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STA Weekly Market Report – Some Inconvenient Truths

INSIDE THIS EDITION:

Some Inconvenient Truths
Chart of The Week: Mixed Economic Signals and the Fed
401k Plan Manager **Recently Updated!
Weekly Technical Comment
Featured Articles & Interviews

Some Inconvenient Truths

The markets were mixed last week. The Dow rose a third of a percent while the small cap Russell 2000 fell 0.22 percent. Rising and falling stocks were about even but we still saw about 300 more new highs than new lows. The Energy sector had a rough week, falling 0.7 percent and is now down 10 percent for the year. Technology stocks had another good run, rising 1.4 percent.

Some of the market’s reticence last week may have come from the looming French election. Some were worried Le Pen would upset Macron and throw the Euro zone into chaos. Seemingly at first, the election went as expected, with Mr. Macron winning easily. The markets appear relieved and will return to chasing other potential problems.

In the U.S. we are in the very late stage of the business cycle, and growth overall is soft. Productivity is weak, and the country is extremely divided politically. The Fed is tightening monetary policy, and markets are overvalued.  We have a price-to-earnings multiple of 18.4x which compares to a long-run mean of 15.2x. Fully priced and then some. Not a bubble necessarily…but overvalued.

So far this year, fully 40% of the stock market’s advance has come from six flashy growth stocks. There are other things which do not seem to add up. First, some technology stocks are casting a shadow over the whole market. Let us look at Tesla for instance. The company is valued at over $51 billion dollars while selling about 4,000 cars a month. Ford sells about 235,000 cars a month but has a value of about $46 billion. GM sells a bit more, about 256,000 cars a month and yet it is only valued at about a billion dollars more than Tesla. Oh, did I mention Tesla has negative earnings while GM and Ford both make a profit. Those companies also pay very nice dividends, which Tesla does not. It may be the company of the future, but then again it may always be just that. Just a thought…

Earnings season is wrapping up, and while it may be true that earnings are coming in nicely for Q1. We should remember that the –year-over-year data are coming off the most depressed first quarter base in four years. So thus far, it looks like the S&P 500 operating earnings growth is running at 21% YoY and sales appear decent at 7.2%. Strip out Energy and profits are up 13.6% but sales are actually softer at 4.4%.

Some interesting data is that U.S. companies with the highest exposure to overseas customers are seeing profit growth of nearly 15% on a year-over-year (YoY) basis, compared with 6.8% for firms with a more domestic bias – in what is the highest differential in five years.

We cannot predict their ultimate direction, but I believe we can improve the probabilities of being successful investors with a sound investment discipline. In our opinion, investors should start to consider getting more conservative. Sometimes our indicators will fluctuate when approaching a change in market direction. The Health Care bill passed the House, Macron won in France and Mr. Trump has presented his tax policy. We have enjoyed the hope rally but the market must now stand on its own two feet. Those feet could be stumbling sooner than we had imagined. Market tops are ragged and take considerable time.

Chart of the Week:  Mixed Economic Signals and the Fed

The Fed met on May 3, 2017 to decide whether to raise short-term interest rates. Investors did not expect a rate hike heading into the meeting and they were right — the Fed decided to leave short-term interest rates unchanged – at least for now. A big driver for the Fed’s pause was a deceleration of economic growth reflected in recent economic data. This brings us to our chart of the week which shows the Bloomberg U.S. Economic Surprise Index, Soft- vs. Hard- Data. What it shows is the divergence that we are seeing between soft data (typically survey data from businesses and consumers) and hard data from the industrial, housing, retail, and household sectors as well as the labor market.

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While the divergence is nothing new, it appears that investors are starting to pay attention. Comments in the most recent Fed press release indicate the Fed is also paying attention, but choosing to view the data through rose colored glasses.

To get a better sense of where markets and the economy stand today compared where we were at the time the Fed met in March, we can review the Federal Reserve Scorecard below. It presents key data points the Fed is likely watching as they mull over further rate hikes.

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Since March, the S&P has remained relatively flat, adding only 24 points. The 10-year yield has slid 31bps. The Broad Trade-Weighted dollar has gone virtually unchanged. The unemployment rate has declined to 4.4%, while both CPI and PCE measures are marginally lower. All of this has resulted in lower estimates for GDP and a likely slower rate hike path for the remainder of 2017.

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Although this data points to an economy muddling along, Fed governors appear to be on the same page – they believe less than stellar economic fundamentals are a transitory occurrence that will pass just in time for a June hike. Markets appear to agree as the odds of a June hike have already moved to near 100%, a large increase since just before the May interest rate decision. Any surprises between now and the June meeting could unleash a bout of volatility and is why having a well-defined risk management discipline is so important.

Weekly Technical Comment

Sector Leadership

One of the problems facing the current stock market is that some sectors have been rising, while others have suffered large losses. Since the start of the year, for example, technology has gained nearly 14% versus a 6.7% gain for the S&P 500. Energy stocks, however, have plunged -10% this year. Industrial metal miners have lost -6% as have telecom stocks. Obviously there’s a tug of war going on within the market as a whole. The question is which side is winning. To determine that, it’s not just enough to count how many sectors are rising (8) and how many are falling (3) and by how much. We have to also consider how those sectors are weighted in the S&P 500. That gives us a better measure of how much the winners are impacting the S&P 500 versus the losers. Our first chart this week shows the top four sector gainers since the start of year to be technology (13.7%), consumer discretionary (10.4%), healthcare (10.3%), and industrials (7.6%). All four did better than the S&P 500’s gain of 6.8%. Four outperformers out of eleven sectors might not sound like much. But those four account for 57% of the S&P 500 weightings. Technology accounts for nearly 20%, healthcare (15%), cyclicals (12%), and industrials (10%). That alone gives an edge to the bulls.

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Average Sector Performers

Our next chart shows three sectors that have pretty much matched the S&P 500. This chart, however, plots the three on a “relative strength” basis versus the S&P 500. In other words, they’re plotted around the S&P 500 which is the flat zero line. They include materials, utilities, and staples. The percentage numbers on the top left scale show them outperforming the S&P 500 by a slight margin (less than 1%). [In absolute terms, all three gained more than 7% versus 6.7% for the S&P 500]. The one surprise in that group is materials which includes base metals like copper and steel which have been falling. Gains in chemical stocks along with those tied to containers and packaging, however, offset those commodity losses. In addition, materials account for only 3% of the S&P 500. The same is true of utilities. Staples account for 9%. That makes for another 15% of the S&P 500 that has kept pace with the market. So far, we have 67% of the S&P 500 which is either leading it higher or matching its gains.

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Market Laggards

Here’s where most of the problem lies. Here again, the three sector underperformers in the chart below are plotted “relative” to the S&P 500 which is the flat black line. The two biggest losers are energy and and telecom, with 2017 losses of -10% and -5% respectively. The scale on the upper left shows them trailing the S&P 500 by bigger margins. I’ve included REITs on this chart only because they’ve started to slip lately on a relative basis on the threat of higher interest rates (as have utilities). Although they’re lagging behind the S&P by -3.2%, they’re actually up 3.5% for the year. The good news is that telecom and REITs have a relatively small combined weighting of about 5%. The big problem is energy which has a larger weighting of 8% in the S&P 500.

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Sector Performance Still Favors the Bulls

By my count, four sectors are doing better than the S&P 500, three are matching its performance, and four are underperforming. The four leaders account for 57% of the S&P 500. The three matching sectors account for another 15%. Two of the laggards (telecom and REITs) account for only about 5%. Falling base metal shares haven’t hurt the materials sector which carries a relatively small market weight (3%). In my view, the two swing votes go to financials and energy. Financials (the second biggest sector) are doing better of late and should benefit from rising rates. That leaves energy as the market’s biggest problem. Energy, however, accounts for only 8% of the S&P. And while that may hold it back a bit, stronger action in most other sectors should be enough to support the market. The chart below plots a relative strength ratio of the Energy SPDR (XLE) divided by the S&P 500 and shows relative energy performance falling to the lowest level since the start of 2016. Its 14-day RSI line, however, is deep in oversold territory (below 30) for the second time this year. That suggests that the energy selling may be overdone.

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Falling Commodity Prices Aren’t Driving Emerging Markets Higher

One of the long-held principles of emerging market behavior is that they’re closely correlated to the direction of commodity prices. That’s because several large emerging markets are exporters of commodities (like Brazil and Russia). China is the world’s biggest importer of commodities. Emerging markets are currently the strongest part of the global stock market. Their 2017 gain of 16% outpaces foreign developed market gains of 12%, and 7% for the S&P 500. The chart below shows the MSCI Emerging Markets iShares (EEM) rising to the highest level since spring 2015 (red line). The brown line plots the Bloomberg Commodity Index ($BCOM). After bottoming together at the start of 2016, both markets rose and fell together for most of last year. Not this year. Since mid-February, the commodity index has fallen -7% while the EMM has gained a similar amount. The weakest EEM stocks since February have been commodity-related ETFs in Brazil (1%), China (1%), and Russia (-4%). Russia has been hit especially hard by falling energy prices. We have to look elsewhere to explain what’s driving EM stocks higher.

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IT’S TECHNOLOGY…

A good case can be made that gains in the technology sector are helping drive the emerging market rally.  Our last chart shows the Technology SPDR (XLK) and EEM rising together over the last four months. Since the start of the year, the 60-day Correlation Coefficient between the EEM and the XLK has gone from negative to 78% (below chart). Here’s a reason why. Six of the ten biggest stocks in the EEM are technology related, making technology the biggest EEM sector (17%). [The next biggest is 2.4%]. The three biggest EEM countries are China (26%), South Korea (15%), and Taiwan (12%) where those big tech stocks are located. South Korea’s Samsung Electronics is the biggest EEM stock (4.5%). China’s Tencent Holdings and Alibaba are the second and fourth biggest (3.9% and 2.9%). Taiwan Semiconductor has the third biggest weight (3.9%). Those numbers show a heavy technology component in EEM iShares, and explains why popularity in technology stocks appears to be benefiting emerging markets.

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Weekly Snapshot of Global Asset Class Performance

 

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Featured Articles & Interviews

Trump Tax Reform
On Wednesday April 26, 2017, President Trump outlined his goals and priorities for major tax reform that could have a significant effect on all businesses and individuals.  This one-page summary highlights the key features of the proposed tax reform which the administration is labeling, “The Biggest Individual and Business Tax Cut in American History.”
Written By: Scott Bishop, Executive Vice President of Financial Planning

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 (atlarge5@houstontx.gov). 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.

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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