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STA Weekly Report – Earnings Season Over, Stocks Quietly Subside

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INSIDE THIS EDITION:
Earnings Season Over, Stocks Quietly Subside
Weekly Technical Comment
Tax Reform Is Here: Here’s What It Mean’s For You
401k Plan Manager

If you didn’t watch closely, you might have missed the stock market’s downdraft last week. It was that quiet. Shares pulled back about 0.5% in slow, summer-level trading levels. Admittedly, there was a dearth of market-moving economic data releases. But not even an uptick in political rhetoric from North Korea was enough to push the market out of tight daily trading ranges.

 

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A rise in 10-year Treasury yields to as high as 3.12%, at one point from below 3% last week, was the main bearish impetus for equity traders. The yield settled at 3.07%.

With the first-quarter cycle out of the way, there isn’t much new for equity investors to focus on besides yields.

Despite increasing concerns about interest rates, small-capitalization stocks, as measured by the Russell 2000 index, hit a record last week, at 1623.63 and had a positive return of 1.3% on the week. Some bulls take that as a harbinger of better things to come from the rest of the market and that it is a sign of “risk on” for the whole market. However, that is not necessarily supported by the technical analysis when you measure the relative strength of the Russell 2000 index compared to the S&P 500. Since 1979, when the ratio is above its 40-week moving average, as it is now, the S&P 500’s return is an annualized 4.2%. That’s one-third of the 12.9% return when the ratio is below the moving average.

Additionally, as recoveries go, this one since the Feb. 8, 2018 low is getting long in the tooth. As of Friday, we are 69 trading days from the low without recovering to a new high. For the stock market drops of 7% to 12% since 1950 – the 2018 correction was 10% – the median time to recover is 33 days.

What’s taking so long? Fundamentals are strong right? As we have been discussing, a good portion of these improvements – such as supercharged earnings growth – was anticipated and baked into the high reached Jan. 26. Maybe the market wants something else.

That something else could well be share buybacks.

In our October 3, 2017 letter, we highlighted one of the shareholder benefits to Trump tax reform would be the additional cash available for publicly traded businesses to boost buybacks. The tax bill was passed in December and since then buybacks are breaking through previous records as we had expected.

Buybacks usually support stock prices by reducing share counts and boosting earnings per share. And companies that make announcements of big buybacks—like Apple’s stunning, new, $100 billion program—tend to be brimming with confidence in their C-suites. Indeed, shares of companies with big buybacks have historically outperformed the market.

Standard & Poor’s 500 companies are on track to announce $650 billion worth of buybacks this year, smashing the previous record of $589 billion set in 2007.

Buybacks offer investors an effective “yield” of about 3%, calculated by dividing repurchases by the $23 trillion market value of the Standard & Poor’s 500 index. Combine that with the 1.9% current dividend yield and investors should get a nearly 5% combined yield this year.

Even as interest rates rise, that combined yield stacks up well against the alternatives, with money-market funds approaching 2% and the benchmark 10-year Treasury note at 3%.

Do share repurchases really buoy stock prices in the long term?

There is debate over that question. IBM (IBM) and General Electric (GE) are two prominent examples of companies that executed large buybacks at high prices and have now scaled back or eliminated those programs in the face of earnings pressures.

And there is also the question of whether a company would be better off using its cash to make investments rather than buy back shares. No matter how you answer that, there is little evidence that big companies making buybacks are skimping on capital spending.

Investors are constantly evaluating management decisions on the use of capital and judging which uses will offer the best returns. If companies are less innovative or more mature, investors would prefer a buyback. Investors trust [Amazon CEO] Jeff Bezos to invest capital in high-returning businesses. They don’t want to see buybacks. Google has more in common with Apple and should be buying back a greater percentage of its stock.

Apple certainly doesn’t appear to be starving its operations. It plowed nearly $13 billion into research and development and capital spending in the first six months of its current fiscal year ending on Sept. 30. In the first quarter, Apple made $23.5 billion of stock repurchases—a record for a U.S. company. It has now repurchased $200 billion since its program began in 2012.

Mindful of the political criticism of buybacks as a gift to wealthy shareholders, Apple has emphasized that it plans $30 billion of domestic capital expenditures in the next five years, as well, and will create some 20,000 U.S. jobs.

What is unique about the Apple situation is that, unlike so many other corporations, it will buy back enough stock to move the needle on earnings per share.

For investors looking for aggressive buyback activity, the banking sector stands out. The giant money centers and regional banks should returned nearly all of their net income to shareholders in buybacks and dividends in the 12 months starting on July 1, in a roughly two-thirds to one-third split of buybacks and dividends.

While it has been cresting for a while, share buybacks may just be that something else that the market wants.

Are the Fears of Peak Earnings Over Done?

First quarter earnings season has now come and gone for most developed market equities. Despite strong first-quarter results, investors didn’t respond as cheerily as one might have expected. Much of this appears to be due to a growing chorus of investors and market prognosticators opining that earnings are at, or very near, their peak.

In no place is this more evident than in the United States. As the chart above shows, tax cuts announced at the tail end of 2017 led wall street analysts to boost earnings per share (EPS) estimates for S&P 500 constituents. However, in a break from what historically happens, the price level of the S&P 500 has not followed the upward trend in earnings estimates. The story is much the same for continental Europe and Japan where earnings estimates have gradually improved, albeit at a slower pace than the US, but the equity market response to these improvements has been similarly muted. Not only have price reactions been lackluster, but company management teams have added fuel to the peak earnings narrative as they have brought in earnings guidance. That, combined with growth concerns and potentially higher inflation, and it becomes easy to see why some are concerned.

However, it may still be too early to call the end of the current earnings cycle.

While the prospect of slower earnings growth is certainly present, corporate fundamentals continue to show signs of strength. Plus, trade concerns with China have abated, potentially lengthening the runway for earnings to continue their upward climb. And let’s not forget the impact that cash on corporate balance sheets will have on corporate spending and investment.

Buybacks, for one, are being announced at break-neck speed and could propel per share earnings numbers significantly higher. Typically, rising earnings are accompanied by rising stock prices. However, with interest rates on the rise and inflation expected to gradually pick up, investors have reduced the amount they are willing to pay for each dollar of earnings. This largely explains the disconnect that we have started to see between stock prices and earnings.

With the possibility that per share earnings continue rising with the help of buybacks, it appears possible that we see support for stock prices, at least in the short-term, even as investors pay less for each dollar of earnings.

More important for investors though, is the impact that more favorable valuations may have on return expectations going forward. As we have noted before, lower valuations set the stage for higher forward returns. However, as has been the case in the past, to earn those returns, investors need discipline and to have risk management processes in place that can help navigate through volatility and today’s economic landscape which still faces significant risk.

 

Industrial Stocks Breaking Out

Good news on the tariff dispute with China is giving a big lift to stocks today. Chart 1 shows the Industrial SPDR (XLI) rising pretty decisively above a falling four-month trendline. The XLI is also trading above its mid-April peak. One of its biggest gainers is Boeing (BA). Chart 2 shows that stock gapping higher to the highest level in three months. Chart 3 shows Caterpillar (CAT) gapping higher as well. They’re also giving a lift to the Dow Industrials.

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The Dow Industrials Are Also Breaking Out

With the industrial sector leading the market higher, it’s no surprise to see the Dow Industrials making positive gains. And it too is breaking out to the upside. Chart 4 shows the Dow Industrials trading at the highest level in two months. There again, Boeing and Caterpillar are two of its biggest gainers. Because of its high price, Boeing is having the biggest impact on the price-weighted Dow Average.

The Dow Transports Are Also Breaking Out

The Dow Industrials aren’t the only Dow Average breaking out. Chart 5 shows the Dow Jones Transportation Average trading at the highest level in nearly four months. That’s good news to Dow Theorists. Upside breakouts by both the Dow Industrials and Transports constitute a Dow Theory buy signal in the making.

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)

Tax Reform is Here! Here Is What It Mean’s For You!

By: Scott Bishop

Last week I attended the Ed Slott Elite IRA Advisor Group workshop in Philadelphia.  It was great to share ideas and network with many other CFPs and CPAs that specialize in Retirement and Tax Planning. Ed’s Slott’s teams are really the best and I was so happy that he agreed to write a new Forward for the Retirement Survival Guide (click on this link to read the forward).

Ed also shared this great summary of the “Tax Reform” law from 2017  and what it means for you:



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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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