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STA Weekly Market Report – Warning Signs for Stocks

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INSIDE THIS EDITION:
Warning Signs for Stocks
Chart Of The Week Beyond the Relationship Between Bond Prices and Interest Rates
401k Plan Manager
Weekly Technical Comment
Weekly Snapshot of Global Asset Class Performance
Houston Pension Reform at Crossroads: How will this Reform Effect Municipal Pensions Like HPOPS for Officers of the HPD?

Warning Signs For Stocks

In last week’s report, I penned a piece entitled, “Record Highs and Future Returns”. If you have not read it, you should soon. It is a good reminder of what we may be able to expect from the markets.

The market finally took a breather last week. The Dow fell 0.4% while the small cap Russell 2000 fell over 2 percent. The market had advanced six straight weeks, so this is not really a surprise. More than 3 stocks fell in price for every one that rose and we also saw more new lows than new highs. We are continuing to observe signs that the market may be weary.

We just celebrated the 8th anniversary of this bull market and are no longer seeing discounted prices. In fact, the same analysis today would show both price-to-earnings (P/E) and price-to-book (P/B) ratios trading more than twice the levels of the market low.

After eight years of rising prices, it is understandable investors are looking to get more aggressive. It is human nature. However, it is a little like the Tortoise and the Hare. The Hare took off, seemed to have an easy victory, but got complacent and the Tortoise won the race. The Tortoise always wins. Consider this; after the market peaked in October of 2007 it took about 5 years to recover the losses in the S&P 500. Some conservative investments recovered in about a year. The Hare is nice to talk about among friends and parties, but every investor has to keep one thing in mind –“Take the least risk which gets you to your goal.” Anything else may lead to a haircut of your portfolio.

After an eight-year hiatus ($200 billion of net outflows), retail investors have thrown in the towel and plowed nearly $80 billion into mutual funds and exchange traded funds (ETFs) since the November election.  With that said, one should legitimately wonder as to why it is that a record 279 corporate insiders have dumped their stock so far this year, and what corporate insiders may know that retail investors do not.

Our indicators are generally neutral and market tops can take considerable time. The change in Washington may continue to impact investor appetites for some time to come. However, excessive bullish sentiment, higher valuations and a Fed likely to raise rates indicate some caution is appropriate. This is not a time to chase the Hare but take a more sober, Tortoise-like approach to the market.

Chart of the Week: Beyond the seesaw relationship between bond prices and interest rates

With a FOMC meeting on the horizon and hawkish Fed statements in the backdrop, the effect on bond investments from rising interest rates have raised concerns for bond investors. The typical discussion of interest rates and bond prices only represents the tip of the iceberg however. Here we will try to walk you through interest rate dynamics in a broad context starting with the seesaw relationship between bond prices and interest rates. This seesaw concept is our chart of the week as it provides an easy to remember graphical representation of the inverse relationship between bond value and interest rates.

Figure 1. Inverse relationship of bond value and interest rates

*Click to Enlarge

                                                                                              Source: STA Wealth Management

  1. Seesaw relationship

Bond prices and interest rates move in opposite directions, much like a seesaw: when interest rates go up, bond prices go down, even though the coupon rate hasn’t changed. The opposite is true as well: when interest rates go down, bond prices go up (Figure 1).

  1. Yield curve and its drivers

The seesaw relationship, however, can be misleading, as sometimes people think about only one interest rate. In reality, the “interest rate” here refers to a set of interest rates, which together make up the yield curve, a line plotting interest rates of bonds with different maturity dates (Figure 2).

The Federal Reserve has full control of the short-term interest rate and uses it as a tool to implement monetary policy. In contrast, longer-term rates are set by the market’s expectations for future economic growth and inflation. Bond investors will demand higher longer-term interest rates when they foresee an accelerating economy and upward inflationary pressure.

After the financial crisis, U.S. and other developed nations, including Europe and Japan, have adopted an unconventional monetary tool, coined as “Quantitative easing (QE)”. Essentially, Central Banks have implemented this tool by purchasing long-dated bonds in an effort to depress long-term interest rates and stimulate economic growth. While the Fed can set short-term rates, it can only partially influence long-term rates by purchasing and selling bonds on the open market. Additionally, monetary policy in Japan and Europe can also affect U.S. long-term rates as capital flows across borders.

Figure 2. Yield curve and its drivers.

*Click to Enlarge

                                                                           Source: STA Wealth Management

  1. Structural changes that anchor long-term rates

Currently, our base scenario is that the yield curve will undergo “bear flattening” in the current rate hiking cycle (Figure 3). Under bear flattening, short-term interest rates increase more than long-term rates. The Fed’s next rate hike will drive the short-end of the yield curve gradually higher. On the other hand, long-term rates are likely to be anchored at a level lower than their historical averages. The reasons are mostly structural (not cyclical), including aging demographics, technological advances, and unsustainable debt-fueled growth, are likely to constrain economic growth and put downward pressure on inflation.

Figure 3. Sharp rise of long-term interest rate is likely to be constrained by structural factors.

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Source: STA Wealth Management

  1. Interconnection between short-term and long-term rates

The reason the U.S. Federal Reserve adjusts short-term interest rates is that it helps meet its dual mandate: to maximize employment and provide price stability. The Fed also has an explicitly stated inflation target. If inflation overshoots their 2% target, the Fed could be expected to increase short-term interest rates. Higher short-term interest rates encourage households and businesses to park cash in saving accounts, rather than boosting spending and investment, which effectively dampens consumer demand and reduces inflationary pressure. It may sound counterintuitive, however, that a proper pace of rate hikes actually prevents hyper-inflation and helps stabilize long-term interest rates and bond prices.

  1. Interplay between monetary policy and fiscal/political policy

President Trump’s ‘reflationary’ policy regime is expected to boost US inflation and growth (Figure 4) and has lifted long-term interest rates. What caused this was that after the US election, the market priced in higher inflation expectations. A reflationary scenario becomes more viable if full employment and wage growth continues. Future interest rates largely depend on if and when proposed policies get implemented. Thus, the near-term tail risks associated with interest rate changes have increased due to uncertainty around the new administration’s policy agenda. Moreover, these uncertainties increase the probability of the Fed making an error in a tough to forecast economic environment. If the Fed runs “behind the curve”, it risks an overheated economy. To catch up, the Fed may have to hike rates more aggressively. Alternatively, if the Fed runs “ahead the curve”, it risks overtightening financial conditions and pushing the US economy into recession.

Figure 4. President Trump’s reflationary policies

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                                                                                 Source: STA Wealth Management

  1. What happens abroad matters.

At the moment, the yield of the U.S. 10-year Treasury bond beats, by a large margin, the yield of both Japanese and German government bonds (Figure 5). At 2.5%, long-term US bonds are very appealing to foreign buyers, especially pension funds and life-insurance companies that have long-term liabilities to offset and will buy at any given yield level, even if other investors are concerned about selloffs. So how the European Central Bank (ECB) and Japanese Central Bank (JCB) implement their ongoing QE program remains a key factor that influence US interest rates, especially the rates on the long-term end of yield curve.

Figure 5. Yield of 10-year government bonds.

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                                                                           Source: STA Wealth Management, as of 03/09/2017.

  1. It is not only about bonds, its stocks too

While investors celebrate the recent stock market rally, few may remember that low interest rates are a key reason why global stocks trade at lofty valuations (Figure 6). To be sure, we have seen US corporations recover from an earnings recession and now are largely expected to experience an acceleration in earnings growth. Moderate interest rate increases typically indicate a healthy economy in the expansionary phase of the business cycle. However, if interest rate increases significantly outpace earning growth, we could experience a selloff in stocks and high yield bonds as a result of valuation multiple contraction and renewed concern about the ability of highly leveraged companies to refinance their debt.

Figure 6. Lower interest rates support higher valuation of all major asset classes.

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Source: PIMCO

  1. Winners and losers in a rising rate environment

Interest rates not only affect the broad stock market. They also can have differing impacts on performance across sectors. In a low rate environment, high dividend stocks in real estate, utilities, telecoms, and consumer staples sectors outperform as seen in the first half of 2016 (Figure 9). A steepening yield curve tends to benefit commodity, industrial, and financial sectors. In addition, value stocks may be expected to outperform growth stocks in a rising rate environment.

Figure 9. Sector performance swings as interest rate expectation changes.

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Source: BlackRock

Summary: As we look beyond the inverse relationship between interest rates and bond value, we see multiple layers of complexity in determining interest rates. Interest rates changes impact future market returns of the broader investment universe, even beyond just fixed income securities. With uncertainty about the global economy increasing, geopolitical risks looming, and monetary and fiscal policy decisions still left to address, we believe that active management stands to add value through in-depth fundamental research, strategic asset allocation, and most importantly risk management.

Weekly Technical Comment

Small Caps May Be Warning Sign

Bond yields are hitting multi-year highs in anticipation of a Fed rate hike tomorrow. Also, stocks do remain in a technical uptrend, but weakness in some stock groups is sending short-term caution signals.  Let’s start with small capitalization stocks. The chart shows the Russell 2000 iShares (IWM) continuing to trade below its 50-day average, and it may retest its January low. That would be an important test. The IWM:SPX ratio (top of chart) shows small caps underperforming large caps by the widest margin since November.

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High Yield Bonds Turn Down

The chart shows the iBoxx High Yield Corporate Bond iShares (HYG) is in danger of falling below its 50-day average for the first time in three months. And it’s falling in heavy trading. Its 14-day RSI line (top of chart) has fallen below its 50-day line from overbought territory over 70 at the end of February. Other short-term indicators (like daily MACD lines) have turned down. That’s not only a sign that high yield bonds are entering a correction. It’s also a warning for stocks. That’s because high yield bonds and stocks are highly correlated. Their 60-day Correlation Coefficient is 0.86%. Both have been rising together since the election. They may be ready to pull back together.

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Energy Stocks Lower on Falling Crude

In this week’s report we review the energy sector.  Another negative warning may be coming from the sell off in energy stocks. The chart below shows the Energy Sector SPDR (XLE) falling to the lowest level in four months, and in danger of ending below its 200-day average. A big drop in energy prices is the main reason why. Commodities have turned lower recently, and a bouncing dollar may be part of the reason.

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Commodities Lower

The selling in energy shares is the direct result of a sharp drop in the price of crude oil. The chart here shows Light Crude Oil ($WTIC) falling below $48 today to the lowest level in four months. It has also slipped below its 200-day for the first time this year. Next potential support is a rising trendline drawn under its August/November lows. Oil isn’t the only commodity dropping. Commodity indexes are also weakening.

*Click to Enlarge

The chart shows the Bloomberg Commodity Index falling to the lowest level in four months. The commodity rally since November was part of the reflation trade. This month’s downturn suggests some rethinking of the inflation outlook over the near term. Chart wise, commodities are in a broad trading range. Having failed at the upper end of the range last month, the commodity index may now retest the lower end. Support around last November’s low may attract new buying. Although record inventories have hurt oil, expectations for higher interest rates, and a firmer dollar, may also be contributing to the selloff.

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 March 14, 2017) indicates relative strength (relative to the S&P 500 Index). Technology is leading relative to the S&P 500. Energy is currently lagging.  Financials, Materials, Industrials, and Small Cap Stocks indicate weakening, with Healthcare, Utilities, 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

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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)


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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