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STA Weekly Report – Bull Markets Don’t Die of Old Age, But Rising Risks Can Make It a Bumpy Ride

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INSIDE THIS EDITION:
Bull Markets Don’t Die of Old Age, But Rising Risks Can Make It a Bumpy Ride

Weekly Technical Comment
Most Business Owners have No Succession Plan or Exit Strategy
401k Plan Manager




Economists typically group macroeconomic readings into three categories: leading, coincident or lagging. Think of it like driving a car by looking through the windshield to look ahead, the side windows to look left and right, and the rearview mirror to look behind you.

Click to show/hide

Leading indicators are most relevant as they are used to predict the future movements of an economy. The Conference Board has constructed a leading economic index, essentially composite averages of several individual leading indicators. It is a tool used by many to summarize economic data and reveal inflection points that may signal peaks and troughs in the business cycle.

In the last three US recessions, this leading Index peaked and started to decline at least 1 year in advance of the US economy entering a recession, thus providing a useful “warning signal”. The index was stagnant between the second half of 2015 and the first half of 2016, as the global economy was stressed by a broad commodity selloff, currency devaluation in China, corporate earnings recession in the US, deflationary pressures, and Brexit in Europe. However, shortly after the Brexit vote, the index resumed trending higher and has not shown signs of fatigue.

                                                                                      Source: STA Wealth Management

The shape of the yield curve is a market-based economic indicator that has correctly predicted the last seven recessions going back to the late 1960’s. Under normal conditions, the yield curve slopes upward as shorter-term bonds offer a lower yield than longer-term bonds. However, the yield curve inverts if shorter-term interest rates exceed longer-term rates, which reflects the bond market’s bearish long-term economic outlook. Thus, an inverted yield curve often signals coming recessions, because bond investors will buy longer-term bonds to effectively lock in higher yields in anticipation of interest rate cuts common during economic downturns.

The following chart displays the yield differential between 10-year and 2-year US Treasury notes. A positive reading (above the black horizontal line) indicates an upward sloping yield curve and a negative reading (below the black horizontal line) indicates an inverted yield curve. The green shaded areas during 1989, 2000, and 2006 were periods when the yield curve was inverted. As you will also notice, this occurred roughly a year prior to recession (shaded grey areas).

Currently, the yield curve remains sloped upward, indicating that bond investors believe that economic expansion still has room to run. However, it is gradually flattening (red arrow), which may signal a transition in the business cycle from mid- to later-stages.

                                                                                                      Source: STA Wealth Management

 

While old age doesn’t necessarily kill a bull market, the Fed often does. Inflation pressure in the late stages of the business cycle often forces the US Federal Reserve to increase interest rates, which tightens financial market conditions. Under more restrictive financial conditions, corporations are faced with higher financing costs for their new projects and can stall investment; consumers find it difficult to obtain inexpensive loans and accordingly cut spending; outstanding debt may have to be refinanced at higher rates, which subsequently increases the probability of default. Overall, a tightening credit market drains liquidity out of the economy and can eventually trigger a recession.

Missteps by central banks in this process of tightening and loosening financial conditions typically poses tremendous risk to the economy. However, the Fed has been slowly and gradually hiking rates since the end of 2015 which may mitigate the risk of error. The two factors driving this are low inflation and a post-crisis economy now saddled by elevated leverage. The first factor enables the Fed to remain accommodative without risking an overheating of the economy. The second factor has resulted in an unusually cautious Fed as they are acutely aware of the dangers policy missteps pose to the economy.

Counterintuitively, US financial conditions have eased despite being amid a rate hiking cycle. What is causing this? First, the global economy is experiencing synchronized growth for the first time since 2010 with double-digit earnings growth in both developed and emerging markets. Second, concerns of a hard-landing for the Chinese economy have eased due to resilient growth in China. Third, protectionism and anti-globalization sentiment have moderated, at least for now, following the Brexit vote and the US election. Fourth, monetary policy in Japan and Europe remain extremely accommodative. Fifth, the US dollar has weakened from its peak, providing support for commodities and US exports. These tailwinds have coalesced to boost business and consumer confidence, have driven stock markets higher, and lowered credit premiums, which, in turn, have eased financial conditions in the US. Therefore, the Fed can remain committed to rate hikes without fearing an over-tightening of financial conditions that push the economy into a recession.

                                                                                              Source: STA Wealth Management

However, investors should remain vigilant as things can change quickly. While the US economy has not shown signs of weakness, we favor taking a cautious stance given lofty stock market valuations and some looming uncertainty about the Fed’s unprecedented balance sheet reduction plans. Additionally, ongoing congressional wrangling over President Trump’s fiscal policy add another source of risk.

Caution, however, does not mean keeping capital idle in a bank account. Instead, US investors should consider overcoming a home bias and welcome broader diversification that includes global investments. Echoing what the yield curve is telling us, Fidelity Investments’ research arm also believes that the US is transitioning from the mid- to late- phase of the business cycle.

Conversely, Europe and China appear to be in the middle stages of their business cycles while Japan, Brazil, and Russia are firmly in a recovery phase. Thus, the economic expansion in foreign countries may outlive that of the US.


                                                                                             Source: Fidelity

Why have other economies been lagging the US during the current business cycle? In Europe, it can be attributed to a sovereign debt crisis and Brexit. In Japan, it has been caused by an aging population, structural deflation, and devastating earthquake in 2011. In emerging markets, it has been the combination of currency devaluation, massive capital outflows, commodity selloff, concerns over China’s economic transition, and political reforms in India. Despite these challenges, earnings in Japan and emerging markets have improved by approximately 50% while Eurozone earnings have now also started their recovery. Economic growth in these regions has simply reinforced growth in the US, helping US corporate earnings double since before the financial crisis and set the stage for tactical global asset allocation to shine.


As the old wall street adage says, focus on the downside and the upside will take care of itself. Said another way, investment success requires sound risk management. This is especially true today as the economic environment changes rapidly and risks can surface quickly. Thus, ignoring market risk dynamics and a failure to make timely portfolio changes can be costly and painful during periods of market stress.

While we remain constructive on the macroeconomic backdrop, we must remain mindful of potential risks and monitor the investment landscape for signs of their emergence. In our view, there are three major risks (ABC) that could meaningfully impact future returns:

  • Aging US economy: We are now in the eighth year of economic expansion which means eventually growth will eventually slow. We are closely watching for red-flags that may signal a recession, including consumer overspending, business overinvestment, sizeable wage and inflation pressure, or asset price bubbles.
  • Balance sheet reduction: The Fed has done a good job communicating its plan for unwinding its giant balance sheet. However, it remains a monetary policy experiment that may put downward pressure on asset prices as it is implemented. For the moment, we are less concerned about this because investors continue searching for income- producing financial assets and ongoing monetary policy action in Japan and Europe should help stymie negative effects. However, if the unwinding of the balance sheet is accelerated, or one of the other major central banks tapers their bond purchasing programs, this could all change.
  • China: Over the last several years, China has prioritized their short-term stability over long-term economic reform. Although China’s enormous ‘One Belt, One Road’ initiative can present attractive investment opportunities, any policy shift toward more aggressive economic reform could slow growth and ripple through the world economy.

All three risk factors are currently manageable, in our view. However, we also face ample Geopolitical risk. Its unpredictable nature can spur market volatility and catch investors by surprise. This is especially true as investors have become complacent as low volatility has become the norm. Without a well-defined investment discipline and pre-determined game plan, investors risk acting emotionally and making costly mistakes when volatility does increase.

 


Ten-Year Treasury Yields Rising Again

After a modest setback last week, global bond yields are rising again. The first chart below shows the 10-Year Treasury Yield ($TNX) climbing. The TNX appears headed for another test of its July/early October peaks formed near 2.40%.

Click to show/hide

An eventual upside breakout appears likely. Bond yields are also rising around the world. The two-year Treasury yield is trading at 1.56% which is the highest level in nine years. That’s based on increased expectations for another Fed rate hike in December. One of the factors holding the Fed back has been low inflation. Rising commodity prices, however, are already hinting at higher inflation. So was last week’s report that U.S. import prices rose 0.7% in September from the previous month. A weak dollar during 2017 has had a lot to do with that. Treasury bond prices are falling as yield rise. That’s because bond prices and yields trend in opposite directions. A lot of that money coming out of bonds is moving into stocks. That’s especially true of financial stocks which benefit from rising rates. Dividend paying stocks (that are also defensive in nature) like consumer staples, utilities, and REITs are lagging behind.

Money Is Rotating Out of Bonds and Into Stocks

Chart 2 plots a ratio of the S&P 500 SPDR (SPY) divided by the 20+Year Treasury Bond iShares (TLT). [I’m using the TLT for comparison purposes because it’s been the strongest part of fixed income since the start of the year]. The falling stock/bond ratio between March and early September showed stocks underperforming longer-dated Treasuries. The ratio started rising sharply during September and achieved an upside breakout near the end of that month. It has since hit a new record high. If you compare the direction of the bond/stock ratio to the 10-Year Treasury yield (in the lower box), you’ll see them rising and falling together. The ratio peaked in March with the TNX, and bottomed with the TNX in September. Notice also that the September upside breakout in the SPY/TLT ratio (upper chart) followed the TNX rising above a falling trendline drawn over its March/ July peaks. Investors favor stocks over bonds in a stronger economy. Again, when bond yields rise, bond prices fall. That encourages investors to switch from Treasuries to stocks.

Foreign Stocks Are Rising Faster Than The US

One of the factors supporting the U.S. stock market is the fact that foreign stocks are also in strong uptrends. To use a word that’s currently popular, that makes for a “synchronized” global rally. But there’s more to that story. To get a better measure of that, it’s useful to look at what foreign stock markets are doing relative to the U.S. The weekly bars in Chart 3 show the MSCI All Country World Index ex US iShares (ACWX) in record territory. That ETF includes foreign developed and emerging markets with its biggest weightings in Japan (17%), Britain (13%), France (7%), Germany (6%), Canada (6%), and China (5%). The bigger message is that foreign stocks are rising faster than the U.S. for the first time in years. That can be seen by the rising solid line which is a ratio of the ACWX divided by the S&P 500. [Since the start of 2017, the ACWX has risen 24% versus a 14% gain in the SPX]. And therein lies an important message. Money has been gradually moving from more expensive U.S. stocks into cheaper stocks around the world. All are rising. But foreign stocks are rising faster. Emerging markets are global leaders in a search for higher yields. Developed markets in Europe and Japan are also playing catch up with the U.S. The falling U.S. dollar this year has helped drive American money into foreign markets. The Fed’s more aggressive monetary policy makes Europe seem more accommodative by comparison which is supportive to European stocks. Japan is even more accommodative. The good news is that the party for global stocks isn’t over. But some of the guests are switching rooms. This is a theme we have been discussing since late 2016.

Weekly Snapshot of Global Asset Class Performance

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
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)

 

For decades vast wealth has been created for millions of Americans through growing private businesses. However as business owners, especially Baby Boomers, reach the later stages of their careers, a new study by US Trust shows that the majority do not have a formal succession plan or Exit Strategy.

For decades vast wealth has been created for millions of Americans through growing private businesses. However as business owners, especially Baby Boomers, reach the later stages of their careers, a new study by US Trust shows that the majority do not have a formal succession plan or Exit Strategy.

U.S. Trust recently released its 2015 US Wealth and Worth Survey, which sampled a group of millionaire business owners with at least $3 million in investable assets.  In this study, nearly two-thirds of business owners do not have a succession plan (which could include either a sale or transfer of the company). Since most of the business owners rely on their businesses for income, the lack of such planning means that their main source of income could be in jeopardy.

Additionally, the results showed many owners have failed to think about the future of their businesses beyond their own lives. Only 16 percent plan to pass the business on to their families, and 64 percent of older business owners (those over 50) have no formal succession plan. In addition, the majority of business owners have not formulated a strategy for ensuring the highest possible valuation of the business or its continuity beyond the life of the current owner.

Many business owners, whose finances and identity are so closely tied to their companies, simply don’t want to think about giving them up. According to the report, three-quarters of the millionaire business owners founded their companies and only 8 percent inherited them.  Thus, most are first generation businesses. Without a plan, many may intend to simply work well past retirement age.

Many entrepreneurs never plan to stop working or they wait until they are ready to retire (not a good plan – what if the unthinkable happens). Others have a plan in mind that they may or may not have even communicated to key stakeholders, but leave its execution to chance by not formalizing it. In my experience not having a formal plan leaves a very low likelihood of an optimal transfer or sale of the business.

At STA Wealth, we find that succession planning is a crucial part of long-term business planning that helps prepare for a smooth, strategic exit by the owner or for an unexpected change in circumstance, such as illness, disability or divorce.

Five Key Elements of a Succession Plan or Exit Strategy

The benefits are vital to all stakeholders, whether they be the founder, the employees or the clients who have placed their trust with the firm. When they’re ready to transition, the business owners are uniquely positioned to capitalize on the value of the firms they’ve built.

The majority of business owners we work with are focused on ensuring that the businesses they’ve built will endure—they want to create a lasting legacy. But they are not always sure how to pursue that goal – especially when there is just one owner (with multiple partners, we find that it can be a little easier…but not easy).

It’s for that reason, at STA Wealth, we believe that business owners need to think through five key considerations necessary to create a successful plan and exit strategy. These elements will benefit the company’s owner(s), whether their goal is internal succession, external succession or a combination of both.

1. Create a Clear Vision

The initial challenge business owners face when developing a plan is to actually understand where to start. There must be a willingness to look closely at personal and professional goals, and an ability to look impartially at the value of their company. Rather than asking what a successful succession plan looks like, a better question for the founding principals would be to ask themselves “What does a successful transition look like—for me?”. Getting to that answer requires personal reflection and careful consideration. Please note that if there are multiple owners, that each owner’s goals need to be accounted for. Setting personal, professional and firm-related goals will help create a clear vision for the owners and the firm, as well as an improved peace of mind for employees, clients and other stakeholders.

2. Determine The Business Valuation

There are many approaches to determining a firm’s value. But operating cash flow (typically viewed as Earnings Before Interest, Taxes, Depreciation, and Amortization or EBITDA) is the common denominator used to establish fair value. Unlike book value, revenue or net income, cash flow is the best indicator of company profitability and overall operating efficiency. Prospective buyers want to see dependable, growing and predictable flows.  Quality of cash flow matters, too. Buyers typically pay a multiple (or measure of equity or firm value relative to revenue or earnings that it generates) based on the quality of cash flow and its growth rate. Companies will fetch top dollar for such things as a stable client base; revenues that are overwhelmingly from a recurring business; a track record of growth and strong margins; and a core group of professionals who are committed and incentivized to operate the firm as the founders reduce their responsibilities and ownership stake (a.k.a. Key Employees).

Many firm owners may either want a quick exit or may want to retain a degree of control in a transition – either can also impact valuations. It’s worth considering bringing in a valuation specialist or transaction intermediary to review the mix of goals, revenue streams, expense structure, legal structure, finances, clients and other available information. A specialist can help ensure that a fair and realistic firm valuation is achieved. While there are many approaches to valuation, attributes that are always considered include risk, scalability, growth and cash flow quality.  It is also time to clean up the books. As any valuation is dependent on EBITDA, it is important to make sure that the books and records are in good shape. For that, we review an audit by your CPA firm.

3. Maximizing Value

Buyers place a high value on business continuity—assurances that clients and key employees will remain in place once the firm begins its transition. Clients who can easily follow disengaged staff out the door are an obvious risk to a successful transition. This risk can be mitigated by hiring key employees and professionals who are a good long-term fit and by creating a compensation strategy with incentives that help employees share in the firm’s success. Creating a structure that allows key employees to participate in ownership is a powerful value driver in successful business succession planning.

Firm value is also enhanced by institutionalizing client relationships—which means ensuring that clients are connected to the firm rather than to any individual employee (or even the owner). Additionally, firms can reduce risk and maximize value by documenting all processes, including compliance procedures and contingency plans. Firms that demonstrate systematized business practices will yield higher valuations than those without this level of transparency.

4. Maximize Scale

Efficiency is another key value driver. It’s worth exploring ways to facilitate growth without adding fixed overhead. Not only do strong margins benefit owners in the short term but they can also serve as a platform for future firm growth—always appealing to prospective buyers. But there’s an important distinction to be made here: While efficient operation is desirable, being lean to the detriment of staff workload and compromised client service is not. Buyers aren’t necessarily seeking a bargain, but they do want lower transaction costs per unit of revenue. Efficiencies can be created, for example, by automating workflows to streamline operations and by creating a segmented service offering that fits the revenue profile of each client segment. Creating proportionally lower costs will equate to higher margins and drive EBITDA and possibly the multiple you receive even higher.

5. Demonstrate Consistent Growth

Buyers will pay a premium for firms that are rigorous about new business development and that have an effective customer growth strategy. The most sought-after companies have multi-tiered growth strategies that utilize customer referral, cross-selling (where possible), marketing, and public relations programs to capture customer revenue opportunities from a number of different channels.  Successful firms tend to have well-documented business development compensation and incentive plans in place for the entire staff, to ensure that everyone has a vested interest in the firm’s growth.

Today’s business owners have spent their careers building firms on a foundation of successful relationships, the entrepreneurial spirit and the desire to grow and expand. Establishing a succession plan that secures their firm’s legacy beyond the founder’s working life is critical not just to their firm and their clients but also to the long-term success of the next generation of leadership. The succession-planning process can take as many as five to 10 years to establish and implement—and there’s just one chance to get it right…having a plan that works for you, your family, your employees and all stakeholders.

Understanding the many factors that influence a succession plan is the first step. Business owners who take the long view by starting to address their risks, scalability, growth and cash flow, will see their efforts pay dividends when it is time to implement their exit strategy (whether solicited or unsolicited).

If you have any questions please feel free to email me at Scott@stawealth.com

Scott

STA Financial Planning Department
Scott Bishop, Executive VP of Financial Planning, Partner
Patrick Fleming, Senior Director of Wealth Management
Elena Sharma, Financial Planner
Stephen Kirby, Financial Planning

Upcoming Event: Business Transitioning: Wrestling a Deal to Close

Strategic Considerations for Business Owners and Entrepreneurs to Maximize the Value of Their Business.  We invite you to join us for an exclusive opportunity to understand the most significant milestones
in the lifecycle of a business transition. Learn first-hand from our panelists stories detailing succession planning, strategic partnerships, recapitalization and sale transactions. Hear how business owners  optimally position themselves to attract and command the most lucrative buyout offers while demystifying a myriad of issues to preserve the company’s legacy.

Business Transitioning
Wrestling a Deal to Close

November 9, 2017
4:00 pm – 6:00 pm
You are cordially invited to attend an exclusive presentation
With reception to follow

The Live Oak Room
at the Norris Conference Center in CityCentre
816 Town & Country Blvd. Houston, TX 77024

Seating will be limited. Direct inquiries to Amanda at
aheflin@selmanmunson.com or 713.400.1562
by Thursday, October 26.

Panelists:

Scott Bishop Partner, STA Wealth Management
Rick Hunter Managing Director, Lexbridge
Manish Seth Partner, ABIP CPAs and Advisors
Michael Churchill Manager, ABIP CPAs and Advisors
Peter Ellen Senior Vice President, Amegy Bank
Vibhu Sharma Wood Group Mustang
Jack Selman President, Selman, Munson & Lerner

 


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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