic indicators generally fell below consensus estimates and coincided with sideways performance for US stocks. Since the US election in November, economic numbers have largely been ahead of expectations and pushed the Surprise Index higher.

The brighter economic backdrop has made analysts more confident about global earnings growth, especially for the US and emerging markets (Figure 6). This has driven P/E ratios higher because faster growth commands a price premium today in exchange for higher expected future earnings.

Figure 5. Bloomberg ECO US Surprise Index

Source: STA Wealth Management; data source: Bloomberg. The positive number of eco surprise index indicates that actual economic reals
*Click to Enlarge

Figure 6. Changes in US, Eurozone, Japan and EM earnings estimates, 2016

*Click to Enlarge

The stronger growth prospects and optimistic sentiment that has developed also boosts investor “animal spirits” so they demand less compensation for taking on the relatively higher risk of equity investing (Figure 7).

Figure 7.  US equity risk premium

Source: STA Wealth Management; data source: Bloomberg.
*Click to Enlarge

Equity risk premium is the excess return that investing in the stock market provides over a risk-free rate, such as the return from government treasury bonds.

In summary, the combination of depressed interest rates, risk-taking behavior, belief that we will see faster earnings growth, along with other factors not covered here (such as Fed’s quantitative easing, corporate share buyback, and foreign capital inflows) has inflated P/E ratios as stock prices have increased. Given the rich valuation of the US stock market, we believe that further P/E expansion is likely limited. Future stock returns are more likely to be driven by earning growth and are expected to be lower than the impressive performance we have seen since the end of the financial crisis. On the other hand, if expected earnings growth, which is partly catalyzed by the promise of a Trump administration economic policy framework, fails to materialized, we might anticipate a market correction.

Next week, we will touch on strategies that can be used to invest in a relatively expensive market.

Andrei Costas, Senior Investment Analyst
Nan Lu, Senior Investment Analyst

Weekly Technical Comment

DOW Flirts With 20,000…

Let’s get this out of the way first. If you’ve been watching business TV, all they’ve been talking about is the Dow nearing the 20,000 level. Much to their dismay, it came close on Friday but couldn’t make it. The Dow touched 19999.63 before backing off. Historically, big round numbers have acted as magnets during market advances. At the same time, traders are often inclined to take some profits as that big number is approached. The hourly bars in Chart 1 show how close the Dow Industrials came to the 20K level a number of times over the last month. Technically, the Dow is still in an over-extended condition which explains why it has been moving sideways for the past three weeks. That’s not unusual with a market working off a short-term overbought condition.

*Click to Enlarge

The bigger market story this week, however, was the stronger action in the Nasdaq market. The Nasdaq closed in record territory on Friday. A rebound in biotechs helped. But most of the buying came from technology stocks, especially those tied to the Internet. It looks like FANG stocks are back in favor.

NASDAQ CLOSES AT RECORD HIGH…

One of the factors keeping the rally going is that when a leading group stalls (like financials), new money moves into lagging groups like technology (and, to a lesser extent, healthcare). The daily bars in the chart below shows the Nasdaq Composite Index closing at a new record on Friday. The Nasdaq was the strongest market index for the day and for the week. The Nasdaq has several things working in its favor. First, it’s the only major stock index that hasn’t reached overbought territory. The 14-day RSI line (top of chart) has remained below the overbought threshold of 70 throughout the recent rally (unlike the Dow and S&P 500 which exceeded that level). Secondly, the Nasdaq has been a market laggard. The solid line in the chart shows the Nasdaq/S&P 500 ratio just starting to turn up after dropping during November. You may recall the post-election rotation out of growth stocks (mainly technology) and into value stocks (like financials) as the market jumped. It now looks like money is starting to flow back into cheaper technology stocks. It’s not necessarily that money is leaving leading groups like financials. It may be more that “new” money is being allocated to stock groups that are starting to catch up to the rest of the market. Like the FANG stocks.

*Click to Enlarge

FANG Stocks Turn Up — NETFLIX Hits New Record…

The next four charts show the individual FANG stocks. Chart 4 shows Facebook (FB) clearing both its 50- and 200-day moving averages on Friday (on rising volume). It’s now at a two-month high. The Facebook/SPX relative strength ratio is just starting to turn up. Chart 5 shows Amazon.com (AMZN) in a similar (though slightly stronger) situation. Chart 6 shows Alphabet (GOOGL) even stronger. Their relative strength lines (top of charts) appear to be bottoming as well. Chart 7 shows Netflix (NFLX) hitting a record high on Thursday. It’s clearly the strongest of the four. [Another positive sign for the technology sector is that its biggest stock — Apple (AAPL) — is on the verge of a new record].




Biotechs Boost Healthcare…

Healthcare was the week’s strongest sector. That’s a big change from being the market’s weakest sector since the election. That may also be a sign that money is looking for bargains. The jury is still out on healthcare, however. The chart below shows the Healthcare SPDR (XLV) climbing above its 200-day moving average this week. It still needs to clear its November high to turn its trend back up again.

The biggest boost to that sector came from biotechs. The chart shows the Nasdaq Biotechnology iShares (IBB) climbing this week. Biotechs have been trending sideways for the last year in a potential bottoming pattern. They have a long way to go to accomplish that. This week’s biotech bounce may also be helping the Nasdaq market. Some of its biggest stock gainers this past week were in the biotech space.

Weekly Snapshot of Global Asset Class Performance

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 January 10, 2017) indicates relative strength (relative to the S&P 500 Index). Financials, Industrials, Energy, Materials and Small Cap Stocks are leading relative to the S&P 500. Utilities, Consumer Staples, Healthcare and REITS have lagged.  Technology Stocks indicate weakening, and Consumer Discretion stocks are 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.


Note: There are four quadrants of 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

Featured Articles & Interviews

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

Generation One
Written By: Luke Patterson. To Learn More about Generation One or to Make a Donation you can visit there Website www.GenerationOne.netClick here for a full list of current and on-going needs that Generation One requires to help make a difference in the community. Also listen to our Interviews with Generation One’s Founder and Executive Director Mike Malkemes, Director of Communications and Events/Mentor Program Coordinator, Claire Barber, and Director of Development, Grants Management/Community Development/Relationship Building, Suri Clark.

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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