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STA Weekly Market Report – Three Factors Behind The Latest Leg Up

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Week of February 13, 2017

INSIDE THIS EDITION:

Three Factors Behind The Latest Leg Up
Chart Of The Week “The Demographic Story
Weekly Technical Comment
401k Plan Manager
Weekly Snapshot of Global Asset Class Performance
Features Articles & Interviews

Three Factors Behind The Latest Leg Up

Well, the major stock market averages have shrugged off the jitters, with prices setting new highs and breadth indicators rather constructive.  Last week was positive for stocks. The large cap S&P 500 closed up 0.9% and set a new record high. The smaller stocks of the Russell 2000 also set a new record high and enjoyed a 0.8% gain. However conviction seemed to be lacking as volume last week was 15% lower than normal.

The primary cause of the latest leg of the uptrend are three-fold in nature.

First, earnings season is coming in with a slate of upside surprises.  With 360 (over 70%) companies of the S&P 500 reporting thus far, earnings per share growth is now running at +5% year-over-year (YoY), surpassing the +3% bottom-up consensus estimate at the start of the first quarter.  The comparable trend in Europe, by the way, is just above 5% – the first time in five years that earnings growth on the continent is in positive terrain.

Second, the OPEC output cut deal is holding (90% compliance reported) and the oil price is holding nicely in the mid-50’s.

Third, President Trump is showing some signs of impressive flexibility of late. After announcing last week that tax reform was to be expected in about three weeks, the market reacted favorably. Also, The President’s cabinet is finally coming together and the ability of his cabinet to become more influential seems to settle investors.

The President’s call with Chinese President Xi Jinping went well and he reiterated American long-standing support for the “One China” policy.

The meeting with Japanese Prime Minister Shinzo Abe was smooth and again, he stressed ongoing military support for Japan.

However, we do find a few areas of concern, including being nearly eight years into an expansion, valuations for stocks, the Federal Reserve and excessive optimism to name a few. Many of our indicators dedicated to measuring sentiment suggest too much optimism and correspondingly they have turned unfavorable.

For example, the cash levels in institutional equity portfolios are at a low 3%. This suggests institutions may have already bought the rally and may not have the resources for a big push higher. A final sign of utter belief in this rally comes from a recent cover of Barron’s which proclaimed, “Next Stop, Dow 30,000”. Rarely are such milestones reached quickly when it has become the popular opinion.

There is one group, with a solid history of stock timing, which holds a different point of view. This is corporate insiders, a group we affectionately call the “smart money”. The latest data, shows insiders are selling 49 shares for every 1 share they are buying. Note: ratios above 12, like we are experiencing today, are usually bearish for stocks.

Given the high level of optimism by Wall Street and the unfavorable configuration of our leading intermediate and short term indicators, we would suggest risk levels are somewhat elevated.

Chart of the Week: “The Demographic Story”

We have found ourselves thinking a lot about international markets to start 2017. In prior reports we have discussed valuations, economic growth rates, and signs of political reform that could help bolster returns in some of these markets. What we haven’t discussed in any detail is the role that demographics plays in making many of these markets potentially attractive for investment. For the chart of the week we look at population growth rates. More specifically the growth in working age populations compared to the growth in the overall population. What we find is that in many emerging markets, working age population growth will exceed overall population growth rates. This general trend is likely to boost productivity in these markets and thus their GDP.

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As economies transition from emerging to developed status, it is common to see increased education levels, lower birth rates and a larger and older population relying more heavily on a dwindling working age population. The next chart illustrates this using what is called the old-age dependency ratio. The old-age dependency ratio measures the proportion of those aged 0-14 and 65+ relative to the working-age population aged 15-65. While the spread between developed (G7) and emerging (E7) economies is expected to narrow over time, developed nations are likely to see higher dependency ratios than emerging nations for decades to come.

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Price Waterhouse Coopers did an analysis that showed that as the dependency ratio increases, average annual GDP growth rates decline over time. The scatter plot below shows a mix of developed and emerging markets, their respective old-age dependency ratios, and the average annual GDP growth rate expectations through 2050. The US finds itself around the middle of the dependency ratio range but also on the low end of the average annual GDP growth rate projection, likely due to high debt levels among other reasons.

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The question for us as investors becomes whether GDP growth rates are really a precursor to higher equity returns. The conventional thinking is that equity returns should track higher as GDP growth rates do. However, a paper on Economic growth (full paper) and equity returns published in 2004 concluded that cross-country correlations of real stock returns and per capita GDP growth over 1900-2002 is actually negative. In other words, higher GDP growth rates typically led to lower equity returns. While it has been about a decade since it was published, it does make a valid assertion — when valuations are low, higher GDP growth rates do in fact correlate to higher equity returns.

As we have discussed in recent reports, international developed and emerging markets are cheap versus historical levels and could be a harbinger for opportunity, if and when we see GDP growth reaccelerate. While there are certain risks to contend with (geopolitical risk, trade policy changes, and currency to name a few), having an allocation to global assets makes sense for many portfolios looking for diversification and potentially higher returns over time.

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Weekly Technical Comment

Emerging Markets iShares With Upside Breakout

Economically-sensitive industrial metals are rising again, along with stocks tied to them.  The recovery in commodity prices is also lending support to emerging markets. That’s especially true for commodity exporters like Brazil and Russia, along with their currencies. That’s helped emerging market stocks outpace developed market stocks over the last year, and at the start of this year. The chart below shows MSCI Emerging Markets iShares (EEM) exceeding last year’s high to reach the highest level since mid-2015. EM stocks have done better since January as Treasury yields and the dollar weakened. An upturn in those two markets could slow the flow of money into EM assets. A continued rally in commodity prices, however, might be enough to overcome those two headwinds. Chinese stocks (the world’s biggest importer of commodities) are also off to a strong 2017 start, as are other Asian markets.

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China iShares Nears Upside Breakout

The world’s biggest importer of commodities, has yet to turn up. But it’s getting close. The chart shows China iShares (FXI) in the final stages of an apparent “head and shoulders” bottoming formation. A move above the flat “neckline” drawn over late 2015/2016 highs (which appears likely) would complete that bullish pattern. Higher Chinese stock prices would hint at a stronger economy. And a stronger Chinese economy is usually a bullish sign for commodities prices (along with stock sectors, currencies, and stock markets tied to them). That’s especially true of emerging markets which are closely tied to commodity prices.

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Crude Oil Nears Upside Breakout

The price of WTIC Light Crude Oil closed near $54 per barrel on Friday. As the chart below shows, that puts WTIC less than a dollar from a new 52-week high. Crude oil is another economically-sensitive commodity that is benefiting from signs of global growth. Energy stocks, which have been lagging behind lately, are helping lead this latest leg up stock rally.

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Energy Sector Bouncing Off Support

The chart below shows the Energy Sector SPDR (XLE) bouncing off chart support along its October high, and not far from its 200-day average (red arrow). In addition, its 9-day RSI line (top of chart) is stabilizing near oversold territory at 30. That is helping support the Energy Sector ETF (XLE) at around $72.

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 Weekly Snapshot of Global Asset Class Performance

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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 14, 2017) indicates relative strength (relative to the S&P 500 Index). Materials and Technology are leading relative to the S&P 500. No sectors are currently lagging.  Financials, Energy, Industrials, 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.

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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

Featured Articles & Interviews

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)

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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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