How "Top Gun" Can Help You Position Your Portfolio when the Yield Curve Inverts

Maverick: “We Were Inverted”

 

During the iconic Tom Cruise scene in Top Gun when he details his interaction with a Russian MIG during a test flight, he explains to a shocked room (not before he removes the cool shades), that the way he was able to see the MIG while flying above it, was that “We were inverted.”  This week, in a shock to the market, the 5-year minus 2-year yield was negative, or “inverted”.  Usually, the longer the duration, the higher the yield; however, short-term interest rates are currently higher.  A more common tracked metric is the 10-year minus 2-year yield which is close to inverting as seen below.

fredgraph (1).png

There are several reasons why this is occurring.  The Fed (which controls short term rates) is witnessing strong domestic growth and an upward creep in core inflation.   Since interest rate changes can take time to move through the economy, the Fed preemptively will move to limit anticipated problems, i.e. runaway inflation.   By increasing rates, they can put the brakes on growth limiting inflation.  It also gives the Fed room to move rates lower if the economy slips.  On the other hand, the market (investors and traders) determines the rest of the interest rate curve.  Currently, the market has a strong demand for longer duration bond for the relative safety of government bonds due to a combination of fear of market volatility and an outlook that the Fed may have to lower rates in the coming years.

What are the implications of an inverted curve? All seven recessions since 1970 have been heralded by a yield curve inversion.  However not all inversions imply a recession.  Tom Lee, the co-founder of Fundstrat Global Advisors LLC, calculates that the 3- to 5-year yield inversion has occurred 73 times since 1954 while the economy endured only nine recessions. “5Y-3Y inversion predicted 73 of the last 9 recessions, too many false positives.”[i]

Now the question is: “What are investors to do about this?”  It really all depends on your risk appetite, holding period and allocation. While market weakness is not a guarantee, there are strong indications, like the higher VIX index, the market will be more volatile going forward.  Investors need to know how they are positioned to ensure their allocations are aligned with their capacity for risk.  At my firm, we use Riskalyze’s risk alignment software to make sure we know how much risk our clients are willing to take and to position their portfolios accordingly.  First, we determine your “Risk Number” though a short survey.  Then we analyze your current portfolio of securities to see how risky your portfolio is.  If you are interested in this, or just curious what your risk number is, click here for a short survey and check out more on Riskalyze here

 


[i] https://www.bloomberg.com/news/articles/2018-12-06/history-shows-inverted-yield-curve-is-no-death-knell-for-s-p-500

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233  Website: www.apgcap.com

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

Third Quarter 2018 Review and Outlook


It was a tale of two markets in the third quarter.  US Equities markets on one hand and, seemingly, the rest of the investable universe, on the other.  US Equities rallied, as evidenced by the 7.7% surge for the S&P 500 for the quarter (+10.6% year to date)[i], while the Developed Markets eked out a 1.1 return in the quarter (-1.3% year to date)[ii] and emerging markets dropped 1.4% (-7.9% year to date)[iii]. Even domestic bonds continued their streak of losing quarters, dropping marginally in the quarter leaving the Barclays’ US Bond Aggregate Index down 1.6% for the year.[iv] 

 

Domestic Backdrop

The effects of lower taxes and regulation have helped sustain the economy’s growth momentum. The 4.2% growth in GDP for the second quarter may have been boosted by a “sugar high” form the tax-cut but expectations are for continued growth as the US Conference Board is forecasting a 3.1% growth rate for 2019.[v] Furthermore, as shown in the Federal Labor Market Conditions Index, the labor market has fully recovered from the Financial Crisis.

 

labor.png

Interest Rate changes

Emblematic of this strength, the Fed has removed their “accommodative” stance for interest rates, signaling continued rate hikes.  The effect of these hikes make housing more expensive and hurts profitability for debt-laden companies. The Fed hopes that, while tempering growth, these increases keep inflation under wraps.  While the Fed makes changes to short term rates, longer term rates are set by the market.  Recently, the 10-Year rate broke out of its trading range and moved significantly higher, from about 2.80% to 3.25%.   Back in February, when we saw these rates jump higher, the market corrected sharply, but since has recovered and have shown decent gains for the year.  We may see another similar situation with the markets acting a bit jittery while the economy sorts out these countervailing impacts. 

With the expansion almost a decade old, we are certainly in the later stages of the growth cycle, but when the economy turns downward is still a question.  Positioning portfolios more cautiously is probably warranted, but we are still optimistic for the mid- and long-term for the US markets.

 

 

International Situation

The current trade policies of the US Administration are a heavy-handed approach to fix some of the unfair treatment of US companies when dealing overseas, especially when it comes to intellectual property.  Specifically, escalating tensions with China are proving to be damaging to the worldwide growth story and most markets are feeling those effects.  Hopefully the new tariffs on trade is ultimately posturing, and a more pro-trade resolution is negotiated.  Ahead of that resolution, maintaining some exposure to emerging markets should be a good risk/reward position considering the current weakness, as these markets are trading at significant discounts to US markets and should witness higher growth.

 

Looking forward, the underperformance of international stocks this year make it a good opportunity to bring portfolios back to target allocations by trimming winners like larger cap growth companies and adding (as painful as it may seem) to those international laggards. 

 

 

 

 

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233  Website: www.apgcap.com

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

 


[i] http://performance.morningstar.com/funds/etf/total-returns.action?t=SPY&region=USA&culture=en_US

[ii] http://performance.morningstar.com/funds/etf/total-returns.action?t=IEFA&region=USA&culture=en_US

[iii] http://performance.morningstar.com/funds/etf/total-returns.action?t=IEMG

[iv] http://performance.morningstar.com/funds/etf/total-returns.action?t=AGG

[v] https://www.conference-board.org/data/usforecast.cfm

 Estate Planning is Not All About the Estate Tax

When most people hear about estate planning, they may remember the $11 million estate tax limit and figure it is irrelevant for their situation.  However, estate planning is not only for ultra-high net worth families.  Careful consideration and planning are important for all individuals and families with handling their end of life legacies.  Here are three scenarios where planning would help insure your estate goals such as protecting privacy, minimizing costs and taxes and ensuring assets are going to the intended beneficiaries.

 

First of all, the probate process is very public.  A quick search in county records of a deceased person’s name, like this, will pull up court filings with assets, motions and rulings.  This public disclosure can be avoided with the use of a revocable living trust and a pour-over trust.  Proper titling of assets and updating your account beneficiaries can also be helpful.

 

Another example covers instances when families own property in another state, as the probate process is not limited to the state of your residence.  In fact, there will be probate in each state where the decendent owned property with all the associated court costs and hassles.   Careful titling of the property can avoid this by using a trust vehicle or “joint tenants with right of survivorship.”

 

The last example is settling an estate with a family-owned business.  In these instances, there are several tricky problems that can arise.  For example, how do you split the ownership if only one of the children is involved in running the business. It may make splitting assets easier to leave the business to that child and then have a live insurance policy that benefits the other children that equalizes the value. Another way that life insurance may help is if much of the assets of the decedent is tied up in the business. Any estate taxes or other cash needs can be handled without having to sell some, or all, of the business.

 

Your estate planning needs evolve over time.  While no substitute for an estate attorney in drafting wills and setting up trusts, a trusted advisor who understands the changes in your life can help navigate some of these issues and recognize when a lawyer is needed.

 

 

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233  Website: www.apgcap.com

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

APG Capital Asset Management First Half 2018 Review and Outlook

Hope everyone is enjoying their summer.  We are returning from some time in Cape Cod.  Always great to step back from the day-to-day grind, recharge, and reflect on goals and aspirations.  As this marks the one-year anniversary of APG Capital, it is also a time of thanks to those who have supported me with their trust and encouragement. 

Budgeting for these breaks from life are important too.  Having some cushion in your retirement plans for the carefree “we’re on vacation” spending that may otherwise trigger a second thought.  Needless to say, we did not splurge on the $185,000/week yacht we saw moored in Nantucket!

After a volatile 1st quarter, the US market calmed a bit in the 2nd Quarter as the S&P 500 rallied 3.4%.  It is now up 2.6% at the halfway point of the year[i].  Within the broader indexes, technology and growth companies continued to be the standouts along with a recent rally in small cap stocks. 

International equities have been a drag on returns, especially emerging market stocks, which have been impacted by the escalating tariffs and trade wars.  Without the impact of tariffs affecting international trade, markets should perform very well this year with a backdrop of good growth, fiscal stimulus, and reasonable valuations.  Much what you learn in business school can be distilled into “tax cuts -  good, tariffs - bad”.  The US should be careful about inciting a trade war with China as trade with the Asian countries is responsible for much of the tame inflation we’ve enjoyed, and their growing middle-class is demanding more of our exports.  In addition, our large budget deficits and the current unwinding of our quantitative easing policies, require large buyers for our bond sales.  China has been that buyer and without that bid, interest rates could go much higher.  Hopefully, free market capitalists within the administration will prevail and talk of a trade war will be bluff and bluster.  That said, bringing international exposures down, might be prudent.   

On the fixed income front, the benchmark 10-year bond seems to be range-bound between 2.8%-3.0% [ii].  With the Fed continuing to raise rates, the yield curve continues to flatten.  It seems like the better risk/reward payoff is reaching a bit on credit risk versus duration risk. Therefore, it makes sense to continue favoring short-term, high-yield bonds and bank loans.

Enjoy your summer.

Safe travels.

 

Adam Gross

 

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233  Website: www.apgcap.com

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

 

 

[i]http://performance.morningstar.com/funds/etf/total-returns.action?t=SPY&region=USA&culture=en_US

 

[ii] https://quotes.wsj.com/bond/BX/TMUBMUSD10Y

First Quarter 2018 Review and Outlook

The first quarter of 2018 certainly saw stock market volatility return.  Stocks rose sharply in January but slid the rest of the quarter.  After the dust settled, the S&P 500 lost about 0.8% for the quarter.  There were few places to hide as International Developed Markets fell about 1.2% and even the Aggregate Bond Market Index fell 1.5%.  One standout was Emerging Markets, which managed to rally 2.5%.

Interestingly, this volatility coincided with a robust and improving earnings picture.  The culmination of world-wide economic growth and the big corporate tax cuts should propel corporate earnings throughout 2018.  Per Factset, analysts are projecting 2018 earnings growth of 18.5%, on revenue growth of 6.7%.  The forward PE of 16.1 (just a tad over the 10-year average of 14.3) may even be considered cheap considering the low interest rate environment.    

Breaking down the quarter in the US market, Growth continued the recent trend of beating Value by a wide margin.  (S&P 500 Growth Index +1.9% vs S&P 500 Value Index -3.6%).  Sector winners were Technology and Consumer Discretionary.  Losers were Telecom, Consumer Staples and Energy.  Expect these trends to continue, although Energy stocks should find some buyers with the wide gap between the steady performance of energy commodities and the weak price of shares of energy companies.

Interest rates have also been newsworthy.  As the Fed’s tightening cycle continues, longer term bond yields have risen. The Benchmark 10-Year Government bond rose from the 2.3% range last quarter, almost touching 3.0%, but settling around 2.8%, hurting the value of bonds.  With the higher yields, longer term bonds are becoming more attractive, so we are looking for opportunities to move investors, having waited in short-term vehicles, to longer duration securities

Making the Most Out of Your Bonus

It’s that time of year when many companies are paying out their year-end bonuses.  Hopefully “congratulations” are in order and all that hard work from the last year paid off.  Now the real decisions begin.

In some fields, like energy trading, your bonus can vary widely from year to year and are only maximized when the stars align -- you have a great year, your group meets their goals, and the company hits their profit targets.  Even the most successful may only get a dozen or so of these big paydays in a career, so it is critical to be thoughtful about how you allocate your bonus.   These are the payments that ought to support you and your family’s hopes and dreams for a lifetime. 

What is your plan?  Upgrade the house, pay off an existing mortgage, invest in the market or just sit in cash?  How much should you save versus spend?

 

·         Working through the hierarchy of how to allocate new capital can be challenging.  A good place to start is making sure to maximize your employer’s matching 401-K plans, Health Savings Accounts and any other tax advantaged account that is underfunded, like an education 529 Plan.

·         While it is tempting to ratchet up your lifestyle with a big payday.  Be careful when adjusting your spending habits that even when there are years when the bonus is sub-par, you can handle your bills.  One way to keep your spending in check is to imagine: what if I had to find a new job?  What kind of salary could I earn in the current job market?

·         Finally, as there are no one-size fits-all decision-making tools, consider working with an independent Register Investment Advisor.  RIAs typically do not market products or have outside pressures as to where these funds go plus as your fiduciary, have an obligation to put the client first and develop solutions that align with your risk appetite and long-term goals.  Even when an advisor’s pay is a function of the amount of assets they manage, your advisor should acknowledge this and determine the best course, regardless of this conflict.

 

We hear of athletes or actors going from rags to riches and end up having financial problems later in life.  Many other careers can have volatile earnings streams. Careful and thoughtful planning during the heady years can help to minimize the impact of the lean years.

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233  Website: www.apgcap.com

 

 

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

Year End 2017 Review, Outlook for 2018 and Planning Tips

For the stock market, the good times kept on rolling.  Fueled by the recently signed tax cuts, world-wide economic growth and optimism for earnings, the S&P Index rallied 6.6% for the 4th Quarter, leaving the index 21.8% higher than the start of the year.  The long-anticipated return of volatility did not arrive in 2017, as volatility during the year was about a third of the long-term average.  Investors lulled into complacency where happy to continue plowing capital into equities.  Leading the gains were technology stocks which rallied over 37%.  The laggard sectors this year were Energy and Real Estate.  What is striking about the Energy sector’s flat performance is that it was not helped by the rally in crude prices in which a barrel of WTI Crude rallied from about $52 to over $60. 

The bond markets overall were also relatively calm.  While the Fed has made good on their promise of raising rates on the short end of the curve, the benchmark 10-year bond yield was rangebound between 2.0% and 2.6%, and ended almost exactly where is started the year at about 2.4%.  There has been some handwringing about the high-yield market which was pressured in the 4th quarter, as this can be a leading indicator for the health of the equity markets, but even this area stabilized in the last few weeks of the year. 

Macro factors are still a concern.  Political wranglings with Iran and North Korea dominate the headlines and questions of how the mid-term elections later this year affect the broader picture will become more acute.

 

Outlook

Overall, the economic backdrop is positive.  Synchronized growth around the world and fiscal stimulus from some of the new tax cuts should continue to propel corporate earnings.  The trends seen in 2017 of technological innovations disrupting areas like certain parts of the energy and real estate sectors are ones we would expect to continue in the new year.  We should see good earnings from energy companies in the short run, but looking out in time that may change as the automotive landscape evolves and solar power becomes cheaper. 

Overall, valuations remain at the higher range of historical averages, but stocks are still competitive with alternative investment options.  One risk to monitor is inflation.  The fear of which would push up interest rates which could alter that calculus for investors’ willingness to support above average valuations.  International equities, where valuations are cheaper and growth is higher, still earn a place in portfolios even after better recent performance.  With markets at these valuations, maintaining faith in the markets is still a struggle but heeding these concerns had some investors on the sidelines for much of this rally.  We’ve seen some outperformance in actively managed portfolios and investigating some active strategies which may utilize more creative ways of minimizing downside risk, while still invested, may be warranted.

Planning Tip for 2018

 

1.       Due to higher standard deductions, bunch your charitable gifting into a single year.  Better yet, establish and fund a Donor Advised Fund.

2.       Move large cash balances to a money market account where you can earn rates over 1% versus saving account that are still “yielding” close to 0%.

3.       For small business owners, investigate with a tax professional ways to take advantage of the new 20% deduction on pass-through, qualified income.

4.       Consider rebalancing your equity exposures to target levels.

5.       Re-evaluate your 529 Account funding, as the new tax bill allows annual payments up to $10,000 to private K-12 schooling.

6.       Owning a home just got more expensive for some with the new limits on property tax deductions. Factor this in when evaluating your current residence and any future purchases.

7.       Consider a mindfulness practice.  If it is good enough for Jerry Seinfeld, Tom Hanks and Oprah (as well as investment gurus William Gross and Ray Dalio), it may work for you.

Hope you have a great 2018 filled with health and happiness.

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233  Website: www.apgcap.com

 

 

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

Who May Be the Next Fed Chair and What That Means for the Market

President Trump is set to name his nomination to lead the Federal Reserve Bank maybe as soon as this week.  The three front-runners are: the current head of the Fed Janet Yellen, Stanford University Economics Professor John Taylor, and current Fed Board Member and ex-investment banker, Jerome Powell.

While Trump railed against Yellen on the campaign trail, her actual track record has been mostly positive for the economy and the market.  She was a part of the Fed while they grappled with the depths of the Financial Crisis and led the fiscal policy during much of the recovery.  Her support of both stricter banking regulations and policies to keep interest rates low have balanced each other out -- putting additional restraints on the system while feeding the economy enough adrenalin to bring back growth.  She has been a steady hand in a turbulent time.

The two men who may replace her could represent a change in general philosophy of the Fed.  They both are more hawkish in terms of their view of fiscal policy, and take a more laissez-faire view on regulations. 

The more known commodity is Jerome Powell who has been a part of the Federal since 2012.  His nomination may not cause much market turmoil as this would not be a huge departure from the incumbent leadership.  While his centrist philosophy is not as dovish as Yellen, he has generally voted in line with the consensus and his time at the Fed has probably given him the experience to ably lead.  One area of departure is Powell’s focus on size of the Fed balance sheet.  Bernanke, in his memoir, has sited Powell as a supporter of the easing of Fed bond purchases in August of 2014 leading to the bond sell off known as the Taper Tantrum.

John Taylor, a disciple of Milton Freidman (and not the Duran Duran bassist), has a body of work including his blog writing and his 2015 book First principles: five keys to restoring America's prosperity, which emphasizes reliance on free markets and a limited role for government.  Taylor lobbies for “rules-based” decision-making for the Fed.  He favors Fiscal responses versus a Keynesian Monetary policy of government intervention through spending.  While his rules-based steering could give clarity for how the Fed will act under certain situations, it may cause some additional volatility when faced with extraordinary, uncharted times.  The Taylor Rule, which he developed to guide the Fed on where they should set the discount rate, currently would put rates at about 3% according to the Federal Reserve Bank of Atlanta’s calculation.  This is significantly higher than the current 1.00% to 1.25% rate.  In these unusual times, rules-based solutions may not be as effective as a more thoughtful, nuanced, and creative approach.

Trump certainly wants to put his mark on the Federal Reserve, in part to deflect some of the market’s rally from the current Fed leadership, placed by Obama.  Although, if Trump is going to use the stock market as a yardstick for his own effectiveness, his best bet may be to keep the Yellen in her position as her supportive policies have been a boon to the market.  While putting a hawkish Republican in the role would excite his base, Trump should be wary of the possible market reaction of a Fed more eager to raise rates and shrink the balance sheet.  Powell’s centralist tendencies and his experience are some of the reasons why he is the odds-on favorite for the nomination

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233Website: www.apgcap.com

 

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.

APG Capital 3rd Quarter 2017 Review and Outlook

Global equity markets maintained recent momentum and continued their slow and steady climb during the 3rd Quarter of 2017.  Considering the backdrop of political unrest, lack of tax or healthcare reform and a litany of disasters, natural and otherwise, the markets around the world have been surprisingly strong.  International Markets paced the rally, as Developed Markets and Emerging Markets rose 8.0% and 5.5%, respectively, in the quarter.  The S&P 500 put up a respectable 4.5% gain, contributing to the 14.2% rally since the beginning of the year.    

SP500.png

The market seems to be looking past the risks and instead focusing on decent GDP growth (3.1% in the latest quarter), low interest rates (2.3% on 10-year government bonds), and the virtuous cycle of the wealth effect from a record high stock market to keep the music going. 

There is considerable hand wringing in the market about the valuation of the US market compared to historical averages.  The chart below shows the forward PE over time and statistical measurements.  On a number of metrics, valuations are higher than historical averages and some analysts are cautioning investors.  In a recent note JP Morgan agrees that valuations seem on the high side from a Price to Earnings (PE) perspective.  They estimate that the US market is about 9% overvalued and they “would not be surprised by a 10% pullback”.

A pullback may come, as there are regularly 5-10% declines in the market, and we are overdue for one.  However, simply looking at PEs is not a best way to value the market.  Investors need the context of other considerations.  Some suggest is more accurate to compare them to the long-term yields for Treasuries, or high-quality corporate debt. That way stock valuations are compared to other investment options. One method of doing this is used by the Federal Reserve Board.  The “Fed Model” compares the earning yield of the market (calculated by the inverse of PE) to the yield to the returns offered by the competing interest rates, namely corporate bonds and Treasuries.  Inherently, bonds are safer and should offer lower rates, but offsetting that, the earnings of the market should grow over time.  It is the market’s job to weigh the relative riskiness versus the growth.

fed model.png

The chart above shows the relative valuation of the earning’s yield of the market to the yield of high-quality debt.  The idea is: the wider the gap the red and blue lines are below zero, the more undervalued stocks are.  The chart goes back to the late seventies. From 1979 until the mid-90’s, the colored lines had fluctuated around the x-axis.  Then, during the tech boom of the late-90s it showed the market was over-valued.  After the tech crash through the Financial Crisis, again the market was anchored to the zero line.  Since the Financial Crisis, stocks have traded for a consistent discount while the Fed pushed interest rates down to historic levels.  Even the stock market rally of the last 20 months has done little to bring stocks back to the “fully valued” level.  

It is doubtful one could simply trade this gap and beat the market, but it does make sense to view the market at about 17 times next year’s earnings (or an earning’s yield of 5.9%) cheap compared to 2.3% Treasuries or 3.5% corporates. 

The two main risks to this theory are: weaker than expected earnings and higher interest rates.  Focusing on the prospect of higher interest rates, the odds of higher rates seem to be increasing.  The Fed had been aggressively buying long term bonds after the financial crisis keeping a lid on interest rates which helped stimulate the economic recovery.  Recently though, the Federal Reserve began detailing the how they will eventually unwind their bond purchases.  With the Fed now selling longer term bonds, the risk of higher rates loom.  Keeping an eye on these yields should be key to judging the direction of the market.

Outlook

Staying committed to your investment plan can be difficult with the litany of risks facing investors today, but stick to investing in equities in-line with your risk tolerance.  Include foreign markets and smaller stocks as their recent out-performance is encouraging, as they catch up to the performance of the S&P 500.   On the fixed income side, a core portfolio of high-quality corporate and municipal bonds should act as a buffer if there is some market turbulence. Also consider add some higher yielding bank loans and bank-issued preferred stocks which still seem to have decent risk/reward characteristics especially in a rising rate environment.

One area to highlight are preferred stocks.  These are generally issued by banks and they have many attributes that make them attractive in the current environment.  A representative mutual fund has a 5.25% yield – higher than similarly rated bonds with the same duration.  Not all preferreds are equal. They can vary in how the dividend rate is set and whether they are sold through retail channels or directly to institutions.  Some funds focus on ones with annual resets of the yield, so as rates rise, so does the yield, mitigating the risk of higher interest rates.  Also, they favor ones sold directly to institutions, which is a deeper pool, and one not affected by retail investors, or the ETFs they trade.  Importantly, preferreds are a form of stock, so that the distributions are considered dividends and eligible for the Qualified Dividend tax rate, so are taxed at lower rates than interest payments. 

 

 

 

Advisory services offered through APG Capital Asset Management, a Member of Advisory Services Network, LLC.

Phone: 713-446-3233

Website: www.apgcap.com

All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.  The information and material contained herein is of a general nature and is intended for educational purposes only.  This material does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities.  The future performance of an investment or strategy cannot be deduced from past performance.  As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors.  All economic and performance data is historical and not indicative of future results.  All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.