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STA Weekly Report – Valuation Update Across Equity Markets

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INSIDE THIS EDITION:
Valuation Update Across Equity Markets
Weekly Technical Comment|
Weekly Snapshot of Global Asset Class Performance
401k Plan Manager

From a price perspective, equity markets are generally at similar levels as they were a year ago. Back then, we were on the verge of downward pressure on global equities as uncertainty about trade and interest rates drove markets lower in October and December.

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Fast forward to today and we are largely in the same place with geopolitical concerns, Fed policy, and signs of a decelerating economy topping the list of investor concerns. While fourth quarter volatility helped cut forward price to earnings multiples, a domestic equity rally for most of this year, has helped reflate forward multiples.

As investors, we are always interested in understanding how much we are paying for each dollar of future earnings and want to allocate to areas of the market that are less expensive. This makes logical sense because when valuations are low, the average expected returns on assets are higher than they would be when valuations are high. Valuations however, can be hard to gauge because they adjust on a continuous basis as new and disparate information is priced into securities. This fact is one reason we employ a multi-disciplinary approach to investment that combines the strengths of fundamental valuation work with macroeconomic and technical disciplines. Additionally, there are several different measures of valuation that can be used depending on the sector, asset class, or nature of cash flows. In other words, valuations and their measurement can be extremely complex. To make things easy, many investors look to valuation multiples like the forward price to earnings ratio to at least have a sense of whether assets are expensive or inexpensive.

For the sake of simplicity, we will focus our attention on the forward price to earnings multiple because it tends to be widely used and thus may be more familiar. The Price to Earnings ratio as it is also called, is simply a calculation that divides price by the expected earnings a certain business or index produces. As an example, if stock ABC traded for $15 per share, and was expected to report earnings of $1.50, it would have a forward P/E ratio of 10 ($15/$1.50 = 10). For the purpose of illustration if company XYZ traded at a price of $15 per share also, but was instead expected to report earnings of $3.00, it would have a forward P/E ratio of only 5. As such, the lower forward P/E ratio offers in this case a more attractive return profile where you get more earnings for the same share price.

While this is a very simplified illustration, it explains how earnings multiples are arrived at and how they can be applied to compare investment opportunities.  Comparing investments across a diverse set of valuation metrics is part of our three-pronged investment management process and is only one factor we consider when deciding which assets to overweight and underweight in a portfolio. 

So where are valuations today?

Domestic equity forward P/E’s briefly touched 23 at the beginning of 2018. They then dropped throughout 2018 as prices came down and corporate earnings reached peak levels. By December they were a more reasonable 16x. However, this year, despite more recent volatility, we have seen the forward P/E multiple increase once again and currently sits close to 19x. By historical standards this is not inexpensive.

Developed International Equities as measured by the MSCI EAFE Index have seen a very similar forward P/E glide path. Although forward P/E ratios for developed international equities peaked a bit earlier than domestic equities (2016), they steadily declined forward recent lows of 14x. This is largely attributed to many of the uncertainties that have plagued international equities for the better part of 24 months including Brexit and monetary policy shifts. Currently, developed international stocks have a forward P/E of just above 16. While this is more attractive than domestic equities on a relative basis, there are considerable risks that investors must also factor in including trade impacts, negative interest rates, and continuing uncertainty about the future of the European Union.

Where we see some more encouraging valuations are in Emerging Market Equities. The MSCI Emerging Markets Index currently has a forward P/E of just above 13x. Compared to domestic and developed international equities, this is much more attractive. A valuation focused investor with a long-term view may see this valuation level as attractive for allocating capital for the long-term. We tend to agree with this view.  However, investors must be aware of the risks. For emerging market investors, risk comes in the form of politics, trade, currency, and commodity risk. Recently, currency risk has been a headwind that combined with trade concerns have had a negative impact on emerging market equities.

However, we believe great opportunities require taking on some of those risks. To manage for them, we favor selectivity in the context of a globally diversified portfolio.  Additionally, we favor small exposures to countries that have catalysts in place that could pay off over an intermediate-term time frame.

Bond Yields and Stocks

  • Before 2000

A lot of attention is being given to what falling bond yields mean for the U.S. economy and stock market. It’s important to understand that the relationship between bond yields and stocks underwent a major change after 2000.

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Prior to 2000, bond yields and stock prices usually trended in opposite directions. As a result, falling bond yields were usually good for stocks. After 2000, however, that relationship changed. Since 2000, bond yields and stocks became more closely correlated. That change meant that falling bond yields since 2000 have usually been bad for stock prices. I believe that the emergence of deflationary pressures for the first time since the 1930s changed the bond-stock relationship. Interestingly, the absence of inflation is one of the reasons that global bond yields have been so weak this year, which suggests that deflationary forces are still in play. And why falling bond yields are still a negative sign for stocks.

Chart 1 compares the S&P 500 to the 30-Year Treasury Bond yield between 1980 and 2000. That period begins just after the hyper-inflationary decade of the 1970s when surging commodity prices resulted in historically high interest rates and a generally weak stock market. The two decades after 1980 saw a period of disinflation which was marked by falling commodity prices and declining bond yields. That disinflationary environment resulted in two decades of rising stock prices. The main point of Chart 1 is to show that falling bond yields usually accompanied rising stock prices. The green down arrows during 1982, 1985, 1991, 1995, and 1997 marked downturns in bond yields. Those downturns in yields were accompanied by rising stock prices (rising black arrows). 

The red circles, however, show three instances when rising bond yields resulted in lower stock prices. They include the stock meltdown during 1987, during 1990 in the months leading up to the first Iraq war, and the so-called “stealth bear market” of 1994. In all three instances, a downturn in bond yields helped resume the secular uptrend in stock prices.

Bond/Stock Relationship Changes After 2000

Prior to 2000, bond yields and stocks usually trended in the opposite direction. Chart 2 shows them trending in the same direction during 2000 and the two decades since then. A comparison of the first two red circles shows a downturn in the 30-Year Yield during 2000 preceding a similar downturn in the S&P 500 later that year. [Yields peaked during January; the Nasdaq peaked during March; and the S&P 500 that August]. The second set of circles show bond yields peaking earlier than stocks during 2007 (yields peaked during June and the S&P that October). Another downturn in yields during 2011 coincided with stock weakness. And again during 2015. The latest downturn started late last year, and the 30-Year Treasury yield has fallen this week to the lowest in history (last red circle). So far, that has had a mildly negative impact on stock prices. But if recent history is any guide, falling bond yields aren’t a good sign for stocks.

The Deflation Scenario

Starting in 1998, the word deflation was heard for the first time since the 1930s. That happened because of the Asian currency crisis between 1997 and 1998 which contributed to a collapse in commodity prices to the lowest level in 20 years (see Chart 3). That plunge in commodity prices raised fears that a period of beneficial disinflation could turn into a harmful deflation.

Falling Commodity Prices

Commodity prices began their decline in 1998 which became a global deflationary trend. Chart 3 shows the Reuters/Jefferies CRB Index of 19 commodity markets rising sharply between 2002 and mid-2008. Since its 2008 peak, however, commodity prices have lost two-thirds of their value. That’s pretty deflationary. That’s very different from what we’ve seen in previous economic expansions. In previous expansions I’ve studied in the postwar era, commodity prices have usually risen later in the business cycle as inflationary pressures increased. That in turn forced the Fed to raise rates to combat that inflation. And that usually led to stock market peaks and ensuing recessions. It also usually led to an inverted yield curve first. Although inverted yield curves in the past have usually led to recessions a year or two down the road, this one has one big difference. It’s not being caused by the inflationary impact of rising commodity prices.

Inverted Yield Curve and Commodity Prices

Everyone’s talking about inverted yield curves. The 10 year – 3 month yield curve turned negative a few months ago. The 10 year – 2 year spread turned negative for a brief time yesterday but hasn’t officially inverted yet. For that to happen, the 10-year yield needs to drop below the 2-year yield and stay there for a while. But it’s getting close enough to get people worried. That’s because inverted yield curves have a strong history of signaling economic recessions. There is, however, something different about the current situation. And that’s the direction of commodity prices. 

The gray area in Chart 4 plots the ten year – two-year yield curve. As of yesterday’s, close, the 10-year yield was one basis point above the two-year. It’s still positive, but barely. The brown bars plot the CRB Commodity Index. The last two yield curve inversions took place during 2000 and 2006 (red circles). Both led to stock market peaks and economic recessions within a year. Notice, however, that the 2000 inversion was accompanied by rising commodity prices (first box). In fact, crude oil prices tripled during 1999 which forced the Fed to raise short-term rates enough to push them above long term yields. Commodity prices also surged during 2005 (second box) which again forced the Fed to tighten, which led to an inverted yield the following year. Both of those yield curve inversions had bad endings. And rising commodity prices had a lot to do with them. This time is different. 

The brown bars show commodity prices in a steep downtrend over the last decade. And they’re down again this year. That’s especially true of agricultural commodities, industrial commodities (like copper), and energy prices. Gold is the only commodity winner this year (along with silver). But that has more to do with falling global interest rates than rising inflation. [Gold is often incorrectly viewed as just an inflation hedge. But it’s also a good hedge against deflation which is its current role]. 

The problem in the present situation is that we have very little history to go on regarding the meaning of the current inverted yield curve (or impending one); or even the reasons for it. Falling commodity prices at this late stage of an economic expansion are very unusual. So are inverted yield curves that are not being caused by commodity inflation. The absence of commodity inflation, however, also carries some risk. History shows that deflation can be just as dangerous. And it’s a lot harder to fight. Just ask central bankers.

Weekly 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)


Caring of Your Aging Parents

By Scott A. Bishop, MBA, CPA/PFS, CFP

Mom? Dad? We need to talk

Later this month I will be hosting a very important episode of the STA Money Hour with author and Journalist Cameron Huddleston.  I have been interviewed by and hosted past STA Money Hour shows with Cameron in the past on “Money Worries”.  This issue is near and dear to me as I have had to deal with this issue with many of my personal family members.

Cameron recently wrote a book called “Mom and Dad We Need to Talk – How to Have Essential Conversations with your Parents About their Finances” – I would encourage all of you to check out her book (in the prior link).

Caring for your aging parents is something you hope you can handle when the time comes, but it’s the last thing you want to think about. Whether the time is now or somewhere down the road, there are steps that you can take to make your life (and theirs) a little easier. Some people live their entire lives with little or no assistance from family and friends, but today Americans are living longer than ever before. It’s always better to be prepared.

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Mom? Dad? We need to talk

The first step you need to take is talking to your parents. Find out what their needs and wishes are. In some cases, however, they may be unwilling or unable to talk about their future. This can happen for a number of reasons, including:

  • Incapacity
  • Fear of becoming dependent
  • Resentment toward you for interfering
  • Reluctance to burden you with their problems

If such is the case with your parents, you may need to do as much planning as you can without them. If their safety or health is in danger, however, you may need to step in as caregiver. The bottom line is that you need to have a plan. If you’re nervous about talking to your parents, make a list of topics that you need to discuss. That way, you’ll be less likely to forget anything. Here are some things that you may need to talk about:

  • Long-term care insurance: Do they have it? If not, should they buy it?
  • Living arrangements: Can they still live alone, or is it time to explore other options?
  • Medical care decisions: What are their wishes, and who will carry them out?
  • Financial planning: How can you protect their assets?
  • Estate planning: Do they have all of the necessary documents (e.g., wills, trusts)?
  • Expectations: What do you expect from your parents, and what do they expect from you?

Preparing a personal data record

Once you’ve opened the lines of communication, your next step is to prepare a personal data record. This document lists information that you might need in case your parents become incapacitated or die. Here’s some information that should be included:

  • Financial information: Bank accounts, investment accounts, real estate holdings
  • Legal information: Wills, durable power of attorneys, health-care directives
  • Funeral and burial plans: Prepayment information, final wishes
  • Medical information: Health-care providers, medication, medical history
  • Insurance information: Policy numbers, company names
  • Advisor information: Names and phone numbers of any professional service providers
  • Location of other important records: Keys to safe-deposit boxes, real estate deeds

Be sure to write down the location of documents and any relevant account numbers. It’s a good idea to make copies of all of the documents you’ve gathered and keep them in a safe place. This is especially important if you live far away, because you’ll want the information readily available in the event of an emergency.

Where will your parents live?

If your parents are like many older folks, where they live will depend on how healthy they are. As your parents grow older, their health may deteriorate so much that they can no longer live on their own. At this point, you may need to find them in-home health care or health care within a retirement community or nursing home. Or, you may insist that they come to live with you. If money is an issue, moving in with you may be the best (or only) option, but you’ll want to give this decision serious thought. This decision will impact your entire family, so talk about it as a family first. A lot of help is out there, including friends and extended family. Don’t be afraid to ask.

Evaluating your parents’ abilities

If you’re concerned about your parents’ mental or physical capabilities, ask their doctor(s) to recommend a facility for a geriatric assessment. These assessments can be done at hospitals or clinics. The evaluation determines your parents’ capabilities for day-to-day activities (e.g., cooking, housework, personal hygiene, taking medications, making phone calls). The facility can then refer you and your parents to organizations that provide support.

If you can’t be there to care for your parents, or if you just need some guidance to oversee your parents’ care, a geriatric care manager (GCM) can also help. Typically, GCMs are nurses or social workers with experience in geriatric care. They can assess your parents’ ability to live on their own, coordinate round-the-clock care if necessary, or recommend home health care and other agencies that can help your parents remain independent.

Get support and advice

Don’t try to care for your parents alone. Many local and national caregiver support groups and community services are available to help you cope with caring for your aging parents. If you don’t know where to find help, contact your state’s department of eldercare services. Or, call (800) 677-1116 to reach the Eldercare Locator, an information and referral service sponsored by the federal government that can direct you to resources available nationally or in your area. Some of the services available in your community may include:

  • Caregiver support groups and training
  • Adult day care
  • Respite care
  • Guidelines on how to choose a nursing home
  • Free or low-cost legal advice

Once you’ve gathered all of the necessary information, you may find some gaps. Perhaps your mother doesn’t have a health-care directive, or her will is outdated. You may wish to consult an attorney or other financial professional whose advice both you and your parents can trust.


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), 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.

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