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Back to The Basics
Chart of The Week “Hidden Dormant Risks in The Market”
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Weekly Technical Comment
Weekly Snapshot of Global Asset Class Performance
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Back To The Basics
The S&P 500 Index fell 0.24% and the smaller stock Russell 2000 Index fell 1.5% for the week. Investors shied away from cyclical stocks, as the sector declined 0.8%. The energy sector advanced 0.6%, as crude oil prices advanced 1.1%. The U.S. Trade Weighted Dollar gained 0.83% for the week.
The FED last week signaled they are ready to begin shrinking their balance sheet later this year. Since 2008, the FED balance sheet has grown to $4.5 trillion. The increase is one of the reasons behind the strong returns in the stock market since 2009. In the end the balance sheet expansion hurt savers, as they earned almost nothing with rates near zero. This also forced many investors into riskier assets, such as stocks. The question will be, will the FED be able to unwind the balance sheet and not cause harm to stocks?
This actually may be more difficult than they think. Recent weakness in some data suggests the path for the FED to raise rates might take longer than expected. The Atlanta GDPNow forecast shows growth of 0.6% in the 1st quarter, and is down from 1.1% just a few weeks ago. Last week non-farm payrolls came in well below forecast. Some point to weather as the cause for the miss but time will tell. However, if rates rise too fast, and recent weakness is not an outlier, there could be a setback for stocks.
Earnings season is underway and the strong U.S. Dollar appears to be a concern for some companies in the S&P 500. U.S. companies are poised to report their strongest quarterly earnings in years, and analysts expected earnings for S&P 500 companies to grow by 9.1% in the first quarter from a year earlier, as of March 31, which would mark the highest growth since the fourth quarter of 2011.
Reporting season heats up over the next few weeks, with banks including J.P. Morgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. expected to report results this week and giants like Johnson & Johnson , Verizon Communications Inc. and General Electric Co. scheduled next week.
Investors have been betting that U.S. corporate profits will soar this year, supercharged by a Trump agenda that includes tax cuts and looser regulations. Last month’s collapse of the Republican health-care bill cast doubt on such policies, but a strong earnings season could give investors a reason to keep investing in stocks.
If earnings disappoint, we could see a dent in stocks’ recent gains. Shares of industrial and materials companies, which helped lead the rally between Election Day and the end of 2016, posted the largest declines in expected earnings.
Stocks are trading near their records, even with some recent declines. The S&P 500 is up around 10% since Election Day, while the Dow Jones Industrial Average has climbed around 13% over the same period. As of last week, companies in the S&P 500 trade at an average of 21.7 times their past 12 months of earnings, above their 10-year average of 16.5 times trailing earnings.
The fundamentals just don’t support current valuations. Some of what was baked into stock prices was that we’d get corporate tax cuts and deregulation boosting earnings. Many investors are skeptical President Donald Trump is close to pushing through a corporate-tax-cut package. While Treasury Secretary Steven Mnuchin has said he hopes to secure a U.S. tax-code overhaul by August, some say disagreement within the Republican Party over how to pay for the plan could set back the scale and timing of any package that passes.
The minute you begin to worry about policies going through, you have to start worrying about the basics again.
Chart of the Week: Hiding Dormant Risks in the Market.
We are not bearish on the market at this point as we have seen a few positive signs emerge for the global economy. That said, risk can rear its head at any time and so for the chart of the week we want to highlight a few of the market risks we see. These risks justify a relatively defensive portfolio as the market does not appear to be fully pricing them into current valuations. Our chart of the week shows total returns for equities across the globe, illustrates that expectations may be overly optimistic, and is our first of four risks we will discuss this week.
Since the U.S. presidential election, we have seen a synchronized rally of global equity markets, led by an uptick of inflation and renewed economic momentum. While most international stock returns have been driven by expected earnings growth, U.S. stock returns have been powered by multiple expansion. This can be explained by an overoptimistic view on the new U.S. administration’s growth agenda, including tax reform, deregulation and infrastructure spending. The failure to pass the health care bill has revealed a fractured Congress and uncertainty about the timing of policy implementation. Elevated stock valuations limit the upside potential for U.S. stocks, particularly if hard economic data lags behind investor’s sentiment.
The investment theme for 2017 has gradually transitioned from central bank policy to reflation, fiscal policy, and politics. Despite great uncertainty over future policies and implementation, the market is unusually calm with the VIX volatility index staying near historical lows. This complacency could easily be disturbed by unexpected news or events, especially as the market is near fully-valued.
For the past 12 months, credit spreads have tightened significantly across U.S. investment grade, U.S. high yield, and Emerging Market bonds. Credit spreads reflect the confidence of bond investors in prospects for the U.S. and global economy. A narrower spread make bonds vulnerable to potential market shocks and significant price corrections. This is concerning, especially when interest rates have remained low for years and investors have increased risk exposure to generate higher yields. Low bond yields also provide less protection from rising interest rates as it takes longer for income to offset any declines in bond prices.
4. Market downplays Fed’s plans for future rate hike.
By raising rates three months after the initial December 2016 hike, the Fed sent a strong signal that it is on the path to hiking rates three times in 2017. While the market agrees with the Fed on 2017 year-end rates, it has ignored Fed-indicated rates for 2018 and 2019. Given the dovish history of the Fed (it signaled four rate increases in 2015 and 2016 and only delivered one hike each year), the market has solid reasons for current expectations. The significant discrepancy between what the Fed and Market see as the hike path (as large as 1% in 2019), puts bond investors at risk if the Fed stays on its course or inflation unexpectedly accelerates. To add more complexity, the Fed has just signaled the possibility of unwinding its balance sheet as early as this year, which is essentially a reversion of quantitative easing (QE). More aggressive rate hikes and balance sheet unwinding will effectively increase expected returns on risk-free assets, such as treasury bonds. On one hand, this is good news for investors as they can hit return targets by taking less risks. On the other hand, it increases the relative attractiveness of risk-free assets, which can cause selloffs in risky assets, including lower credit bonds and stocks as capital flows into risk-free assets.
Weekly Technical Comment
Major Stock Indexes Hold 50-Day Lines
Stocks were slightly negative last week as the S&P 500 closed down 0.26%. Last week’s missile attack on Syria, gave safe havens like bonds and gold a slight boost. The first chart below shows the Dow Jones Industrials SPDR (DIA), staying above its 50-day moving average. Stocks recovered from the downside reversal day that took place on Wednesday. The index is just barely hanging on at this level and should be watched carefully.
The next chart shows the S&P 500 SPDR (SPY) looking pretty much the same.
Small Cap Stocks Need To Do Better
Small cap weakness has been one of the drags on the market this year. The chart below shows the Russell 2000 Small Cap iShares (IWM) trading sideways after holding chart support along their January lows. The falling IWM/SPY ratio, however, shows them lagging behind large caps since December. That’s part of the Trump trade which faded during the first quarter. The IWM/SPY ratio, however, appears to be stabilizing, which is somewhat encouraging. What would be even more encouraging would be a move by the IWM above the red “neckline” drawn over the highs of the last three weeks.
Bond Yields Hold Chart Support
The chart shows the 10-Year Treasury yield trading sideways since mid-December. It is trading near the bottom of its three-month trading range. After hitting a new low last Friday (on safe haven bond buying), it appears to be having an upside reversal. That’s happening while bond prices are weakening near the top of their 2017 trading range.
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 April 11, 2017) indicates relative strength (relative to the S&P 500 Index). Technology, Consumer Discretion, Utilities and Healthcare are leading relative to the S&P 500. Energy is currently lagging. Financials, Materials, Industrials, and Small Cap Stocks indicate weakening, with 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.
Note: There are four quadrants on the chart:
Josh McGee, Ph.D
On Financial Planning Friday, Scott Bishop, Executive Vice President of Financial Planning for STA Wealth Management hosts a special edition of the STA Money Hour with guest Dr. Josh McGee Ph.D. Josh McGee is a vice president at the Laura and John Arnold Foundation and a senior fellow at the Manhattan Institute. McGee is an economist whose work focuses on public pensions and finance and he routinely provides expert testimony and technical assistance on municipal retirement plans like the Houston Police Officers’ Pension System (HPOPS) for the city of Houston. ”
Councilman Jack Christie
On Financial Planning Friday, Scott Bishop, Executive Vice President of Financial Planning for STA Wealth Management hosts a special edition of the STA Money Hour with guest Houston Councilman Jack Christie (email@example.com). Councilman Christie is the Chair of the City Council’s Budget and Fiscal Affairs Committee. As most of our Houston Police Officer clients feel that their HPOPS Pensions are in trouble, we wanted to get the Councilman on the show to share what Council Christie s doing in terms of Pension Reforms.
Tax Planning Environment in 2016
Written By: Scott Bishop, Director of Financial Planning
If you have any questions, please feel free to email me at firstname.lastname@example.org.
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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