Stocks gained a little over 6% last quarter while bonds rose 0.82%.<1> Stocks continued the momentum from late 2016 as corporate profit expectations remained high, while bonds benefitted from the idea that the economy would not grow at an inflationary pace. There is a bit of a contradiction here – corporate profits probably cannot meet expectations without the economy growing fast enough to force interest rates higher – but for the quarter at least, investors got to have their cake and eat it too. They also were treated to a rebound in foreign markets. Currency traders sent the dollar lower last quarter as fears of a soaring dollar through protectionist trade policies faded. Emerging markets, which lost the most post-election, gained the most last quarter.
Technology and health care became market leaders once again as investors observed that the economy under Trump wouldn’t be much different than the economy under Obama – steady but slow. Sectors where expectations were higher, such as energy and financial services, had a disappointing quarter. Real estate struggled because tough times in the retailing industry are leading to soaring shopping mall vacancies. Utility stocks were a beneficiary of flight-to-safety buying when economically sensitive stocks faltered.
As mentioned, foreign stocks performed well versus U.S. stocks last quarter for the most part. It was no more than a reversal to some extent of the “Trump Trade” that investors put on last November when they sold foreign stocks and bought U.S. small and midcap stocks. Emerging markets gained 11.45% while developed foreign markets gained 7.25%.<2> See Chart 1.
Chart 1
Source: Ycharts.com
Bonds earned a little bit more than their coupon payments last quarter as interest rates declined. It paid off for bond investors to take extra risk, either in the form of high yield bonds (credit default risk) or foreign bonds (currency and sovereign risk). Investment grade U.S. bonds returned 0.82%, while high yield debt rose 2.70% and emerging market debt gained 3.28%.<3>
The 30,000 foot view of the markets over the last 12 months is that various narratives have, at different times, pushed particular parts of the market higher or lower depending on whether that sector benefits from a stronger dollar or a weaker one or whether it benefits from a weaker economy or a stronger one. In the end, none of the narratives have had staying power. Stocks continue to meander upward because more money is coming in than there are reasonably-priced alternative places for it to go. I believe that a decent percentage of it is from formerly bearish investors finally throwing in the towel.
Activity
The market has started to realize that a lot less is going to happen legislatively in the first half of 2017 than first thought. As a result bonds, gold, foreign stocks, and “defensive” U.S. stocks are more attractive. On the other hand, that realization has made inflation protected bonds (TIPs), the U.S. dollar, and economically sensitive U.S. stocks somewhat less favorable. I’m not sure it is all that wise to do a lot with one’s portfolio now if the expected changes to taxes and regulations are only going to be delayed by a quarter or two. As a result, we have been more focused on “intra-category” performance than making size or style shifts.
Outlook
Humans are incredibly adept at pattern recognition. It is how our ancestors survived when we were not at the top of the food chain. So when we observe the market rising despite relatively slow economic growth, we rightly conclude that economic growth does not drive stock prices. For the same reason, we can rule out corporate profits – they have been relatively stagnant for close to three years in a rising market. Therefore, the key driver to stock prices must have been low interest rates. When interest rates are low enough that it is profitable to borrow money to buy stocks, stocks are probably going to go up. Lack of economic growth or profit growth did not stop the S&P 500 at 2000 or 2200 so why would it stop the S&P now as it approaches 2400?
Similarly, we observed that every time something unexpected happened in the world over the last several months and the market opened sharply lower, someone (or more likely some computer program) bought stocks and the market actually finished higher. It seems as though we are becoming conditioned to the idea that the correct response to a market sell-off is to buy and as such fewer people fear a protracted downturn.
It is widely believed that market over-valuation is not a sufficient catalyst to cause a market downturn. However, while markets may stay above or below fair value for very long stretches of time, ultimately value wins out. If liquidity remains ample (and I don’t see it changing in the near term) and volatility remains low then stocks will probably grind higher even though just about every non-interest rate- related valuation metric tells us the stock market is considerably over-valued. There just aren’t enough reasonably safe, reasonably liquid (meaning easy to sell) investment alternatives out there.
Commentary – Indexing versus Active Management
I honestly hope the Outlook section you just read made you a little nervous. I hope you were thinking something along the lines of “how does this end?”, or “it can’t be this easy”. More and more market participants are gaining stock exposure via capitalization weighted index mutual funds and ETFs which are investments whose purpose is to closely match the performance of an underlying index. Why? Because it has been working and they believe it will continue to work. For the first time in my thirty plus year investment career, the investment advisor community has basically given up on beating the market. “If you can’t beat the market, join it” many say. If there is one thing I’ve learned, however, it is that no investment idea works when it is embraced by everyone.
There are two primary reasons why indexing has worked especially well over the past ten years (1) it is an inexpensive way to invest in capitalization weighted benchmarks that have disproportionately benefited from the low interest rate environment and (2) superior performance among active funds has not persisted.
Indexing is based on the belief that taking the cost of trading into account, it is difficult (if not impossible) to outperform the market over time. All investors together by definition are the market, thus for any given period some do better than the market as a whole and some do worse. Even the better performers see their advantage eroded when the costs involved in buying and selling are taken into consideration.
Active management is based on the belief that investment management is a skill that is difficult to master and as such, superior returns are available to those who do. The argument centers on the idea that the most skillful can add value through security selection and are therefore worth paying for their superior knowledge and process. The “skill” argument was taken for granted until roughly ten years ago because it was so easy to cite the returns of Warren Buffett, Peter Lynch, Bill Miller or several others. Today, however, nobody’s recent record looks all that spectacular. The Fairholme and Sequoia funds, once revered in the fund industry, have suffered mightily. As a result of the lack of high profile success among active managers lately, indexing through exchange traded funds (ETFs) has captured the lion’s share of new investment dollars.
While I understand why this has happened, I am becoming increasingly nervous. Trademark has used capitalization weighted ETFs for years as a core portion of our portfolios. However, with all the new money piling in, I begin to wonder whether or not those investors understand the risks they are taking. As long as you make the assumption that the stock market is reasonably valued such that one can expect to earn a very high single-digit annual return by buying and holding a market based ETF, it is hard to argue with indexing as a strategy. If you also assume that the past ten years are better indicators of the future than the previous twenty five in terms of the inability of one year’s best performers to sustain their edge, then once again indexing is the way to go. On the other hand, if you see the market as being so overvalued that mid-single digit annual returns are a best case scenario going forward, then simply matching the market’s return doesn’t seem so appealing.
I will say again that high valuation is not a sufficient catalyst by itself to cause stock prices to fall. That said, however, valuation is the best long-term guide to future stock price performance. As I have argued many times in past commentaries, high valuation tends to lead to low subsequent long term performance and low valuations lead to high future performance. It is true that when you buy at levels that are expensive relative to history, you are not necessarily punished by an immediate loss of principal. Often in fact the market goes on to make new highs over the next several months or even years.<4> On a fifteen year basis or longer, however, valuation is hard to beat as a predictor. If you bought the S&P 500 in late 1999, only in the last three years or so would you have a gain in inflation-adjusted terms.
I also want to emphasize that active managers may not have merited the acclaim (or paychecks) the best of them received in the 1990s, but they aren’t idiots either. The more that stocks are purchased due to their inclusion in a capitalization-based index as opposed on their individual merits, the more scope there is for a manager to outperform by doing deep analysis. However, it may take longer for their discovery to be rewarded. In addition, it is much more difficult to add value when you are one smart person competing against a hundred or a thousand other smart people trying to determine what Apple is going to earn next year than it would be if indexing reduced your competition to fifteen or twenty (maybe only two or three if you were researching Donaldson or Fastenal). The skill of stock picking is bound to matter a lot more if the market as a whole is performing poorly (as it was in the 1970s and early 1980s) such that the extra value that someone who can read a balance sheet and income statement can provide is valued once again.
To sum it all up, it’s important to state that this commentary is not to argue against indexing per se. We use indexing extensively, especially in smaller portfolios. The point is to observe that historically anytime a sector, investing style, or strategy becomes almost universally applauded it tends to end badly. Its merits are well-known while its drawbacks are minimized or ignored altogether – until the event occurs in which they become obvious to everyone. We are in the ninth year of an upturn that began in March, 2009. It stands to reason that a strategy that has kept investors fully invested with minimal investment costs would be popular. And as I suggest at the end of the Outlook section, I’m not looking for this bull market to end imminently<5>. What I am saying is that at some point in the not too distant future this bull market will end, and success at that point will probably require a different approach than the one that has been so successful over the past eight years. Trademark Financial Management stands ready with both the historical knowledge and the intellectual flexibility to modify our approach to the indexing versus passive management debate to take advantage of different market environments.
We thank you, as always, for your confidence in us.
Mark A. Carlton, CFA®
<1> Stocks as measured by the S&P 500 Index and bonds as measured by the Barclays US Aggregate Bond Index. Source: YChart.com
<2> Emerging markets as measured by the MSCI Emerging Market Index and Developed Markets as measured by the MSCI Europe, Asia, Far East Index. Both indices include dividends and are stated in U.S. dollar terms. Source: YChart.com
<3> High yield bonds as measured by the Barclays High Yield Corporate Index and Emerging Market Debt by the Barclays EM Aggregate Index. Source: Morningstar Adviser Workstation
<4> Alan Greenspan made his famous “irrational exuberance” comment in December 1996, more than three years before the market peaked.
<5> Typically the market makes a top over several months, and there is no evidence as yet that the topping process has begun.
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Stocks gained 6.07%, as measured by the S&P 500, last quarter.<1> That’s a very nice rate of return (over 24% if annualized). It suggests that everything is going well economically. Paradoxically, interest rates have actually fallen, which is more indicative of a weakening economy. What’s going on here? A look at the performance of industry groups offers an explanation. The most economically sensitive industries – energy, transportation, financial services, and retailing – have either fallen or are up just modestly. The best performing sectors tend to be those that are fairly indifferent to the economic cycle – technology, heath care, utilities and consumer staples. In short, the winners under Trump look a lot like the winners under Obama. Thus far, betting on continuous but unspectacular growth continues to pay off while betting on either slipping back into recession or surging toward inflationary growth has been much less rewarding.
If there is any significant difference so far between Trump and Obama from an investing standpoint, it might just be in foreign markets. Foreign stocks and bonds slumped after the election on the idea that the U.S. would pursue pro-growth strategies that would boost the dollar and inflation. That has not happened so far. As a result the dollar has given up significant ground, allowing emerging markets to soar over 11%<2> and developed foreign markets to gain 7%<3> (in dollar terms). For obvious reasons, it is a lot easier to make money investing overseas when the dollar is falling.
I believe the dollar has seen most of its near term decline already, so I’d be cautious about extrapolating that trend. The 200 day moving average is still rising, though the 50 day has turned negative. That tells me the dollar is trendless right now. (I am aware that that statement might not be all that helpful.) U.S. investors are still buying the dips on the idea that tax cuts (the real prize, as opposed to health care reform) are still coming, and successful legislation on taxes is expected to be very dollar bullish. Others have lost faith in (or fear of) what the U.S. might do and expect the dollar to eventually fall to the range it occupied from 2012-14. Inflation and growth have already picked up in the Eurozone, so the next rate move there is likely to be an increase.
Asset Allocation
Growth significantly outperformed value due to the lack of action on either the tax or regulatory front. It seems certain that there will be a major tax overhaul at some point in the next few months, but the prospects for a major infrastructure bill seem to have lessened considerably. At the margin I would look to shift a little bit from large cap value to large cap growth. Technology has had a great run (12.5% last quarter) and might need a bit of a rest, but health care could pick up the slack in light of its fairly weak 2016 performance. Financials (the largest weighting in value stock funds overall) have been the most hurt by legislative non-action. Long bond yields are kind of a proxy for financial stocks right now, and they have been going in the wrong direction. At some point, maybe in the fall, the cyclical-over-secular-growth trade is likely to return.
Emerging markets are the biggest beneficiary from the Trump agenda not being enacted so far. No border tax means no dollar surge, which was a happy surprise for Asian and Latin American markets (which gained 12.9% and 15% respectively).<4> That kind of return is not going to be repeated go forward, regardless of what happens, because the surprise factor is gone. I am skeptical that Latin American can continue its momentum if commodity prices level off, which I think will happen. I prefer Asia – especially India, where banking reform stands to deliver significant benefits.
Europe is attracting inflows as investors are extrapolating a favorable result in the Dutch election in March to the much more significant French election this quarter. While centrist Emmanuel Macron seems likely to win the run-off on May 7th, there could be a great deal of nervousness after April 23rd if his election opponent is nationalist Maxine Le Pen (as polls suggest). Even if Macron wins, the market may have already discounted it such that all investors would gain is what they lose from now until Election Day.
Small cap stocks gained just 1.06% last quarter according to the S&P 600 Index.<5> With median stocks trading at all-time record highs in terms of PEG ratio (price to earnings ratio compared to growth rate), Enterprise Value (the value of both stock capitalization and outstanding debt) to Sales, and Enterprise Value to EBITDA (earnings before interest, taxes, depreciation, and amortization), it can’t be argued that investor love for indexing is distorting the market in favor of large caps. As long as the current circumstances remain in place (high valuation and no meaningful acceleration in economic growth) I expect small caps to under perform large caps so I would underweight them.
According to S&P Real Estate Index, that sector gained 3.54% last quarter. Don’t feel bad if your real estate fund did not measure up. According to Morningstar, 12 real estate related funds and ETFs beat the category average and 254 did not. The Vanguard REIT index fund gained 0.95%, so I think we should be very skeptical of S&P’s numbers. In any event, real estate has been struggling lately and no area of that market has done worse than retail REITs. Malls are having a hard time because retail itself is undergoing structural change. There is a shakeout underway, and it has a ways to run. Perhaps this is an opportunity for great real estate stock pickers to add value versus the index, but at this point I’m not interested. 266 real estate funds is too many. The sector is over-owned due to the desire for income. Underweight real estate.
<1> Source: S&P Dow Jones Index Dashboard: US March 31,2017
<2> S&P Emerging Market Index as reported by S&P Dow Jones Index Dashboard: US March 31,2017
<3> S&P Developed Ex-U.S. Market Index as reported by S&P Dow Jones Index Dashboard: US March 31,2017
<4> S&P Latin American 40, S&P Asia 50 as reported by S&P Dow Jones Index Dashboard: US March 31,2017
<5> Source: S&P Dow Jones Index Dashboard: US March 31,2017
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
All eyes are on two things this week – the U.S. Federal Reserve meeting and the Dutch election. The former is expected to end Wednesday in a 25 basis point rate hike. Depending on the market’s assessment of the tone in the comments that accompany the rate hike, stocks and bonds could conceivably have a relief rally. That said, this bull market has been built on low borrowing costs. No matter what the fund company propaganda tells you, it will not tolerate three rate hikes in 2017 well. The Dutch election is seen as a referendum on European populism and by extension the future of the Euro experiment. A strong showing by Geert Wilders will be taken as a sign that the “common” European citizens have had enough of the EU, and the portents for the more important French election in April will be ominous.
Energy prices have been falling in recent weeks on data showing supply consistently running ahead of demand. Apparently U.S. shale producers are only too happy to fill any supply gap stemming from OPEC production cuts. As prices fall into the upper $40s and stay there, how long before the Saudis get exasperated and flood the markets again? I think this is a risk, and I would add that oil prices and the U.S. stock market as a whole don’t historically move in opposite directions for long.
Emerging markets have done well so far in 2017 as the MSCI Emerging Markets index is up 8.8% through March 13th. See Chart 1. These are some of the reasons:
The U.S. dollar was expected to soar but it opened the year weak and has only begun to recover as Wednesday’s Fed meeting approaches.
The EM news has largely been good. For instance, Modi’s party in India picked up seats in regional elections, economic growth edged higher in China for the second straight month and Argentina’s expected economic contraction in 2017 has been almost completely erased.
Valuation remains attractive relative to developed markets. Chart 1
Source: YCharts.com
Here’s a few emerging market funds I feel have done a good job.
Fidelity Emerging Market Discovery
Ticker: FEDDX
Though the management team has been on the fund for less than three years, I like this fund. It’s more of a midcap value fund so you don’t get the same positions you tend to get in the average EM equity fund like Taiwan Semiconductor and TenCent Holdings (which are usually also found in large cap international funds). Templeton Global Bond
Ticker: TPINX
The fund has positioned itself as a dollar-bullish (and Yen bearish) world bond fund. Much of its holdings are in emerging markets, but from a currency standpoint that doesn’t really matter – it tends to do very well when the dollar is up (and the Yen is down) and poorly when the opposite is true and hence its terrible relative performance from 2014 through August of last year and its category crushing return since September. Another sector I’m warming up to is biotechnology. The health care sector (biotechs included) was crushed in 2016 by overvaluation and concerns that either presidential candidate would put limits on drug company pricing. Overvaluation is for the most part not a concern now, as multiples have come down in this sector and risen almost everywhere else. Regulation is still a concern, but not as much as it would have been had the Democratic candidate prevailed. In any event, biotech companies rely less on protecting the pricing of blockbuster drugs like the major pharma companies do, so for the most part they are less vulnerable to what Washington might do. A few funds I believe have done a good job in this sector are Fidelity Select Biotech (FBIOX) and T. Rowe Price Health Sciences (PRHSX). It should be noted that T. Rowe Price Health Sciences has a new fund manager in Ziad Bakri. Also, this is the second time in four years the fund has experienced a manger change so proceed with caution.
Last week was a bit of a wake-up call for high yield bond investors. I had mentioned that yield spreads over Treasuries were at multi-year lows, so there was no room for any kind of bad news. You can never tell in advance when this particular “rabbit” is going to get spooked, but it certainly did last week as high yield gave up all its 2017 gains in just six days. On February 27th the iShares High Yield ETF (Ticker HYG) was up 2.5% and proceeded to give it all back and more. See Chart 2. I believe the best strategy in this sector right now is to get defensive, both in duration and credit quality. When the Fed is clearly in tightening mode, the focus for bond investors has to be on preserving principal, not generating superior returns.
Chart 2
Source: YCharts.com
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
So far this has been a great year for investors. The US stock market was up 5.6% year-to-date through February and overseas markets are up 4.1%.<1> Bonds, as measured by the Barclay’s Aggregate Bond Index, are only up about three-quarters of a percent so far this year, but annualized that is 4.5%. So we have, in two months, received essentially all from stocks that we should expect in a year if we believe those that have studied valuations levels and subsequent returns, such as GMO and Research Affiliates. As a portfolio manager, I want to believe that there are further gains ahead. Sometimes, however, you get piece of data that makes you feel as though you are kidding yourself. I received this from Goldman Sachs via Heisenberg:
Source: www.heisenbergreport.com
Holy 1929 Batman! This has the potential for a very disappointing outcome. I am aware of how many times I and others have suggested the top must be near because of how expensive stocks have become. Even reaching the 100% percentile, as the median stock has done, is no guarantee that the market rolls over starting tomorrow. But this peak seems different. Stocks did very well in 2013, and they surged again in the third quarter of 2014, the first half of 2015, and again in 2016 after Brexit brought interest rates to fresh lows – but not after any of those events did you have the sense that the bears had thrown in the towel. Investors were still nervous. Today, the narrative of tax cuts and de-regulation as a rationale for further gains is so strong that investors find it difficult to NOT be in the market. Reflecting this, the technical measure of investor sentiment (RSI) has been above 70 for three weeks, which is extremely unusual. This confirms the capitulation to the bullish side. So does a VIX of 11 and near record narrow corporate bond spreads. Apparently, nothing bad can possibly happen right now.
Having established that valuation is scary, investor sentiment (usually a contrary indicator) is off the charts, and market technicals are so good they are alarming, the question is what do the fundamentals say? The fact that earnings are rising and interest rates are low is bullish without question. The sustainability of rising earnings also looks good, at least in the short term. The sustainability of low interest rates is less certain. The Fed meets in mid-March and it appears likely that they will hike rates a quarter point. It also seems more likely that the three hikes scenario – proposed last December but priced out of stocks by mid-February as some economic measures remained sluggish – is back on the table.
It is my belief that the “Trumpflation” narrative is so powerful right now that nothing else matters. Every advisor should be asking themselves what their core strategy is. If it is some variation of “buy low, sell high”, you have to start doing some selling now (they don’t make a percentile above the 100th). If it is “buy relative strength, sell relative weakness” that is fine, but you are setting yourself up for a future where you and the crowd are all trying to get out at the same time. From a client management standpoint this is hard, but shouldn’t it be? Think about it. If you tell your client you believe we should be lightening up on stocks and they say fine, we are probably not at the top. If on the other hand they push back and you feel like they are probably right, then I suggest the top is very close. Outperforming the crowd always involves doing something that they were unwilling or unable to do.
All of that said, there is one thing that troubles me from a “this is the market peak” standpoint: low volatility sectors are not underperforming. The fact that utilities are up 6% or so and the low volatility factor fund (USMV) is up around 6.5% versus the S&P 500’s 7% tells me that a correction may be coming but the ultimate peak is a ways off. At the very, very top of a bull market, you are not only squeezed out of bonds and cash but also the “wrong” stocks.
<1> Source: YCharts.com as measured by the S&P 500 and MSCI EAFE.
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Summary
The U.S. stock market rallied to new highs last quarter. Investors appeared to be nervous leading up to the election, but whatever concerns they had quickly faded against the promise of lower corporate tax rates and reduced regulation. Investors didn’t buy everything, however. They enthusiastically bought smaller companies and those more sensitive to an economic upturn but they seemingly lost interest in larger, safer companies. The Russell 2000 small cap index rose 8.83% last quarter and many financial services companies gained more than twice that. On the other hand, the NASDAQ 100 Index rose just 0.09%, and dozens of funds in the large cap growth category actually lost money in the 4th quarter. Both Amazon and Facebook dropped more than 10% as technology fell out of favor. So we have to look at the S&P 500’s 3.82% quarterly return as averaging out some spectacular performance and some very dismal returns. See Chart. Please note that on the chart we display the returns of ETFs that track the underlying indices because those are the returns an investor would experience. Please see the endnote for more information.
Chart 1
Source:YCharts.com
Whatever one might say about U.S. stock performance, however, it was quite a bit better than what one received elsewhere. In fact, every single region outside the U.S. experienced a decline last quarter in dollar terms – that includes Europe, Asia (including and excluding Japan), Latin America, and emerging markets as a whole. And mind you, even before the quarter began the U.S. had been soundly trouncing world markets. The ten year annualized return on U.S. stocks is 7.07%, according to Russell, while the ten year annualized return on stocks outside the U.S. is 0.75% in dollar terms. That is more than 6.3% every year for ten years! As you can see in Chart 2 the difference in returns is stark. Even if you allow that some of this is due to the effect of a stronger dollar, this has to create, at some point, an incredible opportunity to shift into foreign stocks. U.S. stock out-performance also occurred in the 1990s, leading to a multi-year period of foreign stock strength from 2003 through 2007.
Chart 2
Source:YCharts.com
Bonds were also weak last quarter. Interest rates surged on the belief that the Trump Presidency would mean greater economic activity and higher inflation. The Barclay’s Capital Aggregate U.S. Bond index shed -2.98% (the ETF shed -3.12%). Municipal bonds declined even more (the Barclay’s Municipal Index declined -3.62% while the index tracking ETF shed -4.43%) on the idea that a lower tax rate would reduce their attractiveness on an after-tax basis. Foreign also had a rough quarter as the strong dollar hampered securities with foreign currency exposure. High yield corporate bonds managed to eke out a small 0.86% gain. See Chart 3. After such a poor quarter for bonds, sentiment has understandably become quite poor. This might actually create a bit of a buying opportunity.
Chart 3
Source:YCharts.com
Activity
It is hard to overstate the change in the market that occurred after the election. Prior to the election the market was defensive, favoring larger companies and defensive industries. After the election, risk was suddenly vigorously embraced. Smaller companies and economically sensitive industries performed much better. A great deal of our activity, therefore, was making sure portfolio were not overly exposed to less volatile, high dividend stocks, which had been so successful in 2015 and early 2016. We bought more small caps and sold some positions that were too defensive to succeed in the new environment, including USMV. We also made several transactions in non-qualified portfolios to reduce realized capital gains or in a few cases to more effectively use a capital loss.
We have been gradually decreasing cash levels in portfolios. All of this has had the impact of making portfolios modestly more aggressive. That said, we are most comfortable owning larger, dividend-paying companies and industries that are a little less economically sensitive because statistically that cuts down on volatility. For that reason, we weren’t predisposed to sell funds that had done very well for years – both in absolute terms and relative to their peers – just because the fad was to bet on a huge recovery.
What surprised us the most when we looked at November’s performance was how different returns were among funds that we didn’t really believe had much of a cyclical or defensive bias. Principal Midcap (PEMGX), for example, is a 5-star Morningstar rated, middle capitalization, fund with a top decile 3, 5, and 10-year ranking in its category. It gained only 0.85% last quarter. T. Rowe Price Capital Appreciation is in the very top 1% in its peer group over the trailing 3, 5, and 10 years and it could only scratch out a meager 0.15%. On the foreign side, MFS International Value is another 5-star, top decline 3, 5, and 10 year fund that had a surprisingly rough (-5.76%) fourth quarter. We did not fully appreciate the extent to which our portfolios expressed a preference for consistent growth over opportunistic growth. We are not going to abandon great funds because they went out of favor for a few months. Everybody underperforms from time to time. We obviously want to know why, and if we know the answer and are satisfied by it, we don’t make a change. If over the next several quarters it becomes apparent that this is truly the dawn of a new economic era then we will make more changes.
Outlook
I’m going to refrain from making any predictions, because I believe the outlook has never been more uncertain. We have spent the last eight years in a policy regime that emphasized low interest rates as a means of forcing investors to use their cash balances to invest. Investors were generally rewarded, but savers were unquestionably punished. The financial economy (stocks & bonds) did well even as financial services companies themselves were hamstrung by regulation. Main Street (the net worth of the average person) did not do nearly as well, though employment improved dramatically. In any event, the market is predicting that all of this going to change with the new administration and congress. Fiscal policy will replace monetary policy as the main economic lever as Congress in theory now has a President it is willing to work with. Global trading relationships seem certain to change. How this will impact the dollar is uncertain but critical. It is widely expected that corporate tax rates will be slashed. This should improve corporate balance sheets as well as provide more fuel for stock buybacks. Almost certainly, however, the federal budget deficit and debt beyond 2017 will increase.
Until we get more clarity on how all of this will play out, our instinct is to run fairly neutral portfolios, with very little sector exposure and no major interest rate bets. The markets, both stock and bond, have probably overstated the degree to which one individual can change the larger economic forces shaping the globe at this time – the deflationary implications of an aging world population, high and growing government debt burdens, and the increasing use of technology to improve productivity by replacing human workers. Politically, however, one individual can do quite a lot.
Commentary
The market traded at all-time highs in December. Many clients we spoke with conjured up a mental picture of a rising ocean tide; the idea that all stocks were higher. In reality, you should picture coffee in a mug in a car travelling down a bumpy road. Upon hitting a bump and the level of coffee surged in some areas and plunged in others. Over the five week period between November 4th and December 9th a very large amount of money “sloshed” from bonds and foreign stocks to U.S. stocks. The actual volume of coffee in the mug did not change very much. So if you had a well-diversified globally invested portfolio, then last quarter was entirely unspectacular. Chart 4 highlights the difference in the U.S. stock market (ticker: VTI), the developed economies stock markets (ticker: VEA) and the emerging economies stock markets (ticker: VWO).
Chart 4
Source: YCharts.com
Diversification is a play on the notion that not everything can have its worst performance simultaneously, because money that comes out of one asset class may go to another. For example, in 2008 almost every asset declined, some quite sharply. However, U.S. Treasury bonds increased 11.34% as investors fled from the risky to the safe. While diversification is good at helping you avoid the large loss, it will sometimes produce small losses where is might have been possible to avoid them. In a mediocre year like 2015, due to modest weakness in emerging markets and commodities, it actually subtracted from returns.
Diversification is also a hedge on the notion that the asset class we think is going to perform best often doesn’t. In recent years the most popular assets, U.S. stocks and bonds, really have performed well. It is easy at this point to believe that the American economic system is so superior that U.S. securities will always outperform the rest of the world. Experience tells me the outperformance cannot continue in perpetuity. I’ve seen long impressive runs by Japanese stocks (1980’s) and Chinese stocks (2000’s). It seemed at the time that those markets were unstoppable forces. Of course, as we all know those markets because wildly overvalued and eventually re-priced. I often need to remind myself that markets are driven by humans who are subject greed, fear, enthusiasm and despondency. Ultimately all market movements, be they bullish or bearish, are susceptible to those emotions and thus the animal spirit become unsustainable. Keeping some of your eggs in other baskets helps ensure you lose less when the inevitable re-pricing happens. The hardest things to do as a money manager is to remain disciplined and committed to one’s investment strategy, in our case global diversification, after periods of relative underperformance. It is precisely at those times when maximum opportunity is created but it is also the most difficult time to invest.
For our part, we observed the surge in stocks and in the dollar in the days following the election and identified the pockets of greatest strength (small and mid-size stocks, and the industrial, materials, and financial services industries) and greatest weakness (large “blue chip” stocks, and the utility and consumer staples industries). We analyzed our exposure to these asset classes and made changes we felt we were warranted based on relative under or over weights. We believe that markets overreacted in terms of expected 2017 economic growth and that investors will return to less cyclical industries at some point. So far in 2017 bond yields are falling once again and more growth-oriented industries (think info tech and biotech) are performing the best. Regardless, we remain committed to our process of disciplined, globally based investing.
The intent here is to give you an insight into how markets moved over a particular period of time and how diversification plays an important part in our portfolios. Investment decisions always seem easier in retrospect and we are not inclined to chase after sharp market moves. Last quarter the market reacted strongly to the environment it believes will be in place shortly after Inauguration Day, but right now that is all speculation. Those moves might not look good six months from now. You have placed your trust in us to act prudently with your money and we take that trust very seriously. Much like our country’s largest endowments, Trademark pursues a globally diversified portfolio approach because it is the highest standard of practice in the investment management industry.
Please Note – Fee Reduction
We have reduced the fees our clients are charged in several of our asset management programs. The changes are summarized on our Form ADV. Copies of our ADV can be found on our website at www.trademarkfinancial.us/current-disclosures.
Thanks for your continued trust in our management,
Mark Carlton, CFA
Index Return Source: Morningstar Adviser Workstation
Russell 2000 as measured by iShares Russell 2000 ETF (Ticker: IWM), NASDAQ 100 as measured by PowerShares QQQ ETF (Ticker: QQQ), S&P 500 as measured by iShares Core S&P 500 (Ticker: IVV). Source: YCharts.com. Tracking error, or small differences in the return of the ETF and index, are normal and the result of share creation and redemption, and dividend payments.
Russell 3000 Index, through 12/31/2016, according to Frank Russell & Associates.
MSCI EAFE Index, through 12/31/2016, according to Morgan Stanley.
Total returns as measured by iShares Russell 3000 (Ticker: IWV) and iShares MSCI EAFE (Ticker: EFA). Source: YCharts.com
Total return as measured by iShares Core U.S. Aggregate Bond (Ticker: AGG), SPDR Nuveen Bloomberg Barclay’s Municipal Bond ETF (Ticker: TFI), and iShares iBoxx High Yield Corporate Bond ETF (Ticker: HYG)
Total return as measured by Vanguard Total Stock Market ETF (ticker: VTI), Vanguard FTSE Developed Markets ETF (VEA) and Vanguard FTSE Emerging Markets ETF (VWO).
Diversification is a risk management technique that mixes a wide variety of investment within a portfolio. (Hat tip to Investopedia) The idea is that by spreading ones assets among a number of different investments not all will move in the same direction at the same time.
Total return as measured by Bloomberg Barclay’s Intermediate Term Treasury ETF (ticker: ITE). Source: Morningstar Adviser Workstation
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
The first week of 2017 is in the books and this is what we learned:
Foreign stocks really like it when the U.S. dollar stops rising. Emerging markets especially. The dollar pulled back less than half of one percent last week, but that was enough to take pressure off foreign currencies, especially those in Latin America, Asia, and Africa. Those areas have dramatically underperformed in dollar terms for many years. Last week was a little reminder of what is possible if currency markets stabilize at these levels.
If the yield curve does not continue to steepen in a bullish way, then financial stocks might have overshot to the upside. Interest rates fell last week as skepticism grew about the nature of President-Elect Trump’s anticipated infrastructure program. With long rates falling more than short rates, the yield curve flattened. Smaller banks, which are more sensitive to yield spreads, were one of the few sectors not to gain last week. The more diversified money center banks posted a modest gain.
Big growth stocks are apparently back in favor. Large cap growth outpaced large cap value approximately 1.81% to 0.27% last week.<1> Facebook rose 5.61%, Amazon 5.62%, and Alphabet (Google) 2.55%.<2> My best guess is that the big tech stocks are cash repatriation plays as investors bet that lower corporate tax rates bring a large amount of foreign-earned profits back home.
U.S. consumers are not spending money on apparel or household items. This is hurting mainline retailers across the board. Instead, discretionary money is flowing more toward food, travel, and entertainment. This trend appears to be generational; it has persisted for several years among millennials who have so far defied predictions that they would soon begin having kids and buying homes in large numbers. This is positive news for apartment REITs but negative news for shopping mall REITs. The Dow Jones Industrial Average came oh-so-close to breaking the 20,000 level last Friday afternoon (1/6/17). I’m sure it’s just a matter of time. Friday, I did some valuation research to see how expensive the average stock was because index levels can be deceiving. Value Line estimates that the U.S. stock market’s appreciation potential on a 3-5 year basis is 30%. By way of context, I have used Value Line since 1987 and at no point has appreciation potential ever been lower. There have been times (2002 and 2009) where appreciation potential was well over 100%. The average stock is at or above their historical price-to-earnings and price-to-cash flow peaks. To find a cheap stock, I had to look at beat up consumer growth company like Garmin or GoPro.
Goldman Sachs cut Proctor & Gamble to Sell on Monday (1/9/17). The cut was instructive in that the analyst noted that unless a company has a high tax rate or substantial cash overseas such that it could benefit from tax changes (neither of which P&G has), there is no upside from here. How many other stocks are in the same boat? Elevated market valuations are concerning but momentum is clearly toward higher prices. At some point I believe that valuation will win that tug-of-war and revert to a more reasonable level, but I have no idea when.
We have had potential catalysts to take the market lower (Brexit, the U.S. election, rising interest rates) and they have all failed spectacularly to do so. This makes trying to forecast the next “black swan” incredibly difficult. If the Chinese credit market implodes, for instance, that would theoretically be a very bad thing. But who knows that investors don’t buy the sell-off? I remember the period from 1995 through 1999 in which valuations were completely ludicrous in a few sectors of the market (though quite reasonable in others). I felt it would end at some point but it lasted so long that I almost gave up on the notion of value ultimately being restored. I believe the market is in a similar quandary today. I’m not selling stocks and bonds yet but I am creating hypothetical portfolios with sizable alternatives exposure so that we will be ready if and when this all rolls over.
<1> As measured by Vanguard Value (VTV) and Vanguard Growth (VUG) 1/1/2016 – 1/6/17. Source: YCharts.com
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Scoreboard
The S&P 500 has added another 3.08% so far this month, lifting its year-to-date advance to 12.7%. The EAFE foreign stock index is up 2.4% on the month, dragging its 2016 return back into positive territory at 0.68%. The Barclays Aggregate Bond Index is down -0.07% December, but it still clings to a 1.75% gain on the year. Chart 1 and 2 illustrate month to date and year to date returns through 12/28, respectively.<1>
Chart 1
Chart 2
Near Term Outlook
The Russell 2000 small cap index rose close to 20% from its November 3rd close to its December 9th high.<2> It has been moving sideways in a tight range ever since. The S&P 400 Midcap Index tells the same story. This is a pretty impressive move basis on the belief that tax and regulatory policies are going to change after inauguration day (especially when you consider that stocks weren’t considered cheap back on November 3rd, and the 10 year Treasury bond is 75 basis points higher). Technically, there is no reason to think that the path of least resistance isn’t higher both in stock prices and bond yields. However, I have two concerns. (1) There has been very little in the way of profit taking during this rally. It could well be that sellers are holding off until 2017 on the belief that tax rates will be lower next year. For this reason, even though I think there are further gains ahead this year, I would be careful about buying right now. Pent-up selling may occur in early 2017 and might offer a buying opportunity. (2) Pension funds with mechanical year-end rebalancing strategies could be moving as much as $58 billion out of U.S. stocks (and into foreign stocks and U.S. bonds)<3> in order to remain compliant with IPS asset allocation guidelines. If that comes to pass it may put further pressure on stocks.
Changes to Our Longer-Term Outlook
We are no longer negative on municipal bonds relative to taxable bonds. Munis sold off sharply after the election on the twin fears of higher inflation and lower tax rates (which makes their tax-equivalent yield less competitive). At current prices, their outlook as a whole is now no worse than that of high grade corporate bonds.
There is very little value in high yield bonds. BB spreads have declined to 264 basis points. The last time they were at that level was August 2014. The cyclical low was June 2014 at 243bps; the previous cyclical low was in May 2007 at 171bps. Spreads reached 1182 basis points in November 2008 and more recently 510bps in early February. One could make the argument that the riskier end of the junk bond market still could get cheap since the current 998 point spread on CCC rated bond is quite a bit higher that the 632 point spread back in July 2014. <4> On the other hand, cyclical lows are made when the economy appears to be on solid footing such that investors will sell their lower yielding (interest rate sensitive) bonds first. Ultimately, rising rates create recession fears which crush high yield bonds. We’ve already moved up 75 basis points. How many more before investors lose their nerve? Bank loans are also far less attractive – the average bank loan trades at 99.5 today with a call somewhere between 100 and 101. <5> People will continue to buy these bonds in the short run because they have performed very well, but you should know they are priced to provide very little upside regardless of how well the economy does.
It is very hard to be positive about emerging markets right now. We had become fairly enthusiastic about emerging markets over the summer because in a slow growth, low interest rate environment most emerging markets would benefit from having a lower level of indebtedness and a higher level of growth than developed markets. The U.S. election has changed the picture greatly. The general consensus that U.S. growth and inflation has embarked on a multi-year upswing has caused the dollar to soar relative to other currencies over the past six weeks. Many EM countries have U.S. dollar-denominated debt, meaning that it has become much more expensive to service this debt now that the dollar is stronger. The more of a country’s money that goes toward debt service, the less there is to use in ways that would grow the economy. We will see economic contraction in many EM countries. I believe Turkey is vulnerable, as are many African and South American countries. China has been selling U.S. bonds frantically trying to keep the decline in the yuan gradual. Final Note
I do not believe trade war risk is priced into stocks. The market currently expects experienced businessmen like Wilbur Ross and Rex Tillerson to steer Trump away from his campaign promises to punish countries like China and Mexico. That may well happen. If it does not, however, stocks are going to do poorly, here and elsewhere. Trade war risk is a big reason that the stock market appeared to favor Hillary Clinton before the election. Keep this issue in the front of your mind because its “black swan” potential is considerable. As I said, it is not priced in; investors will ignore it unless, and until, they can no longer afford not to.
<1> As measured by iShares Core S&P ETF (Ticker: IVV), iShares MSCO EAFE (Ticker: EFA) and iShares Core US Aggregate Bond (Ticker: AGG). Source: YCharts.com
<2> As measured by iShares Russell 2000 (Ticker: IWM) Source: YCharts.com
<3> The Heisneberg “The (Pension) Grinch That Stole the Christmas Rally” (12/23/16). Source: Seekingalpha.com
<4> As measured by US High Yield BB Option Adjusted Spread and US High Yield CCC or below Option Adjusted spread. As of 12/22/16. Source: YCharts.com
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Market Perspective
November was a very good month for U.S. stocks, but not much else. Even among U.S. stocks there was a very high dispersion between the best and worst performing stocks and industries. For example, financial services stocks rose 13.94% in November, according to S&P Dow Jones, while utilities declined –5.40% over the same time period.<1> A high dividend-oriented fund might have had the bulk of its assets in the top three yield sectors, utilities, consumer staples, and real estate and if so, it would have declined close to -4% in November. This would have badly trailed the S&P 500’s 3.7% advance.<2> On the other hand, a portfolio equally weighted to the industrials, energy, and materials industries (the three most economically sensitive sectors) would have gained 8%.<3> There has been a real opportunity (finally) to outperform the S&P 500 by owning stocks and industries that do not depend on a friendly Federal Reserve and unusually low interest rates. The catch is that you have to be willing to bet on a significant acceleration in corporate profits and major corporate tax reform. That was not priced into the market on November 9th, so there was the potential for strong gains if one was over-weighted in the right industries at that point. Three weeks later, I believe that scenario is fully priced in.
As nice as the month was for U.S. stocks, however, it has been brutal for bonds and international stocks. Rising interest rates and a soaring dollar have put tremendous pressure on those asset classes. In fact, a globally diversified investor probably made a slight profit in November but is still down for the quarter. If you figure that a 60/40 portfolio is probably 45% U.S. stock, 15% foreign stock, 30% U.S. bond, 5% foreign bond and 5% cash, then 45% of your portfolio rose about 3.7% and 50% of your portfolio lost -2.7% in November, leaving you with a gain of less than half a percent. Quarter to date, 45% of your portfolio has gained 1.8% and 50% of your portfolio is down 3.1%, so you are off three quarters of one percent. <4> That might be tough for clients to understand when they hear that the stock indexes have hit all-time highs.
The most important thing is to be earning at least the market equivalent in in US stocks and to be losing less than the market equivalent in U.S. bonds. Stock investors should think about shifting towards companies offering cyclical earnings growth, because that growth promises to be more dynamic than secular growth industries like health care and technology (which trade at significant premiums when they are the only growth assets available, as is no longer the case). Low growth, high dividend industries will be the most out-of- favor until interest rates rise enough to threaten the expansion (whereupon their high dividends will provide the most cushion in the ensuing recession).
Bond investors should consider reducing interest rate sensitivity. Bonds have enjoyed a phenomenal three decade run. Let’s hope the great bond bull market has ended such that we can gradually get to a level that rewards savers. If a 3% 10-year bond is enough to kill the economy, then we have almost no chance of growing the economy at a fast enough rate to pay down our national debt.
Keep in the back of your mind that rising rates are a headwind for stocks. Every dollar earned in the future has to be discounted at a higher rate. During the long bond bull market, P/E multiples rose from less than 10 times earnings to well over 20 times. This multiple expansion carried along all but the worst run companies and the most economically sensitive sub-industries (think things like base metal miners, steel companies, and shipbuilders). Earnings multiple contraction is going to hurt all companies that can’t grow their earnings fast enough. If we do successfully get the economy to 3-4% real growth (6-7% nominal growth) once again, Main Street will do better than Wall Street. Why? Because we could not have a 30% profit increase (about what is currently projected) without that growth leading to at least 2 interest rates increases, which probably causes a 2-3 point drop in P/E’s. That reduces your 30% earnings gain to a stock price gain of around 12%. We are not at the threshold of a new bull market no matter how fast the economy grows next year.
The short term – stocks are overbought and bonds are oversold. The trend has clearly changed but investors have moved prices too far too fast. Look for a period of sideways action as the stock gains and bond losses are consolidated. The end of December traditionally brings portfolio stuffing (buying the year’s winners so one’s annual report looks better), so financial and materials stocks might finish strong.
Thoughts on Italy
On Sunday, Italy votes on a referendum that would give Italian Prime Minister Matteo Renzi the ability to affect certain constitutional reforms which would make it easier for him to govern. More specifically, it would limit the power of the Italian Senate to block his reform proposals. The significance of the vote is that the fairly popular Renzi has said he would resign if the referendum failed. Renzi has been working to shore up struggling Italian banks. The Italian banking system would become more fragile in the case of a “No” vote, and that fragility would not likely be limited to Italy as major European banks would be exposed to losses by Italian banks. The polls have the No side modestly ahead. The markets are very nervous, as one can see from the spectacular underperformance of Europe versus the United States over the last month (obviously, it is not the only reason).
It should be noted that global macro funds are said to be quite short Italian securities, so a Yes vote has the potential to produce as much or more of a “relief” rally than a No vote would produce a loss. These binary events certainly make investing more challenging.
<1> S&P Dow Jones Index Dashboard, November 30th, 2016
<2> S&P Dow Jones Index Dashboard, November 30th, 2016
<3> S&P Dow Jones Index Dashboard, November 30th, 2016 & Trademark Financial Management
<4> S&P Dow Jones Global Index Dashboard, November 30th, 2016 & Trademark Financial Management
The Election
We knew this election would be a binary event – a decision in which there are two possible outcomes, and the difference would be huge. The pre-election polls suggested that Hillary Clinton would win, therefore things would not change much from an economic or regulatory perspective – very modest growth, very gently rising interest rates. This favors economically insensitive, dividend-paying stocks, because if the economy is not going to grow much, profits won’t rise. Most of an investor’s return, it follows, will have to come from dividends. Utility, Consumer Staples, and Telecom stocks became effectively bonds, since they pay a pretty good dividend and they tend to be recession resistant.
Of course, Hillary Clinton did not win. The market believes that the Donald Trump administration is almost certainly going to change things quite a bit. Yesterday gave us a taste of what the market expects from Donald Trump. Some of the changes to note:
The market expects deficit spending as several new infrastructure programs are initiated. This favorably impacted industrial and materials stocks. Bonds were crushed as the market digested the inflationary potential of this change.
The market expects the regulatory environment to change 180 degrees. Environmental concerns will no longer stop oil drilling or coal mining. Energy and materials stocks got a boost. Environmental services companies understandably did not fare well.
With inflation concerns causing long term bond yields to spike, financial services companies gained. Wider net interest margins are bullish for lenders.
With the cost of borrowing money rising, slow growing large companies will have a tougher time borrowing money to buy back their shares to give the illusion of faster growth (or even ANY growth). P/E multiples for the Cola-Colas and IBMs of the world are almost certain to contract.
Technology companies were among Clinton’s biggest supporters as they rely on liberal immigration policies to attract qualified foreign tech workers. Tech was the only economically sensitive industry to decline yesterday. I don’t foresee it being a market-leading industry in the near term.
Emerging markets had a terrible day. The dollar strengthened on the idea of stronger economic growth in the U.S., while the threat of trade wars weighed heavily in the minds of emerging market investors. EM stocks had performed very well this year as their fundamentals are on the whole better than those of developed markets. That move is OVER. That argument holds true for EM bonds as well. So, unless President Trump governs differently from candidate Trump, investors should consider:
Prepare for higher inflation by reducing interest rate sensitivity in their bond portfolios;
Prepare for greater economic growth by shifting stock portfolios away from stability and dividends and toward economic sensitivity and revenue growth.
Prepare for trade conflict by cutting exposure to emerging markets (and perhaps non-dollar investments in general).Other Observations
Humans are experts at pattern recognition. The stock market didn’t sell off partly because everyone compared the election to Brexit, and we all know that selling after Brexit proved to be foolish. This is not Brexit. That said, a lot of money came out of the market prior to the election and is coming back in now that uncertainty is removed. A relief rally in the short term is a pretty sure bet. The bigger problems – staggering public debt in developed countries, lack of growth globally, and poor demographics – are still going to be with us, however. Add risk exposure, but thoughtfully.
The sharp change in the characteristics of the market provides an opportunity for active management to shine. Active managers need dispersion (high variation in performance between both industries and stocks within an industry) in order to outperform the indices and it appears that we are going to get it.
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Friday’s Unemployment Report
No surprises either way. Very little impact on the market’s narrow belief in a December hike. Doesn’t give either candidate an advantage going into the final month.
Thoughts on the Market
The U.S. stock market has mostly been treading water ahead of the election. Stock prices remain elevated, but without a negative economic surprise or a spike in interest rates they are likely to maintain these levels. Neither sell-offs nor rallies have been able to gain traction of late, though the recent upturn in rates has brought about a small downtick in P/E multiples. The all-time high was made on August 23; we have mostly chopped around within two percent of that level ever since. In a low growth, high leverage world, small movements in interest rates can become magnified. Markets overreact to market noise – a hint from a Fed governor, a comment by the head of the BOJ, ECB, or high ranking Chinese authority – but ultimately retrace those moves as they are revealed to be just noise.
It continues to be extremely hard to add value in an environment where time horizons have become so short. This past Tuesday I was at a CFA meeting where an oil industry insider discussed the current energy environment. He said that public (mutual fund and ETF) money was flowing into companies that had a higher percentage of their oil production in the Permian Basin and Eagle Ford fields, where the cost of production is lower. Private money, on the other hand, was going into the Bakken and other areas where the cost of production is higher but the cost per acre was so much lower. Later that same day I had a conversation with a mutual fund company representative about the tremendous value discrepancy today between higher yielding real estate investments (REITs) and lowering yielding real estate operating companies. Let’s call all of this the ETF effect, because it is a function of how lower rates have pushed up multiples on stocks and how ETFs have been the perfect vehicle to capitalize. Performance pressures on active funds have been so great that fund managers (and advisors) would rather gain a penny today at the cost of a nickel in the future, because if they don’t get that penny they might not be around to see the future.
All that said, as long as rates stay artificially low, chasing yield at the expense of underlying value is probably going to continue to work. The risk (and it is increasing) is that rates don’t stay low. Utilities gave back over 5% last quarter on a fairly modest uptick in rates, and REITs are off over 5% through yesterday<1>. Statistically, rising rates benefit value investing and active managers.
Thoughts on specific sectors:
Gold has sold off sharply on the breakout of the U.S. dollar. K. Prime Minister May has called for Brexit talks to begin in March 2017 at the latest. This broke a state of Brexit complacency (“it will take at least two years to sort out all the agreements”) that had prevailed since mid-July. The pound hit multi-decade lows today under $1.24. The dollar has smaller gains against the euro and yen. The belief is now that no matter who wins the U.S. election, fiscal policy (government spending) is going to replace monetary policy as the primary tool to stimulate the economy. I’m sure the Fed would be delighted if the pressure on it to lift the economy could be diminished.
“Assets can be very safe or very popular, but rarely both”<2>. The low volatility effect (low volatility stocks outperform high volatility stocks over time) was documented several years ago, but only recently has the market had the tools to really take advantage. Low volatility ETFs have been all the rage lately because they performed much better across every single equity asset class in 2015 – large cap, midcap, small cap, international developed, and emerging markets – and they continued to beat capitalization weighted benchmarks well into 2016. Not lately, see the three month chart below. The correction in defensive industries like utilities, consumer staples, and real estate that began in July has re-accelerated this month. The beneficiaries have been energy, financial services, technology and materials, each of which should benefit from a strong economy and mildly higher interest rates. This plays out more dramatically in the large cap value area. Some LV funds are very dividend-oriented, and others rely more on traditional value metrics like P/E and price to sales. For example, Dodge & Cox Stock (DODGX) and Invesco Diversified Dividend (LCEAX) are technically both large cap value funds. Both are up roughly 9% this year through September 30th. DODGX earned almost all of that (8.79%) in the third quarter, benefitting from over weights to Financial Services, Technology and Health Care. LCEAX made almost nothing in the third quarter (0.12%), since its only over-weights were to consumer staples and utilities. The market may look like its treading water, but knowing what you own can still be very important.<3>
EFAV: iShares MSCI Min Vol ETF, EFA: iShares MSCI EAFE, USMV: iShares MSCI Min Vol USA, IVV: iShares Core S&P 500. Source: YCharts.com
Knowing the percentage of your international fund that is in emerging markets can be very significant as well. Vanguard Developed Markets is up 3.95% though the end of September, while Vanguard Emerging Markets is up 16.20%. It should be no surprise then that American Funds Europacific Growth (22.4% emerging) is up 5.1% while Artisan International (1.4% emerging) is down -1.3%.<4>
TIPs are looking more interesting with the downtrend in inflation quite possibly over. Labor prices and commodities in the U.S. have appeared to have made a bottom. Even mildly upward inflationary pressure would improve the attractiveness of TIPs relative to regular coupon bonds, and trailing one month prices show this (ishares TIPS +0.06% versus Barclays Aggregate -0.36%).<5>
Given concern over rising interest rates (duration risk) and due to the effect upcoming changes in money market rules in the U.S. are having on LIBOR rates, floating rate debt might be in the sweet spot on the fixed income side right now.
<1> Dow Jones Utility Average per Morningstar; Vanguard REIT Index ETF
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
