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STA Weekly Report – Stocks Start Year with a Bang…Proceed with Caution

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INSIDE THIS EDITION:
Stocks Start Year with a Bang…Proceed with Caution
Does a Flattening Yield Curve Mean We Are Close to Recession?
Weekly Technical Comment
Happy Birthday Roth IRA – and Tax Changes to Disallow Recharacterization Starting in 2018

401k Plan Manager



In two months, the climb from the depths of the financial crisis market low is set to reach nine years. The cumulative S&P 500 gain is now 306 percent, not including dividends. That’s better than any other except the 1987-2000 run — which was a stunning 582 percent.

The market so far in 2018 is showing signs it might be ready to accelerate toward those heights, on an uncommon combination of faster growth and plentiful liquidity.

Last week’s 2.6-percent S&P 500 gain in four days would have made it the best week of 2017, a sign of expanding risk-taking appetites and more eagerness among buyers. To be aggressively optimistic on this stock market now is to bet that it can challenge the greatest bull market of all-time — the 13-year run that ended in early 2000.

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In terms of its cumulative gains, persistence, valuation and the public’s exposure to stocks, only the final years of the 1990’s advance sit at higher elevations.

This might sound scary, given how singular that bubbly period now seems — and given the brutal wealth destruction that followed. And it should be sobering, in terms of what it means for longer-term expected equity returns. What is an investor to think?

The annualized gain since March 2009 is nearly 16 percent. That’s well above the long-term average, but then again, when major bull markets have ended, the trailing 10-year annualized gain has often topped 20 percent.

(There is no absolute definition of bull markets. Some quibble that the recovery from the 2009 low didn’t turn into a wholly new bull market until it hit a fresh record high in early 2013. Others say the 1990 setback or the tumble in late-2015 into early 2016 was effectively a mini-bear market that reset the clock. Fair enough — that’s what makes market debates.)

Valuation — whether based on the past year’s reported earnings, forecasted earnings for the coming year or the fun-spoiling Shiller-CAPE measure using 10 years of average profits — all show U.S. stocks more richly valued than any period except the late-’90s.

The trailing 12-month price/earnings multiple for the S&P 500 is now approaching 23. The tech bubble was so extreme that there remains plenty of room between here and that peak.

It is also true that momentum has been quite favorable. Recently, 75% of S&P 500 stocks were trading above their 200-Day Moving Average. Additionally, one must go back 15 months, to October 2016, to find the last month where the market fell.

High hopes are also implicit in investors’ elevated equity holdings. There remains a stubborn narrative that the little guy has boycotted this bull market, but the monthly asset-allocation survey of American Association of Individual Investors shows stocks at 72 percent of member portfolios. This would be the highest since the peak of the 2000 dotcom bubble, when they peaked at 77 percent.

The Fed’s measure of household equity holdings shows a similar trend. And cash reserves in Charles Schwab client accounts recently hit an all-time low.

Margin debt, which is viewed as a measure of speculation, has been at elevated levels all year. According to the most recent data from NYSE, it hit $580.95 billion at the end of November, its fifth record in a row, and up 3.5% from October. Records aren’t rare- more than 23% of all monthly readings are records—but debt has been creeping up basically all year. The 11 highest readings on record all occurred in 2017.

So, does this mean that the stock market is a bubble on the verge of implosion? Of course not. In the near-term, the stock market will do whatever it wants. That includes the possibility of rallying for some time longer, despite the present elevated reading. Stocks did precisely that in the lead up to the 2000 bubble burst, when they first registered a reading of 72% on AAII’s asset-allocation survey in late 1997. Do we believe this bull market has several more years left in it? No, but the point is that it is difficult to derive any precise timing from this indicator.

We will simply say that this reading implies a significant level of potential longer-term risk in the market. It is not going to be a catalyst in causing a market reversal and subsequent correction. However, if the market does start to head meaningfully lower, this condition could exacerbate the decline given the amount of capital with the potential to exit the market. In such an event, the substantial potential risk could, thus, become realized risk.

Does a flattening yield curve mean we are close to Recession?

The yield curve plots the yields of treasury bonds with different maturity dates. Under normal conditions, longer-dated bonds should offer higher yields to compensate for interest rate risk. The slope of the yield curve, however, can flattened or even invert ahead of an economic downturn, a phenomenon that has repeated itself leading up to the last seven US recessions.

This is a timely topic to discuss as 2017 saw the yield curve flatten significantly as the yield on the 1-month T-bill has increased by 80 bps and yield on the 30-year T-bond has decreased by 32 bps.

Investment professionals like to use either the yield differentials between 5- and 30-year Treasury or between 2- and 10- year treasury to measure the steepness of the yield curve. At a 50bp spread, both measures are at their flattest level in the last 10 years. As a result, many investors are asking whether this indicates a warning about a looming recession and whether it means investors should become more defensive in their portfolios.

Source: Bloomberg.

We are in the camp who believe that a flattening yield is less of concern for now.

First, the rise of short-term yields, rather than a decrease in long-term yields, is what has caused the flattening of the yield curve more recently. It is also important to remember that short-term interest rates are controlled by the US Federal Reserve. With three rate hikes in 2017, the Fed sent the signal that they are confident in the growth momentum of both US and global economies. The decrease in long-term yield, in comparison, indicates that market participants anticipate a slowdown in economic growth and inflation in the future. With the 10-year Treasury unchanged, it indicates that investors are maintaining a constructive view of the market.

Second, the inversion of the yield curve has historically occurred about one year prior to recession. Currently, we remain 50bp away from an inverted yield curve.

Third, the stock market can trend higher even after an inversion of the yield curve, as it has ahead of the last three recessions. See chart below.

Together, it appears to us that the yield curve may be forecasting that the market may have more room to run.

Of course, it would be shortsighted to judge the probability of a bear market, simply based on the shape of the yield curve. Using history as our guide, bear markets have typically been triggered by recessions, commodity spikes, overly aggressive Fed, or extreme valuation levels. By thoroughly going through this check list, we get a better sense of the current macro environment, on which the ongoing bull market has heavily relied.

Source:  FactSet, NBER, Robert Shiller, Standard & Poor’s, J.P. Morgan Asset Management

We first check the US conference board leading economic index, which aggregates ten US economic leading indicators. Acting as a wind vane, the leading index has successfully forecasted the last seven US recessions. As the chart below shows, the index has risen steadily since the end of the financial crisis and has not yet shown any weakness.

Source: The US Conference Board.

We then compare S&P 500 P/E multiples to their 20-year averages. The forward P/E of the S&P 500 index, along with most sectors, is above historical means. However, this can be justified by low interest rates and low market volatility, important factors that influence stock valuations. Even if stocks look expensive in a historical context, valuations are not at an extreme level. An elevated valuation level typically suggests intermediate term (5-10 years) returns are likely to be muted. It, however, has poor predictive power of near-term (6 month – 1 year) returns.

 

The Federal Reserve continues taking an accommodative stance. The appointment of Jerome Powell as new Fed chair is widely regarded as a signaling of a continuation of Janet Yellen’s cautious monetary policies. Interest rate projections in the Fed’s December meeting has remained largely unchanged despite upbeat economic data and buoyant financial markets. The timeline for the Fed’s balance sheet reduction program has been well communicated and is not expected to spur any meaningful market instability.

Unexpected commodity spikes have been recession triggers in the past. The most recent rebound in crude oil prices merely represents a moderate uptick. Commodities, especially industrial metals, could have an upswing, given the backdrop of synchronized global economic growth and revitalized capex spending. However, the commodity super-cycle seems to be behind us. Supply-demand dynamics still need time to rebalance: on the supply side, previous commodity booms have created spare capacity, including unused capacity as a result of OPEC oil output cuts; on the demand side, China, the biggest commodity consumer in the world, has increasingly focused on clean industries and capacity reduction in heavy industrial sectors. So, we don’t expect commodity prices to suddenly spike.

Source: Bloomberg.

While economic fundamentals and monetary policy both look supportive, how about investor sentiment? Are we seeing euphoria in markets? To help answer this, we refer to BlackRock’s U.S. risk ratio. The risk ratio is calculated by dividing the value of outstanding U.S. risk assets (defined as equities, corporate bonds, mortgages and bank loans) by the value of perceived safe-haven assets (government and agency mortgage securities and bank deposits). A higher ratio indicates that investors are taking a more aggressive asset allocation strategy: increasing the amount of capital chasing risky assets. As the risk ratio chart points out, the market has yet to reach euphoria like we saw during the dot-com and US housing bubble.

Source: BlackRock Research Institute.

Good news, however, has already been baked into consensus expectations and asset prices. This means that the market has essentially borrowed returns from the future. Based on consensus analyst earnings estimates, the S&P 500 and some sectors are projected to grow double digits in 2018, well above historical trend. If reality falls short, a market correction could follow.

Source: FactSet, Russell Investment Group, Standard & Poor’s, J.P. Morgan Asset Management.

Moreover, markets have been underpricing potential geopolitical risks such as hard Brexit, North Korea nuclear crisis, and NAFTA negotiation failure. 2018 is also full of political uncertainty with elections in Italy, Russia, Mexico, and Brazil set to occur. Geopolitical risk could spark market volatility, especially as complacency has increased amidst the current goldilocks environment.

That said, we remain constructive on world markets for 2018 and don’t see a U.S. recession on the horizon. However, it is unlikely that 2018 will see returns as spectacular as what we saw in 2017. Instead, we expect more modest positive returns. At the same time, we expect volatility to trend higher. This means that to get incremental returns will require taking on higher risk. If 2017 was a year of the flattening yield curve, then 2018 looks to be the year of the flattening investment efficient frontier.

 

 

Weekly Technical Comment

Global Stocks Start Year with a Bang…Proceed with Caution?

Global stock markets started off the new year with a bang. U.S. stock indexes exploded to record highs for the best start in years. Foreign stock benchmarks did the same, including the FTSE All World Stock Index which also hit a new record. New records were set in North America, Europe, and Asia and in both developed and emerging markets. So, what’s there not to like?

 

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Well, there is one thing. Stocks are very stretched on a historical level. That may not be a problem at the moment. But could become one later in the year if some things start to go wrong. But first let’s look at how much stocks are stretched. The black bars in Chart 1 compare monthly bars for the S&P 500 to a 14-month RSI line. Readings over 70 show a major overbought condition. The last two times that happened was in the 2006/2007 period and in 2014 (circles). The earlier condition led to a major downturn in 2008. The later version led to a downside correction in 2015 in excess of 10%. What really jumps out in Chart 1, however, is that the monthly RSI reading of 86 is higher than both of those two prior peaks. In fact, it’s now at the highest level since the late 1990s. That puts the S&P 500 at the most overbought level in twenty years. That’s not necessarily a bad thing over the short run. But it is a caution sign that things may have gotten a little too good. The 14-week RSI line has now risen to the highest level since 1958. That’s sixty years ago. That makes me a little nervous that 2018 may not end as well as it started.

 

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)

 

Happy Birthday Roth IRA – and Tax Changes to Disallow Recharacterization starting 2018

By Scott A. Bishop, CPA/PFS, CFP®

Most people know that 2018 starts a year with a brand new tax law (some of the highlights can be found in this linked summary).  However FEW know that it is the 20th anniversary of the Roth IRA…I started my first personal Roth IRA in 1998!  I was talking about this anniversary with team as part of Ed Slott’s Elite IRA Advisor GroupSM.  The Slott team had a lot of thoughts to share.

The year 1998 seems like a long time ago. In January 1998, Bill Clinton was in the White House and about to be impeached. The Unabomber was in the news and the Spice Girls were winning music awards. January 1, 1998 also brought us the launch of Roth IRA. However, unlike other ‘90’s memories, the Roth IRA is still going, stronger than ever. You may already be reaping the tax benefits of your own Roth IRA. Or, maybe you’ve hesitated to open one. The 20th anniversary may be the time for you to take the plunge…

Before we proceed, I wanted to let you also know that my friend and IRA Guru Ed Slott, CPA also reviewed and wrote me a Forward to our Retirement Survival Guide that will appear in the 2018 update.  I talk about the benefits of the Roth IRA many times in the guide where we help you with an eye toward “Planning for Retirement the R.I.T.E. Way®” (R.I.T.E. Stands for “Retirement Income Taxed Efficiently).

Ed Slott was recently quoted in Forbes as saying (and I agree):

To celebrate the 20th Anniversary of the Roth IRA, Ed Slott and Company wanted to share 20 Roth IRA facts you need to know to maximize the value in YOUR Retirement Plan: 

  1. Roth IRAs offer the benefit of tax-free earnings when you follow the rules. With a Roth IRA, you can look forward to completely tax-free distributions when you retire.
  2. According to Investment Company Institute statistics, 24.9 million American households had a Roth IRA in 2017.
  3. If you are young, a Roth IRA can be a smart strategy because you will have years to let your earnings accumulate and grow tax-free.
  4. For 2018, the maximum Roth IRA contribution is $5,500 for those under age 50 and $6,500 for those age 50 and older in 2018.
  5. There are income limits for Roth IRA contributions. If you are single, your ability to contribute will begin to phase out when your income exceeds $120,000 ($189,000 if married filing jointly).
  6. A strategy for high earners to fund a Roth IRA may be to do a back-door Roth IRA conversion.
  7. You are never too old to contribute to a Roth IRA. Your age is no barrier if you are otherwise eligible.
  8. A minor can make a Roth IRA contribution if they have earned income, such as earnings from a summer job.
  9. You can convert your traditional IRA to a Roth IRA. There are no income limits that apply. You will need to decide that the benefit of future tax-free earnings outweighs the downside of a tax bill now on the conversion. Conversion is not one size fits all.
  10. While the benefits of conversion can easily be seen for younger people, being older should not rule out conversion. It can be a smart estate planning strategy. By converting, you can leave your retirement funds to your beneficiaries tax free and they can stretch tax-free distributions for years from the inherited Roth IRA.
  11. Thinking conversion might be for you? Talk with a knowledgeable tax or financial advisor. You will want to be sure. The Tax Cuts and Jobs act eliminates the ability to recharacterize or undo a Roth IRA conversion so there are no “do-overs” anymore.
  12. You can still recharacterize tax-year contributions. So, if you make a 2018 traditional IRA contribution and decide a Roth IRA contribution would be a better move, you can recharacterize your contribution to your Roth IRA.
  13. Are you retiring and deciding what do the funds in your employer plan? Funds that are rollover eligible to a traditional IRA can also be converted to a Roth IRA.
  14. If you have both pretax and after-tax funds in your employer plan, rules allow you to convert after-tax funds to a Roth IRA and roll your pretax funds to a traditional IRA. These rules are complicated so be sure to discuss your situation with your tax advisor.
  15. If you are under age 59½ and do a Roth IRA conversion, you will need to wait five years before you can access your converted funds without penalty.
  16. Roth IRAs are never subject to required minimum distributions (RMDs) while you are living.
  17. Your Roth IRA beneficiaries must take RMDs. However, those distributions are almost always tax-free.
  18. To take a tax-free distribution of the earnings from your Roth IRA, you must be over age 59½ or disabled, or purchasing your first home and you must have satisfied a five-year waiting period that begins with your first Roth IRA contribution or conversion.
  19. The five-year waiting period for tax-free distributions of Roth IRA earnings does not restart with additional contributions or conversions. It begins with the first one and never restarts again.
  20. The future looks bright for Roth IRAs. These accounts have grown in number and in balance size over the past 20 years. You can expect Roth IRAs to play an even bigger role in the future. The trend in Congress when debating retirement savings is toward more “Rothification,” not less.


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 (“STA”), 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.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  STA 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’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a STA client, please remember to contact STA, 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, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

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