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STA Weekly Report – How to Position Your Portfolio for the Late Cycle

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How to Position Your Portfolio for the Late Cycle
Russell 2000 Small Cap Index is Trying to Clear Its 200-Day Moving Average
Energy Stocks are Trying to Clear their 200-Day line
IRS Issues Annual List of Tax Scams
401k Plan Manager*Updated on 12/31/2018

How to Position Your Portfolio for the Late Cycle

Generally, a business cycle can be divided into four phases: early cycle, midcycle, late cycle, and recession. If the current economic expansion continues into July, it will become the longest in U.S. history.

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Most Wall Street economists, strategists and analysts agree that the U.S. economy is entering the late cycle — the last phase before a recession.

Source: Corporate Finance Institute

As fiscal stimulus fades and the Fed brings interest rates higher, we expect to see growth decelerate and peaks in profit margins, sales and stock multiples. In the late cycle, a combination of slowing growth, rising interest rates, and fear over an incoming recession can drive up market volatility, as we experienced last December. Historically, investment returns have been strong in the midcycle but became more muted in the late cycle phase. During the late cycle, performance of stocks is typically dragged down by decelerating earnings growth. Bond returns are also negatively affected by rising rates. Commodity performance has typically been an exception however as commodities tend to perform well in the late cycle as inflation pressure builds. Overall, risk-return dynamics are less favorable in the late cycle as modest returns are paired with higher volatility. In other words, investors receive less reward for taking more risk.

So, how should we invest in a late cycle?

Source: Fidelity Investments

First, stay invested, especially for long-term investors. While returns on stocks and bonds are modest in the late cycle compared to the early and mid-cycle, they are still positive and likely to outperform cash. It is notoriously difficult to time the onset of a recession. The economy can continue growing for an extended period in late phase, albeit at slower pace.

Second, take a “barbell” approach. In the late cycle, we see great uncertainties. Future developments can drive markets either higher or lower. Today, for example, markets may climb higher if muted inflation keeps central banks dovish or if a resolution of the U.S. trade dispute with China materializes.  Conversely, markets may go the other direction if undesired outcomes trigger risk-off sentiment. Thus, it is prudent to own both risky assets such as stocks and safe haven assets such as government bonds in a portfolio. While it may be tempting to owning assets in the middle of the risk spectrum, investors should know that they may not be compensated sufficiently for this positioning. A recent example is what has happened with high yield bonds — they have turned in their worst historical performance compared to any other late cycle period.

Third, consider reducing exposure to economically sensitive assets while increasing exposure to defensive sectors, and adding inflation-protected assets.

Fourth, choose wisely between certainty and performance. Stocks tends to outperform bonds, even in the late cycle. In the 28 quarters that qualify as “late-cycle” periods since 1988, quarterly returns of global stocks have topped U.S. bonds by more than 1%. However, return dispersion of stocks, especially in emerging markets, has been much wider. So, if an investor’s investment horizon is reasonably long and wealth accumulation is the primary goal, it may be better to have a heavier allocation to stocks in the barbell structure. On the other hand, investors may want to own more safe assets if a near-term liquidity need is expected.  

Source: BlackRock

Lastly, focus on quality. For bonds, it means stepping-up in credit quality. For stocks, it means a quality tilt, which favors companies with higher profitability, lower financial leverage, heathy growth rate, and good corporate governance. Indeed, we have observed that the US quality factor indexes have outperformed the broad market index and other factor indexes since 2018. In addition, investors may consider including a minimum volatility factor tilt, which tend to perform well when market volatility picks up, as seen in the last quarter of 2018. This allows investors to stay invested but with a defensive posture.  

Source: SSGA

Russell 2000 Small Cap Index is Trying to Clear Its 200-Day Moving Average

Last Wednesday’s message showed the S&P 400 Mid Cap Index clearing its 200-day average; and suggested that only the small caps were left to join the market rally.

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That may be about to happen. Chart 1 shows the Russell 2000 Small Cap Index sitting right on its red 200-day line. A decisive close above that red line would a positive sign for smaller stocks, and would broaden out the market rally. A few other market groups are either trying to clear their red line, or stay above it. That includes airlines, energy, and financials.

Energy Stocks Are Trying to Clear Their 200-Day Line

Crude oil has gained 40% this year and recently cleared its 200-day average. Chart 2 shows the Energy Sector SPDR (XLE) trying to do the same. The Energy Sector SPDR (XLE) is the only S&P sector to remain below its 200-day line. That’s because the Financial SPDR (XLF) cleared that red line last week.

Banks Are Holding the XLF Back

Chart 3 shows the Financial Sector SPDR (XLF) trying to hold last week’s breakout above its 200-day moving average. Falling bond yields (and a flat yield curve) have been cited as the main factor holding financials back. That’s especially true of banks. Falling bond yields make it harder for banks to charge higher rates for their loans. Which explains why banks have been one of the weakest parts of the financial sector. Chart 4 shows the KBW Bank Index ($BKX) still trading well its 200-day line. But there’s a more positive side to that story. Falling bond yields have pulled mortgage rates lower, which has boosted mortgage and refinancing applications. Chart 5 shows the Dow Jones US Mortgage Finance Index already testing their September highs. Consumer finance stocks are also financial leaders. That may offset some of the drag from bank stocks.

Weekly Global Asset Class Performance

If you have any questions, please feel free to email me at


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)

IRS Issues Annual List of Tax Scams

The IRS recently issued its annual list of tax scams.  The list highlights various scams that taxpayers may encounter, many of which occur during tax filing season.  Here are some of the scams that are highlighted on the list. At STA Wealth, we want to help you avoid being a victim of these scams!


Phishing scams usually involve unsolicited emails or fake websites that pose as legitimate IRS sites to convince you to provide personal or financial information. Once scam artists obtain this information, they use it to commit identity or financial theft. The IRS will never initiate contact with you by email to request personal or financial information. This includes any type of electronic communication, such as text messages and social media.

Phone scams

Phone scams typically involve a phone call from someone claiming you owe money to the IRS or that you’re entitled to a large refund. The calls may show up as coming from the IRS on your Caller ID, be accompanied by fake emails that appear to be from the IRS, or involve follow-up calls from individuals saying they are from law enforcement. Sometimes these callers may even threaten you with arrest, license revocation, or deportation.

Identity theft

Tax-related identity theft occurs when someone uses your Social Security number to claim a fraudulent tax refund.  You may not even realize you’ve been the victim of identity theft until you file your tax return and discover that a return has already been filed using your Social Security number. Or the IRS may send you a letter indicating it has identified a suspicious return using your Social Security number.

Return preparer fraud

Sometimes scam artists pose as legitimate tax preparers and  try to take advantage of unsuspecting taxpayers by committing refund fraud or identity theft. It’s important to choose a tax preparer carefully since you are legally responsible for what’s on your return, even if it’s prepared by someone else.

Inflated refund claims

Taxpayers should be wary of anyone promising an unreasonably large or inflated refund. These scam artists may ask you to sign a blank return and promise a big refund without looking at your tax records or charge fees based on a percentage of the refund.

Fake charities

Groups sometimes pose as charitable organizations in order to solicit donations from unsuspecting donors. Be wary of charities with names that are similar to more familiar or nationally-known organizations. Before donating to a charity, make sure that it is legitimate. The IRS website has tools to assist you in checking out the status of a charitable organization.

Important Disclosure:
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 article / 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 article / 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 article / 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. Please Note: 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. STA shall continue to rely on the accuracy of information that you have provided.


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