STA Weekly Report – As the Fed Announced Another Rate Hike, Investors Should Watch Other Risks
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As the Fed Announced Another Rate Hike, Investors Should Watch Other Risks
Weekly Technical Comment
Using Options in Your Financial and Investment Plans
401k Plan Manager
For the better part of three years we have been in the middle of a slow, gradual, rate hiking cycle that the Federal Reserve has done a fairly good job telegraphing for investors. This week, the Fed tried its best to continue “threading the needle” on normalizing rates without derailing a resilient domestic economy and announced another quarter point rate hike.
As the charts below show, the US economy has been robust with strong employment and Composite PMI Readings which indicate still expansionary manufacturing and service sectors.
Looking ahead, it now appears that traders have repriced the Fed hiking cycle yet again. Until recently, we had seen traders positioned for two more rate hikes this year (likely after the September meeting this week and again in December), and two more hikes in 2019. However, as we look ahead, it now appears that traders are in the process of repricing the change for a continued rate hiking cycle into 2020.
As the chart above illustrates, the spread between euro-dollar futures in December 2019 and 2020 has broken away from its prior inversion. Although, only a miniscule break from that inversion (only a spread of 4bps), it does indicate a jump in the probability of further rate hikes in 2020 to 16%. Based on what we have heard from the Fed, this higher probability appears to be in the process of falling in line with the Federal Open Market Committee’s (FOMC) comments.
If there is some good news in this for investors it is that if expectations converge with the thinking of the FOMC, the likelihood of a market-shaking rate hike may be on the decline. However, there are other risks worth keeping in mind that have nothing to do with the rate hiking glide path that investors should pay attention to.
Corporate Debt being used for financial engineering rather than future growth
It is no secret at this point that low interest rates have encouraged borrowing by corporate America. While the low cost debt corporate America has taken on has been used to fund share buybacks and M&A that have supported equity prices throughout this nine-year bull run, there are downsides to this use of capital – First, it can constrain financial flexibility in the future and lead to a jump in corporate defaults and second, the debt has been used to fund activities like share buybacks which do little to fuel future earnings growth. Since investment returns tend to correlate to earnings growth, this is something for investors to keep an eye on.
Earnings expectations showing signs of deterioration
Another key risk for equity investors is that forward earnings deteriorate. The chart below shows the aggregate earnings expected by analysts on the S&P 500. As the chart illustrates, over the last month we have seen those earnings per share expectations come down.
Source: STA Wealth Management
Further adding to this concern is that a large percentage of S&P 500 companies have issued negative earnings per share guidance for the third quarter.
Investors should thus be asking themselves if peak earnings are behind us and whether it means a higher risk market environment lurks on the horizon.
Complacency about the strong economy – Investors remain greedy
As they say, risk happens fast in investment markets. Another risk that nobody is talking about is investor complacency. As the chart below from Gallup shows, since 2009 we have seen a steady decline, to 12% in the last survey, in the number of people worried about economic issues.
Investors on the other hand, have been driven by greed for the last month as shown in the Fear & Greed Index. While we are not in “extreme greed” territory, greedy investor sentiment is something that should concern investors because sentiment and emotions can quickly shift. As Warren Buffet has famously said, be fearful when others are greedy.
Ten-Year Treasury Yield Is At A Critical Point
Treasury bond yields are going through an important test of overhead resistance. Chart 1 shows the 10-Year Treasury yield ($TNX) challenging its May 2018 intra high near 3.11%. After pulling back from its May high, the TNX entered a sideways trading range that lasted from the end of May to the start of September. Last week, however, it rose above its summer highs to reach the highest level in four months. As discussed in previous messages, the May peak represents an important long-term resistance barrier.
Monthly Bars Show Why May High Is So Important
If you’ve been reading messages on this site, you’ve seen this chart before. The monthly bars in Chart 2 show the same 10-Year Treasury yield forming a potential “double bottom” between 2012 and 2016. It’s now in the process of challenging the peak formed at the end of 2013. A move above this year’s spring high would constitute a major bullish breakout, and would put the TNX at the highest level in seven years (since 2011). It would also break long-term down trendlines extending back for several decades. The 2013 peak followed the “taper tantrum” caused by the Fed’s mentioning that it would start ending its policy of quantitative easing (and lower interest rates). The Fed is now in in the process of raising short-term rates (which is expected to continue with another rate hike this afternoon). That should continue the upward pressure on bond yields. Rising bond yields are also reflective of strong economic conditions, and some easing of global trade tensions. But there’s another important factor supporting higher Treasury yields. And that’s the fact that foreign yields are also starting to rise.
Weekly Snapshot of Global Asset Class Performance
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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)
Using Options in Your Financial and Investment Plans
Scott A. Bishop, MBA, CPA/PFS, CFP® and Scott Phillips, MPA, CPA
The trading and tax rules for options are complicated, to say the least. The knowledge needed to truly understand options before starting to trade them or use them as a planning tool are also complicated. In terms of tax ramifications, the tax consequences of an options transaction depends on many factors, including the investor’s tax bracket, the type of property that underlies the option (e.g., stocks, bonds, commodity futures, currency contracts), and the nature of the options transaction. While this discussion attempts to shed some light on the subject, investors should consult a tax planning professional before including options in their portfolios, and refer to IRS Publication 550, Investment Income and Expenses.
For this discussion, it’s assumed that individuals investing in options understand this form of investing, but the following quick review may be helpful.
Read Full Article Here
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