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STA Weekly Report – Do Earnings Estimates Mean This Bull Has Legs?

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INSIDE THIS EDITION:

Chart of the Week: “Do Earnings Estimates Mean This Bull Has Legs?”
401k Plan Manager
Weekly Technical Comment
Financial Planning:
   Afraid of retiring into a bear market? Tips to hedge bets

While the Dow Jones gained over 1% last week, most of the popular indexes were not as fortunate. The large cap S&P 500 was flat for the week and the small cap Russell 2000 Index fell by almost half a percent. Advancing and declining issues were roughly the same.

The biggest gain, from a sector perspective, came from Energy. Meanwhile, Healthcare and Technology were among the biggest losers.

Perhaps the decline in Healthcare makes the most sense in light of the failed effort by Republicans to repeal-and-replace Obamacare. There is much uncertainty as to what will happen next. There are rumors the president is considering ending the Cost Sharing Reduction payments to insurance companies if a repeal-and-replace bill is not forthcoming.

What has been of keen interest lately is the change in leadership by stocks due, in part, to government action and inaction.

How has government inaction affected stock leadership? After the Trump election many investors expected tax reform for corporations to come through swiftly. Those companies with the highest effective tax rates blossomed as it was assumed they would see the biggest benefit of a lower tax rate. Then, in late March, obstacles to quick tax reform were seen when the House had to pull their healthcare replacement bill from a vote. Investors quickly noted this might be a harbinger of delays in things like tax reform. The result? Since that failed non-vote, stock leadership has changed back to those companies with the lowest effective marginal rates.

What should investors do in this situation? With earning season still in full swing, now is not the time to rush blindly into stocks. On the other hand, this is the perfect time to review current holdings to make sure they are in line with your investment objectives and risk tolerance.

Chart of the Week: Do Earnings Estimates Mean This Bull Has Legs?

Consensus earnings estimates are far from perfect as they are subject to error and continual adjustment. Despite these drawbacks, they play an important role in determining stock valuations and can influence market direction. Our chart of the week shows the 2017 aggregate estimates for S&P 500 earnings per share as of July 28 and also the historical trends in estimates over the four preceding years.

As the chart illustrates, downward revisions to consensus earnings estimates in 2017 have been less pronounced than they were in 2015 and 2016. In those years, we observed a substantial reduction in earnings expectations during the month of January.

*Click to Enlarge Source: STA Wealth Management; Bloomberg

In fact, by normalizing the percentage change in estimates to the beginning of each year in the chart below, we see that in 2015 and 2016, as analysts became less optimistic they lowered aggregate earnings estimates by 4% and 5%, respectively. We believe that by lowering the earnings targets at the beginning of the year, the probability of generating positive returns in both years increased (returns were 1.37% and 11.95% in 2015 and 2016, respectively). We posit that the wide differential in returns that we observed in 2016 compared to 2015 was largely driven by improved sentiment built on promises of tax reform, infrastructure spending, and healthcare reform.

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

While the optimism for those policy items has cooled, they remain on the table. However, we do see a key difference this year compared to last in that at the start of 2017, there wasn’t a large downward revision to earnings expectations across domestic stock markets. Naturally, one must ask whether this bull market has any legs left to carry it to yet another positive year. So far, the market appears to believe so, with the S&P holding onto nearly double digit returns to date.

Despite improved fundamentals (chart below), we aren’t so sure that we have significant upside left this year.

*Click to Enlarge

At this point it is no secret that valuations across most asset classes are largely inflated, at least relative to historical averages. That alone is likely pointing to a more constrained expected return outlook for stocks over a longer time horizon. However, what we are seeing in response to earnings releases may be even more worrying for the short term.

We broke the S&P 500 into its 10 major sectors and plotted the aggregate earnings surprise for each along with their 30-day price changes (chart below). What we see is that most sectors (and the broad market) are trading lower despite positive earnings surprises in what could be a sign that investors are starting to worry that fundamentals may not support current earnings expectations and valuations.

*Click to Enlarge Source: STA Wealth, Bloomberg

In no place is this more evident than in the technology sector. Earnings estimates for the sector have increased more than 8% during the recent quarter, yet in the aggregate the sectors actual earnings surprise has been shy of 8%. In fact, this could explain why technology has had the worst performance of all S&P 500 sectors over the last 30-days as investors become concerned about overly aggressive estimates. Based on our current view of the macroeconomic environment, technology sector fundamentals, and technical analysis, we believe that recent performance is not a reason to eliminate technology exposure in a portfolio.

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

It is however, a reason to be focused on risk management. Markets can, and do, change quickly and it is our experience that having a well-defined risk management discipline helps when inflection points arrive. Particularly as we get into the later stages of an economic cycle.

As we sit in the eighth year of the post-financial crisis recovery, we encourage you to ask yourself whether you have a risk management plan in place for when markets do in fact change direction.

Weekly Technical Comment

A Lot is Riding On Dollar Direction

After hitting a 14-year high at the end of 2016, the U.S. Dollar Index has lost 8% during 2017. A lot of that slide came from disappointment in the so-called Trump reflation trade which was supposed to boost the U.S. economy, bond yields, and the dollar. As well as inflation. Strength in overseas economies also boosted foreign currencies in developed and emerging countries along with their stock markets. One of the side-effects of a weak dollar is that it tends to drive global funds into foreign markets which has been the case this year. The falling dollar, however, has had positive influences on the U.S. market as well, especially large cap multinationals that derive nearly half of their revenues from foreign markets. Its been estimated that a 1% drop in the dollar translates into a one-half percent gain in earnings per share for U.S. large caps. The falling dollar has been especially good for U.S. technology stocks which derive 57% of their revenues from foreign markets. A falling dollar also boosts commodity prices which usually leads to higher inflation. That could encourage the Fed to stick to its plan for hiking rates later in the year which would benefit financial stocks. There’s a lot riding on the direction of the dollar.

Dollar Index is Nearing Major Support

The chart below shows the U.S. Dollar Index ($USD) in decline since the start of 2017. The chart also shows, however, that the USD is entering a potential support zone formed by previous lows formed during 2016. The potential support zone ranges from 94 (the low formed last August) to 92 (the low formed that May). The lower number is the more important of the two because it represents a 50% retracement of the 2014 to 2016 dollar rally. Also because it represents the bottom of the last major correction in the dollar. A case can be made that the 2017 decline in the dollar is nothing more than a normal correction in an ongoing uptrend. For that view to hold, however, so does the low formed during the spring of 2016. The line on top shows the 14-week RSI having fallen to 30 which qualifies as oversold territory. This marks the first time the RSI has reached the oversold threshold since 2011 when the dollar formed its last major bottom. If nothing else, the chart suggests that this year’s decline in the dollar is getting overdone. It also suggests that the USD may be nearing a bottom.

*Click to Enlarge

Weekly Snapshot of Global Asset Class Performance

*Click to Enlarge

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)

 

Financial Planning
Afraid of retiring into a bear market? Tips to hedge bets

Who would want to retire into a bear market? Certainly stocks are roaring now, but the problem is, we never know when one will happen.

Bear markets are defined as a decline in the S&P 500 Index of at least 20 percent from the previous high. They are not infrequent and have happened, on average, about every three years over the last 80 years, with an average decline of 35 percent.

So for all the talk of 2008–2009 being the “worst recession since the Great Depression,” the S&P 500 losing 37 percent in 2008 was very close to that average decline. Even with this in mind, it seems that we, as investors, are surprised every time there is a market correction or bear market.

Each year that we work allows us to earn and save more money to replace capital lost in a market correction. Moreover, the money we invest toward the bottom of that correction earns a great return during the recovery.

However, in retirement—when you are not working—not only can you not replace that lost capital with future income, your predicament is compounded by three additional factors: You have less time for the market to correct itself; the loss of the market is compounded by the fact that you are withdrawing money from your portfolio to live on each year; and bear markets can lead to uncertain times, which leads to bad investment decisions.

As a financial planner, I work with clients as they prepare to enter retirement. Like many financial planners, I utilize sophisticated financial-planning tools to project various outcomes in retirement so that I can help retiring clients answer their No. 1 question: “Will I run out of money if I retire?”

In running all the scenarios, whether using traditional straight-line financial-planning software assuming 6 percent to 7 percent average returns, or even using more sophisticated, Monte Carlo simulations, it is very possible for a client whose projections show a very high likelihood of success to still run out of money if they retire into a bear market.

A Monte Carlo simulation is a problem-solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called simulations, using random variables.

A 2014 T. Rowe Price retirement research report ran Monte Carlo simulations to show that a client with a balanced portfolio who withdrew 4 percent of the portfolio assets the first year and grew that distribution by 3 percent annually had an 89 percent probability of sustaining those withdrawals for 30 years of retirement. In the financial-planning world, it was a winning plan.

I wanted to test that “winning plan” to see how it would fare in the first 10 to 20 years of retirement using recent market returns. To do this, I used the return figures from 1991 to 2010 for the S&P 500 Index, the iShares Core U.S. Aggregate Bond ETF and even a balanced (50/50) split of both indexes.

I used the same withdrawal and inflation assumptions from the T. Rowe Price study, gave the retiring individual a portfolio of $1 million and started his first year in retirement with a $40,000 distribution for living expenses and taxes.

If all of the assets were from an individual retirement account, he would actually have less to live on as these distributions would be fully taxable. I used two retirees, one starting in the year 2000 and the other in 2010. I had some startling results.

If a “bull market retiree” who started with $1 million in January 1991 took annual distributions totaling $40,000 and increased the distributions each year for inflation, he or she ended Dec. 31, 2000, with $2.9 million if invested 100 percent in stocks; $1.4 million if 100 percent in bonds; or $2.1 million if in a balanced portfolio. Not too shabby, and it gets even better for bull market retirees.

They were still in great shape by 2010, even if they lost 37 percent in the stock market in 2008, as well as stock market losses of 12 percent and 22 percent back in 2001 and 2002, respectively.

By 2010, the bull market retiree would have $2.4 million if he or she invested 100 percent in stocks; $1.6 million if 100 percent in bonds; and $2.2 million if in a balanced portfolio. By this time, annual distributions after inflation total $84,000. After 19 years of retirement, our retiree took out $1.2 million dollars in distributions and still had more than he or she started with.

In contrast, how did a “bear market retiree” fare when beginning retirement in 2001? Not so well, actually.

“Create a disciplined investment and distribution plan to protect against downturns, remove emotional reactions to market declines and determine ahead of time what the plan is in terms of spending during a market downturn.”

If the bear market retiree started with $1 million in January 2001, took out the same $40,000 per year and followed the same strategy 10 years later—on Dec. 31, 2010—he or she was left with only $567,000 if invested 100 percent in stocks; $1.1 million if 100 percent in bonds; and $880,000 if in a balanced portfolio.

By early 2009—at exactly the wrong time—bear market retirees were probably thinking about “going to cash” in their portfolios to stop the losses. They are not feeling good about things, and they are wondering what the next decade has in store for them.

So what should people near retirement do to avoid being in the shoes of the bear market retiree? There are several things, but to start with:

  1. Meet with a financial planner or CPA to “run the numbers” and help them build a plan for retirement.
  2. Calculate their “hurdle rate,” their personal minimum rate of return needed to meet their retirement goals. This is more important than any index return. If their hurdle rate is 3 percent, they should be fine. If their hurdle rate is 15 percent, they will need to reevaluate their retirement date and goals.
  3. Create a disciplined investment and distribution plan to protect against downturns, remove emotional reactions to market declines and determine ahead of time what the plan is in terms of spending during a market downturn.

Originally published by CNBC
Written by: Scott Bishop, MBA, CPA/PFS, CFP®
Executive VP of Financial Planning and Partner STA Wealth


Investopedia Announcement

Scott Bishop, our head of Financial Planning at STA Wealth, was recently invited to join Investopedia’s group of expert advisors that fields questions from users of their website.  If you would like to follow Scott’s weekly thoughts on financial planning topics, check out his Investopedia webpage at the link below.

Scott Bishop, Investopedia



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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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