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STA Weekly Report – The Market is Upset, and It’s Not About Earnings

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INSIDE THIS EDITION:
The Market Is Upset, and It’s Not About Earnings
The State of Merger and Acquisition Activity
Weekly Technical Comment
Social Security Awareness Month: Five Pointers to Consider
401k Plan Manager

There appear to be several things weighing on the market, but it isn’t this earnings season, closely followed trader Art Cashin told CNBC on Tuesday.

“We’re maybe one-third of the way thru earning season and 83 percent of companies that have reported have easily beaten the estimates. And yet the averages are below where they were when earnings season started. So it’s something other than earnings that has the market very upset here”.

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Part of the reason for the sell-off was the 10-year Treasury breaking above 3 percent for the first time in more than four years. However, there are also general concerns about trade and tariffs, as well as whether earnings will peak this season.

On Tuesday, Caterpillar reported earnings that beat expectations. However, during a conference call, Chief Financial Officer Bradley Halverson said the company’s outlook assumed that the first quarter would be “the high-water mark for the year.”

On top of that, the quarterly reading on gross domestic product is coming up, and that continues to be marked down, noted Cashin.

“The market’s saying ‘yes, things have been good but what are you going to do for me tomorrow?'” he said.

What should an investor make of this situation? As we have mentioned in previous summaries, it seems smaller stocks are beginning to lead. Smaller stocks are generally less influenced by international concerns, like tariffs, as they are more focused domestically. Furthermore, they are more likely to enjoy better earnings growth thanks to the new tax law.

Indeed, S&P 500 companies have had profit growth of 25% this past quarter. The small-cap Russell 2000 securities have done even better, showing growth of over 29%. With such amazing growth one might wonder why stocks are not doing better.

A major part of this may come from the old adage of “Buy the rumor, sell the news.” In 2017 the S&P 500 advanced impressively, gaining over 20% on a total-return basis, on high hopes of a favorable tax law for corporations. The tax bill is now law and earnings gains are impressive (again, growing at 25%). However, this is stale news to market participants and the average reporting company has seen their stock price decline 1.3% in the five days following their announcement.

Looking to the future, it is a good sign to see most industries performing well. A high number of market industries are trading above their 30-day and 90-day moving averages. Our research team looked over the last 10 years and found when this condition is in place the market enjoyed 14.9% annualized returns.

Still, we have some concerns. One major concern remains valuations. Despite the tremendous growth in earnings and the overall decline in stock prices since January, current Price-to-Earnings (PE) ratios remain over 20 today. Historically this is an elevated level.

Overall our leading intermediate indicators are mostly favorable but still suggest a somewhat cautious approach. Our short-term indicators are unfavorable, given further credence to this caution. Given negative market reactions to this earnings season, we would avoid excessive aggressiveness at this time.

Bond Market Analysis

It was a difficult week for U.S. bonds. All maturities were down, especially longer dated maturities. U.S. Treasury bonds, mortgage backed bonds, U.S. TIPS (Treasury Inflation Protected Securities) and corporate bonds decreased in price. The yield on the U.S. Treasury 10-Year Note ended the week at 2.96%, up from 2.82% a week ago. The trend of a flattening yield curve continued last week. This is a narrowing of the difference in yields of different maturities. Presently the spread (that difference) between the 10-Year Treasury and the 2-Year Treasury is at its narrowest since 2007.

The latest economic projections from the Atlanta Fed model, GDP Now, continue to soften. Their quantitative method predicted strong growth of over 5% back in February. Now they are suggesting annualized growth of less than 2%. Despite this, the Fed Funds futures market now predicts a 45% likelihood of a 4th rate hike this year. This is a sharp increase since the beginning of 2017.

What should an investor do? Even if the FED Funds rate continues to rise, we see a few areas which may be beneficial for U.S Treasuries. First, we see a dramatic shift in sentiment for U.S. Bonds. Speculative bond investors are net short, meaning they expect yields to head much higher. When this has happened in the past rates generally moved in the opposite direction.

Still, our strategic concerns about valuations, Fed actions, excessive optimism, a bubble in ecommerce stocks and potential trade wars are sobering. During periods like this, investors should avoid being too aggressive and use upward and downward volatility to respectively trim expensive and buy bargain securities.

 

When the Trump administration announced tariffs on the import of steel and aluminum many believed that it would signal the beginning of a trade war with China. Since that initial announcement, there have been several additional moves by both Washington and Beijing on the trade front that stand to alter the balance of trade for the foreseeable future.

 

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Source: International Trade Centre

While it appears unlikely that a full blown trade war will develop, trade tensions between the two super powers are high with some in China going as far as suggesting that the Chinese consumer could be weaponized if a full-on boycott of US goods were to be imposed by Beijing. It does not appear we will ever get to that, however that does not mean there haven’t been impacts. Take for example cross-border deal-making.

The following chart shows global mergers and acquisitions currently on pace for a record year in terms of deal value. In fact, for 2018 through March 29th, more than $1 trillion dollars of mergers and acquisitions (M&A) have already been announced. The record pace has been largely driven by still low interest rates, availability of cash on corporate balance sheets, companies shedding assets to focus on core businesses, and the need to stimulate growth inorganically. Many of these announced deals involve cross-border corporate tie-ups which historically have been tough to execute due to their complex nature.

Consider for one moment that for a cross border merger deal to go through, two companies must agree on the terms and conditions, management teams at both firms must agree on who will drive the process to closure, where potential synergies (i.e. cost savings) will be realized, and what the time table for integration might be. Of course that’s before a deal even makes it to the approval process by regulatory bodies in multiple countries.

This environment over the last several years has only become more complex. For example, in deals announced involving China-to-US takeovers (with deal value of nearly $160 Billion), nearly half have been terminated or withdrawn since 2015.

Now, with a potential US-China trade war possibly looming, the cross-border deal making environment stands to see even more complexity. Take for instance the 101 pending Mergers and Acquisitions transactions involving North American companies as of April 23, 2018. Of those, 9 require the approval of the Chinese Ministry of Commerce (MOFCOM), which is responsible for already postponing the approval of several large M&A transactions since trade tensions emerged with the US. It is widely thought this tactic by MOFCOM is being used by Beijing to gain leverage in trade discussions with the US.

As a result, deal spreads with China/US cross border deals have widened to an average of 9%. In contrast, the entire North American M&A universe is trading at a much narrower average spread of only 1.8%. Because of wider cross-border merger arbitrage spreads, annualized spreads have widened to levels not seen in well over a year. While spread volatility isn’t always pleasant, more volatility does open the door to better potential returns however.

This is especially true when the reason for wider spreads is a market dislocation due to reasons not related to deal-specific risk like we appear to have today.

For investors, the current state of M&A should thus serve as a strong reminder that markets sometimes do dislocate and provide attractive investment opportunities. However, to take advantage of them requires working with an advisor that is looking at the investment universe through multiple disciplines (we blend macroeconomics, fundamentals, and technicals) and has the capacity to conduct deep due diligence and can stay abreast of changes in markets across asset classes and geographies.

 

Dow Industrials Clear 50-Day Line

Stocks are opening the new week on a positive note. Our first chart this week shows the Dow Industrials clearing their 50-day average by the widest margin since late February. It’s also clearing a down trendline line drawn over its January, February, and March highs.

 

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The falling trendline was being touched for the fourth time since the January peak. The third try to break through it is usually the one that works. So far, it appears to be doing that. Its 9-day RSI line (top box) is back over 50; and its daily MACD lines (below chart) have turned positive. The Dow Transports also cleared their 50-day line yesterday. It’s a good sign when they’re both rising together.

Dow Transports Exceed 50-Day Average

Transportation stocks are having an especially strong day. The daily bars in Chart 2 show the Dow Transports continuing to climb. More importantly, the $TRAN is trading above its 50-day moving average (blue circle). It also appears to be on the verge of rising above a falling trendline drawn over its January/March peaks. The transportation group bounced off its 200-day moving average just a couple of weeks ago (red arrow). Its relative strength line (top of chart) shows the group starting to outpace the Dow Industrials. The two groups leading the rally are truckers and rails. Among delivery services, FedEx is also having stronger momentum.

Weekly Snapshot of Global Asset Prices

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)

At STA Wealth, many of our clients are owners of small and closely held businesses.  For those clients, we believe it is very important that their financial plan incorporates their ultimate Business Succession Plan and/or Exit Strategy.  For many business owners, their business is one of their largest assets.  To help assure that they and their families maximize the value for their business, at STA Wealth we believe that that they need to understand the Five Key Elements of a Succession Plan or Exit Strategy.

In the December/January 2017-18 edition of their Forum Newsletter, the Houston CPA Society highlighted one of my articles on Business Succession Planning.  Scott is also a former Director of the Houston CPA Society and has served several times as the head of its Personal Financial Planning and has served on its Investment Committee.  He was also named Young CPA of the Year by Houston CPA Society in 2002-3.

If you would like to see a copy of the article, please follow this link:  Leaving Your Legacy:  Business Succession Planning.

Social Security Awareness Month – Five Pointers to Consider when Filing for Social Security
Written by: Scott A. Bishop, MBA, CPA/PFS, CFP®

In April, we celebrate National Social Security Awareness Month – a month dedicated by the Social Security Administration to educate the public about knowing and maximizing their Social Security Benefits.  As Social Security is also an important Retirement Benefit, we also talk about it extensively in our Retirement Survival Guide.

I just participated in a recent webinar presented by Laurence Kotlikoff, an economics profession at Boston University, in which he offered several pointers to the audience on Tips to consider when filing for Social Security.

At STA Wealth, we have been talking for years about how best to maximize your Social Security Benefits – see:

As financial planners, our advisors at STA Wealth have a broad understanding of how to advise our clients on maximizing their Social Security benefits – and the answer varies depending on each of our clients own personal circumstances.

Per Mr. Kotlikoff, this had become even more difficult due to recent changes to the file-and-suspend benefit rules of Social Security, which take effect this year and restrict that benefit to a limited number of couples. (The spouse who files and suspends must be 66 years old as of May 1, 2016, and submit his or her request to file and suspend by April 29.  The other spouse, who will receive that spouse’s benefit, must be 62 years old as of Jan. 1 of this year.) It’s also because Social Security is complicated, and even the workers at the Social Security Administration may not fully understand it.

With that in Mind, Mr. Kotlikoff has these five pointers to consider before you file for your Social Security Benefits:

  1. Social Security Workers Can Get it Wrong (although most are well intentioned):

Therefore, you need to know the rules yourself. “People in Social Security offices don’t seem to understand the new law,” said Kotlikoff, who’s also author of “Get What’s Yours — the Secrets to Maxing Out Your Social Security Benefits.” He then recounted stories of several retirees who were given erroneous information by their Social Security office.  We have seen the same issues with our clients here at STA Wealth.  So before you apply for benefits have your game plan on how best to maximize your Social Security given your needs and situation:

  • Age (of you and your spouse if married),
  • Tax and Work/Employment situation,
  • Longevity (how long do you think you will live), and
  • Cash Flow Needs.

At STA Wealth, we have software to help you maximize your benefits and there are also online tools at www.ssa.gov.

  1. Retirees Should Tell Social Security What They Want to Do – Don’t Just Ask

As discussed above, Retirees need to have the right information about their benefits — which we can provide at STA Wealth — and then tell Social Security what they want to do, preferably in writing. They should not ask Social Security workers questions about their benefits and expect to get the right answer, says Kotlikoff.

Mr. Kotlikoff recommends that retirees specify in writing in the remarks section of their application what they want to do, such as claim spousal benefits, and be definitive and clear. “The application form can be misleading,” said Kotlikoff. It says on top that you’re filing for all available benefits even when you’re not always doing that. You can’t undo that statement. The only place to specify … [what you want to do] is in the remarks section.

If someone wants a spousal benefit and the spouse has already applied to file and suspend and won’t take benefits sooner than his or her 70th birthday, “that has to be in writing … definitive and clear,” said Kotlikoff.

  1. File Social Security Applications Online Rather Than by Phone or in Person

For most of my career, I have recommended that clients should schedule an appointment in their local Social Security Office – I have had few problems with that.  Perhaps that is because my clients have a plan.

However, Mr. Kotlikoff believes thatit may be safer to file for retirement benefits and spousal benefits online. In that case, he believes that retirees can state exactly what they want to do, and specify in the remarks section of the application form. “You can’t write what you want by phone,” said Kotlikoff. Filing online can also avoid the problem of a worker at a Social Security office writing down the wrong information.  Widow and child benefits, however, cannot be applied for online, said Kotlikoff.

  1. Specify When You Want to Take Social Security Benefits

If you are beginning your Social Security benefits at Full Retirement Age, for those currently filing, it would be age 66, you will need to specify the exact date they want to begin taking benefits in the remarks section of their social Security application.  Otherwise Social Security will provide six months’ worth of retroactive benefits in a lump sum, which will have the effect of slightly reducing future monthly Social Security payments.

  1. Keep Track of Ex-Spouses if You’re Collecting Their Spousal Benefits

During the webinar, Mr. Kotlikoff recounted the example of an ex-wife who’s 63 and made the grandfather cutoff to collect under file and suspend. She can file for full spousal benefits of an ex-spouse when she reaches full retirement age at 66, then collect those for four years until the larger retirement benefit kicks in at age 70. At that point, if the ex has passed away she can take the larger of two benefits – the divorced widow or the divorced spouse. Per Mr. Kotlikoff, you should keep track whether your ex-spouse is still alive.

 





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.

Financial Planning and Investment Advice offered through STA Wealth Management (STA), a registered investment advisor. STA does not provide tax or legal advice and the information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters or legal issues, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

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