Stearns Financial Poolside Chat – May 7, 2017

Welcome to the Stearns Financial Poolside Chat.

U.S. economic fundamentals remain good, despite the weather-related, soft first quarter economic growth. The public and investor concerns over whether Congress and the president will get pro-growth legislation passed this year (or at all) remains, although our sources close to the “sausage making” suggest corporate tax reform and an infrastructure plan will be moving to a vote in September.

The House of Representatives passed the new health care bill which now goes to the Senate. We expect much debate and input from numerous health care organizations.

The U.S. stock market doesn’t know whether to vote thumbs up on Trumponomics and continue the upward bull market, or to assume positive legislation for public companies won’t happen and get on with the overdue (and typical) downside correction, historically often in the 5-10% range, in stock prices. It does appear investors in general are still giving the new administration the benefit of the doubt. Some risk measures and stock valuations are a bit high for our taste, which is why we’re taking a more moderate risk approach with most portfolios.

One of the most revealing examples of investors’ increased appetite for risk lies in the “FANG” stocks. You may recall in early 2016 when we profiled these four stocks – Facebook, Amazon, Netflix, and Google. They had great returns in 2015 – despite lackluster returns in the S&P 500 index itself that year. These four companies are considered the leaders in the “new” economy (largely Super Trend-driven). These stocks as a group have significantly outperformed the S&P 500 since 2015.

Whenever you hear “new” economy, it’s good to be skeptical, like in the 1990s when the term was supposed to justify Price-to-Earnings (P/E) ratios of 50X or more technology company earnings. The same for dot.com companies with (perhaps) growing revenues, but no profits in sight for many, many years. Many of these companies couldn’t grow their way into the big bubbles being created, leading to many of them not being around today, as well as the major stock and economic downturn in 2000.

This time, these companies have real business models with growing revenues. The problem lies in the valuation of the stocks, which is very rich and “priced for perfection,” meaning leaving very little room for any disappointments. They trade at a combined P/E ratio of 47.3 based on trailing earnings – which is nearly twice the S&P 500’s P/E ratio. Facebook was not yet a publicly-traded company in 2011, but it’s good to note the other three companies suffered a 37.5% loss in the 2011-2012 correction (source: Investech).

Key Points to Consider

  • U.S. jobs increased by 211,000 in April, topping expectations and rebounding from March’s more sluggish advance of 79,000. The unemployment rate was 4.4%, down from 4.5% in March and the lowest reading since May 2007. The broadest measure of unemployment, which also includes part-time workers and discouraged workers who have stopped looking for work, improved markedly, dropping from 8.9% to 8.6%. If there was any disappointing news, it was around wage growth, which ticked down to 2.5% year-over-year. From a consumer spending standpoint, it is important that we start seeing some improvement in wages. Overall, it was an encouraging report and should lend support to the Federal Reserve’s goal of continuing to gradually raise interest rates as the year progresses.

  • Corporate earnings are the main driver of the reason stock prices rise over 80% of the time, over multiple decades. With 288 companies in the S&P 500 reporting, BCA reports that 77% have beaten profit expectations.

Healthcare, financials and technology have been the sectors with the best profit gains.

More impressive is the 7.1% gain in S&P 500 company revenues in Q1 so far. Corporations appear to have pricing power.

The Employment Cost Index (ECI) increased a little in the first quarter, a reflection of growing labor shortages causing increased labor costs. BCA believes this implies that profit margins will hold up, which will continue to support positive growth in many stocks, regardless of whether Trumponomics initiatives are enacted. Still, a failure of Trump pro-growth measures to get passed this year will be disappointing to the stock market.

  • Major blue-chip public companies are still sitting on huge amounts of cash, lowering the risk that they will have cash flow problems in the next recession.

Apple has $148 billion of its record $257 billion cash pile invested in corporate debt alone, according to a company SEC filing from last Wednesday. That’s enough to buy all the assets in the world’s largest fixed-income mutual fund, the Vanguard Total Bond Market Index Fund, which has about $145 billion of assets including company, government and mortgage bonds.
After corporate bonds, Apple’s next-largest holdings in its pile of cash and marketable securities are $53 billion allocated to Treasuries and $21 billion kept in mortgage and asset-backed securities.

In the News

Dennis Stearns, CFP® was a keynote presenter several weeks ago at the Financial Planning Association Retreat conference, a gathering of many of the top planners in the country. His presentation was on “Converging Trends that are Rocking our World.” Our clients have been hearing from us for many years about the accelerating change caused by the four converging Super Trends: Technology Accelerators/Automation; Globalization; Demographics/Global Age Wave and Urbanization. What happens when “Trumponomics,” the economic plans of the Trump administration, collide with the powerful Super Trends?

As a precursor to our Summer 2017 Financial Trends newsletter we’ll offer in July, here is a “Reader’s Digest” version of Dennis’ presentation and follow-up workshop for the leaders of the planning profession.

1. Investing will require more skill – coming off the depths of the Great Recession in 2009, making money in stocks and bonds was relatively easy as long as you had the intestinal fortitude to actually invest. Even some of the savviest investors were so shell-shocked by the events of the Great Recession that they stayed on the sidelines in cash too long.

In the future, key questions include:

• Will more international exposure be beneficial, given there are more bargains overseas and more growth prospects? Or will Trumponomics make the U.S. dollar stronger, hurting some exporters (like GE) and making international investments less attractive?

• If Trumponomics is successful, will U.S. growth support the next leg of the bull market, or will Super Trend disruption forces create hundreds of “Eastman Kodaks” (companies that have hurricane headwinds and face possible extinction)?

• Do your clients need more diversification in areas that zig and zag less with traditional stocks and bonds?

• Will tax efficiency wag (and break the back) of the economic dog? The quest for tax efficiency is laudable and has been one of our mantras. However, shifting winds caused by Super Trends, Trumponomics and other forces make it more likely portfolios should be adjusted with more frequency in the future.

In other words, are your clients prepared to pay a small capital gains tax in order to reap potentially better portfolio results, or protect more against downturns? The taxes to gain these benefits may be less than 5% of portfolio value, but for larger portfolios, will clients balk because they remember when that amount of money was their salary in their first job or the cost of their first home?

2. The U.S. innovation culture that is the envy of the world is built on the belief that “if it isn’t broken, break it and fix it better.” In the future, Super Trends are likely to favor the powerful U.S. innovation infrastructure (featured in our last two SFG Financial Trends newsletters) that includes 18 of the top 20 research universities in the world and powerful brain-belts growing throughout the country, bookended by MIT/Boston and Silicon Valley.

Career and business planning has never been more critical. The theme of many thought leaders in Super Trend research is that “average is over.” The Super Trends are creating faster-than-normal disruption and dislocation in many career and business fields. This is a time to be better, stronger, faster, although leaping over buildings in a single bound is still optional.

Ideas for the future:

Figure out ways to be better than average, and keep sharpening your skills in key areas every year.

Embrace technology improvements, but marry them with old-school approaches like strong emotional intelligence, still a higher predictor of career success than IQ.

Hire an executive coach for yourself and encourage your clients to do the same thing. Interview several and pick the one that seems to get you and your needs. Don’t scrimp – if they could protect your ability to spend and save for the next 10 years, or maybe even enhance it, how much is that investment worth? Probably way more than the most expensive coach you’ll interview. Just make sure to get the right fit – or pivot to new choices after several months if it’s clear the fit isn’t right.

3. Change anxiety is running rampant as a result of the speed and power of change happening in the world. Combined with the 24/7 media focus on problems associated with the change, and political concerns here and abroad, it’s no wonder stress levels are trending higher. Steps to deal with this stress:

Understand the root cause of the Super Trend changes. No Ordinary Disruption and Thank You for Being Late are both good resource books.

Read books that help you deal with change. We recommend the new book Change by Dr. Gary Bradt, a top change expert.

Focus on what you can control.

Disconnect from the 24/7 media if needed. Yes, it’s entrancing watching the drama playing out, almost like a slow motion Daytona 500 car wreck. The relentless drama may also be causing unhealthy “fight or flight” chemical changes in your body.

Find positive people and projects that enhance your self-esteem and view of the world.

Traditional healthy living suggestions like good diet and exercise are common sense ways to lower stress levels, but not so common in a world where shopping and eating desserts are considered stress relievers.

4. Planned well for longevity? The technology accelerator Super Trend is growing fast in the health care field. Many thought leaders in health care believe we are on the verge of another leap forward in living longer while also maintaining a good quality of life.

Key issues:

• Are savings for the fourth quarter of life adequate to provide expenses for living needs that may be longer than your parents?

• Staying engaged in life is harder to begin with for many people in the fourth quarter. Adding another 10-20 years to normal life expectancy will create a risk of boredom for many people, which usually leads to bad decisions, anxiety and even gray divorce.

• There are 101 ways to fumble the ball in the fourth quarter of life [Editor’s note: this is the subject of Dennis’ upcoming book.] Consider how clients would grade themselves in the areas of transition planning, investing and financial planning, estate planning, health care advocacy, social network savvy, communication with friends and family, having a reason to get out of bed in the morning, lifelong learning and housing plans for later stages of the fourth quarter.

Good long-term care planning goes well beyond long-term care insurance and whether updated powers of attorney are in place.

5. Prepare for a challenging future. Here are just a few of the good and not-so-good potential issues we’ll need to deal with in a Super Trend-charged world of tomorrow.

Confusing politics – the last U.S. presidential race on both sides reflected Super Trend influences. It will continue – many experts predict the rise of even more authoritarian presidents and dictators in the future, as a result of citizens of those countries feeling change anxiety and the need for stronger, close-to-home focus and policies.

Disturbing geo-political turmoil – Geo-political hotspots like North Korea, Syria, Russia and Iran will continue to be in the news. Some of the problems in these countries are directly tied to Super Trends – in Russia, low oil prices (caused by emerging technology making it easier to extract oil and natural gas) are creating a greater need for Putin to flex his muscles around the world. Tom Friedman ties the problems in Syria to Super Trend effects.

The rise of four villains in decision making – the work of the Heath brothers described in the book Decisive [Editor’s note: previously profiled by SFG] includes the four decision areas that trip people up frequently. Unfortunately, McKinsey reports that converging Super Trends and the anxiety they foster are also creating more bad decisions as a result of narrow decision making, short-term emotion, confirmation bias and overconfidence. Note that under-confidence is another villain that has caused many bad decisions.

Understand the insidious ways of these villains and learn the antidotes that can make your life easier in normal times, and be critical to happiness and avoiding fumbles in a Super Trend-charged world. (Visit http://heathbrothers.com/ot/wp-content/uploads/2013/03/The_WRAP_Process_one_pager.pdf.)

Frequently Asked Questions

Q: Housing prices seem to be surging. Is this one of the many growing mini-bubbles you’ve talked about?

A: BCA Research, one of Stearns Financial’s key resources, recently provided an update on the housing market which includes the accompanying chart. The stock of unsold new and existing homes is still at relatively low levels by historical standards, which means we are nowhere near the bubble levels of 2006-07. The number of unsold new homes is rising, so we believe this is one of those mini-bubbles that isn’t worrisome yet, but needs to be watched. (See BCA chart below.)

Home prices are surging in many parts of the country, particularly in the areas with limited new home supply and a growing job market. A survey last week indicated that over one-third of millennials age 17-37 are still living in their parents’ home, with a large concentration of these in the northeast U.S.

The tightening in the labor market discussed elsewhere in this Chat and cyclical rebound in real disposable income growth is allowing millennials to finally move out, boosting the demand for new housing stock. The number of millennials entering the housing market is still a smaller percentage than Boomers when they were the same age, but the total number of millennials is so huge (they are the largest demographic in America by a wide margin over second-place baby boomers) that even small shifts in buying habits can create large demand.

The home-ownership rate has returned to its long-term average (bottom panel of chart). We believe the pre-Great Recession bubble in the homeownership rate has been fully unwound, which removes a headwind for construction activity.


inventory

Summary

The U.S. economic news remains positive and SFG believes conditions are good for modestly accelerating growth, regardless of whether Trumponomics initiatives are enacted by Congress.

Overseas economies are looking more promising and SFG continues to consider our balance between U.S. and overseas stocks.

Given outsized investment opportunities in select areas and larger-than-normal political and geo-political threats, we continue to like diversification with a strong emphasis on high-quality investment themes.

Dennis, Glenn, John & PJ
(the SFG Investment Committee)


STEARNS FINANCIAL GROUP (Triad office)

324 W. Wendover Avenue, Suite 204
Greensboro, NC 27408
Telephone: 336-230-1811/ nationwide 800-881-7374

STEARNS FINANCIAL GROUP (Triangle office)
1450 Raleigh Road, Suite 105
Chapel Hill, NC 27517
Telephone: 919-636-3634/ nationwide 800-881-7374

E-mail: StearnsFinancial@StearnsFinancial.com
Website: www.StearnsFinancial.com

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