mileagedev, Author at Trademark Financial Management

Last Friday (9/6/16), the market experienced one of the “reddest” days I have ever seen. The advance-decline ratio on the NYSE was 152 to 2929, which is approximately 19 to 1. The cause of the decline appears to be the idea that interest rates have put in their lows, and therefore bond prices have made their highs. Of course, the market has had this fear many times and has always been wrong. We won’t know for several months at least whether the post-Brexit vote interest rate plunge in early July marked the interest rate bottom or not, just as it took until July of this year to establish that the U.S. equity market hadn’t peaked in June 2015. Still, for a market that had been experiencing near record levels of intraday stability, a day where practically everything declines in both the stock AND bond markets is probably significant.

World central banks have been providing an extremely benign investment environment by expanding liquidity in the banking system and buying bonds outright in order to drive bond prices up and interest rates (borrowing costs) lower. It became extremely profitable to play the “carry trade”, or in other words, to borrow money denominated in a low interest rate currency (like the Japanese yen) and invest that money in a currency where yields are much higher (say the U.S. dollar or the Malaysian ringgit). If you were interested in a dollar based investment, you could pick a safer security such as a treasury note and add multiples of leverage to the trade, or you could opt for a higher yielding but less leverage-able corporate bond. You can see how this would fuel a surge in riskier fixed income securities, but it also fueled a surge in equity prices as well. Many investment strategists calculate the value of the stock market as a function of a given risk premium over bond yields, as bonds are in theory a competing investment. To them, lower bond yields justify a higher P/E multiple.

Therefore, on 9/8 when Mario Draghi said that the ECB had done enough and he wanted to wait before doing more, he was echoing Japanese Prime Minister Shinzo Abe’s recent ambivalence about the benefits of reducing rates when they are already below 0%. Asset prices (stocks, bonds, and to a large extent commodities) are priced to reflect the idea that policymakers are committed to stimulating the economy through interest rates and that this commitment is not bound by 0%. The notion that this might not be entirely true, therefore, potentially impacts all asset prices and is negative for almost any of them you can think of (including gold). On September 8th Jeffrey Gundlach of Doubleline made that point during a webinar. He predicted that going forward economic weakness will not be met by lower interest rates but instead by fiscal stimulus (government borrowing). If he is correct, bonds will underperform, as will interest rate sensitive equities.

Keep in mind that one bad day does not end a bull market. Today’s down market may prove to be a “shot across the bow”, or in other words a warning of what may eventually happen. It is by no means a guarantee that the market is topping and asset prices are heading lower. In my opinion, the most vulnerable securities right now are longer duration bonds and interest rate sensitive equities, because they benefitted the most from the “lower interest rates for a longer period of time narrative”. I would make an exception for the very longest Treasuries, which will have a natural buyer in pension funds that need safe, higher yield assets. I would feel less worried about assets that would stand to gain from a higher level of economic activity, such as natural resources. Higher interest rates would likely bring about a stronger dollar, which would not be favorable for gold.

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.

1) Investors have seen new highs from all of the major indices in August, but through last Friday the S&P 500 stands less than 0.5% above its July 31st close.<1> The real action has been overseas. Emerging markets are up 3.90% in August and developed international markets are ahead by 1.99%. See Chart 1. Latin America and Asia have led the way (Brazil is up 14.4% this quarter as everyone expected the Olympics to be a nightmare and that scenario did not come to pass). <2> That said, I’m concerned that the Brazil story may be a “buy the rumor, sell the news” situation where the market sells off after the Olympics as investors refocus on the fundamentals.

Chart 1

Source:YCharts.com

2) This Friday Janet Yellen gives a speech from the annual Jackson Hole conference in Wyoming. The market will probably trade very cautiously this week as concerns grow that she will prepare the markets for a rate hike. The trade that keeps working is to be short treasuries on the lead up to a rate hike announcement, then to get VERY long treasuries just before the Fed ultimately backs off.

3) The shift to “risk-on’ behavior in the market continues. Low volatility funds and industries have performed the worst here in August and so far this quarter. I believe the bulk of the opportunity to benefit from the low volatility factor has passed for the time being as traditionally low volatility sectors like consumer staples, real estate, and utility stocks are richly priced. However, the time to be really underweight low beta is at the beginning of a bull market when the bear has crushed valuations. This is definitely not that part of the cycle. It is increasingly tempting to add risk now because the market is rewarding higher beta stocks, but that always happens near market peaks. If a tactical manager is doing their work correctly, he or she should underperform at the top of the market cycle because they should be less willing to accept the risk/reward tradeoff at that point.

4) New money market rules – On October 14th, the SEC is imposing a floating net asset value requirement on institutional prime and municipal money market funds. These funds will be priced to the nearest 1/100th of a cent (i.e. four decimal points). Retail prime and money market funds will still have a stable NAV. Other important changes:

Institutional AND retail money market mutual fund boards will be allowed, but not required, to impose a liquidity fee of up to 2% or a temporary suspension of redemptions if a money market fund’s liquid assets fall below a certain threshold.
Those funds will be required to impose a liquidity fee if liquid assets fall below 10%.
These changes are what is behind the surge in LIBOR rates to 0.82% last week<3>. LIBOR will probably go even higher in the next few weeks as corporate liquidity is constrained (in order words, there is a dearth of ultra-safe parking places for institutional cash). Rising LIBOR rates often signal trouble in the global economy, but this is probably not the case this time.

________

<1> Source: YCharts.com, IVV (iShares Core S&P 500)

<2> Source: YCharts.com; EWZ (iShares MSCI Brazil capped), VWO (Vanguard Emerging Markets ETF, VEA (Vanguard developed Markets ETF)

<3> LIBOR per YCharts

Disclosure

The month of July was extremely kind to investors worldwide. This was undeserved, in our opinion, given Brexit, a surprisingly weak second quarter GDP report, the sixth consecutive quarter of earnings declines in the US, an upcoming election in which there will likely be considerable unhappiness no matter who wins, terrorist attacks in Europe, and the turmoil in Turkey. The US stock market posted a 3.65% gain last month, but that was bettered by a 4.16% gain for the world-ex US.<1> See Chart 1. It is as if a fever gripped investors that compelled them to buy bonds before yields fell to 0% and stocks before the Dow hit 20,000. I have a very unscientific contrarian indicator that I use to gauge market sentiment that I call the “right margin indicator”. It refers to the right margin on the internet page where I get some of my market information. It’s generally filled with fear mongering ads designed to prey on investor emotions. During the Dow run up from under 16,000 back in February, every single crank on the right margin was forecasting a stock drop of 50% or more. Now it’s filled with ads predicting Dow 50,000. As a contrarian investor seeing those ads gives me pause.

Chart 1

If it does turn out that we are close to a market pull back, the following is likely to be viewed in hindsight as one of the signposts. Last Friday, the Bank of Japan surprised the market by deciding to postpone the decision to further cut interest rates. That followed by one day the Bank of England doing essentially the same thing<2>. Some observers suggested that world central bankers are close to saying, in essence, “Enough. We’ve done all we can do. Fiscal policy has got to carry us from here”.<3> Central banks have been trying to assure investors and government across the globe that they can keep us all out of global recession, but all that has done since 2009 is give politicians in Europe and United States an excuse to do pretty much nothing of substance. As an example, the United States has not passed a budget in five years. They’ve been using so-called continuing resolutions to fund the government. Central bankers are well aware that recent policy moves have done little for average citizens because the benefits from lower interest rates accrue to investors while hurting savers. They are also keenly aware that a backlash against these policies is behind Brexit and populist movements around the globe. Citizens are demanding an end to policies that they believe, rightly or wrongly, benefit only elite groups of well-connected citizens and corporations.

The risk, of course, is that if there is to be no more quantitative easing or extraordinary monetary policies then eventually the market starts to “normalize”. The pendulum swings back to fiscal policy (Main Street) and away from monetary policy (Wall Street). Legislatures have to spend in order to put people to work to keep recessions from becoming Depressions. Deficits rise, interest rates rise, and price-to-earnings multiples contract. As interest rates rise, companies are forced to “make stuff” to prosper, because financial engineering (borrowing in order to leverage the profits) no longer works. In fact, companies have to reduce leverage. More businesses will fail because the cost of bad decisions rises, but successful businesses are more dynamic and have a greater ability to increase wages.

The bottom line is that the period from the early 1980s through the present has seen great gains for investors but very little wage growth. One way or the other, a reversal of this trend needs to happen, at least in part, and at least for a little while, or the tradition of liberal democracy in Europe and America is in danger. Individuals will put up with the feeling that other people are prospering, but they aren’t, for only so long before they become angry and demand change. The current rise of populism is symptomatic of that. Sometimes those change agents are benign and the changes are positive. Sometimes they are not.

Sector Performance and Risk On

Breaking down the performance of various sectors in July, we saw a dramatic shift to “risk-on’ behavior. Utilities and consumer staples declined while technology, health care, materials, and financials gained.<4> Foreign stocks outperformed domestic stocks<5>, while small stocks led big stocks<6> and growth outperformed value<7>. The trend appears to be moving away from dividend and high quality stocks. As one would expect, higher risk was once again associated with higher return. Bonds peaked with the stronger than expected employment report on July 8th and are starting to break down technically. This is consistent with the notion that investors are giving up on the “yields are going to 0% so you better buy the highest safe yield you can find” fear trade thesis that we saw after the June employment report. It will be very interesting to see what happens with this Friday’s unemployment report.

Gold peaked on July 6th and went into a correction for three weeks. The weak GDP report last week helped restart the rally. While gold bullion is still short of its recent highs, mining stocks have made new cycle highs. It is tempting to focus on the 100%+ rally of the early February low, but the mining stock index (GDX) is still over 50% below its September 8, 2011 all-time high.<8>

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.

<1> As measured by the SPDR S&P 500 and iShares MSCI ACWI ex US Index ETFs. Source: YCharts.com

<2> On the morning of August 4th the Bank of England did finally cut interest rates. The British economy has been contracting in the wake of Brexit, which forced BOE Governor Mark Carney to act. He had been very reluctant but in my opinion ultimately decided that implementing a flawed policy was better than admitting there was nothing constructive that he could do.

<3> Central bankers are responsible for monetary policy. Political bodies are responsible for fiscal policy.

<4> S&P Global Index Dashboard, July 2016

<5> MSCI ACWI EX USA NR $ (4.95%) versus Russell 3000 NR $ (3.93%).

<6> Russell 2000 Index (the smallest 2000 of the Russell 3000) gained 5.95% while the largest 1000 rose 3.77%.

<7> The Russell 3000 Growth Index gained 4.86% in July, beating the Russell 3000 Value Index (3.09%) handily.

<8> Source: YCharts.com as measured by GDX

Our take on “Brexit” is that it has set in motion a re-examination among European Union nations of the benefits and drawbacks of that union. This process may ultimately resolve itself several different ways. It could result in a tighter union between the remaining nations if they can resolve some currently sticky issues (such as immigration), a weaker union (if concessions are made to remaining countries in order to get them to stay), or it could lead to the break-up of the EU altogether. It ultimately may lead to the end of the Euro currency and the re-emergence of country specific currencies such as francs and marks. On the other hand, leaders in the United Kingdom could effectively nullify the vote by not invoking Article 50<1> of the Lisbon Treaty, making the Brexit referendum a non-event. To put it bluntly, no-one knows how this is all going to play out.

British leaders aren’t sure what they want either as the implementation of Brexit has become a political hot potato. Even the leaders of the Leave campaign have been hesitant to assume leadership and “pull the trigger,” so to speak. At first, EU leaders seemed to stress that they intended to negotiate harshly with the U.K. in order to dissuade any other countries from leaving. After Prime Minister David Cameron resigned and Brexit champion Boris Johnson pulled out of the race to succeed him, it became clear no British leader wanted to rush into Brexit. This led EU leaders to a much more measured response. In any event, it appears the negotiations will not take place until Britain has a new Prime Minister. There are 80,000 pages of EU agreements, according to British newspaper the Guardian. The actual process could take years.

Again, despite all that has been said and written over the past week, I really don’t believe anyone knows what Brexit’s impact will be. Some have suggested that it will be a boon for the English to be free of EU regulation. That may be. On the other hand, trade that was once tariff free will certainly no longer be so. Economically that is huge. Import and export quotas will have to be negotiated, as will the right of British citizens to live and work in EU countries.

Because of this, it seems to me that this uncertainty should cause investors to be cautious and demand a small uncertainty premium from all stocks in general and a larger one from European stocks specifically. For the two days following the referendum, that is exactly what happened. Then on Tuesday June 28th markets began to rally. At the close last Friday (7/1), the S&P 500 stood almost exactly where it had closed on Thursday June 23rd, having rallied close to 2% between June 20th and 23rd on the unfounded notion that the U.K. would vote to remain. Heads the market goes up, tails it goes up apparently. Clearly there is a more powerful force at work than whatever comes of Brexit, because in essence U.S. stocks have completely shrugged it off<2>. See Chart 1. That force is low and falling interest rates.

Chart 1

Brexit spurred a decline in the ten year Treasury note from 1.74% to 1.36%, as investors concluded the ongoing uncertainty almost assures no rate hike in 2016. See Chart 2. Lower long term interest rates implicitly raise the current value of every future dollar earned, thus theoretically justifying higher prices. Every time you think stock prices can’t go any higher unless corporate earnings improve because bond yields certainly can’t go any lower, bond yields somehow do go lower. It doesn’t even seem to matter that earnings are flat. As the July 2nd Barron’s aptly put it, people are buying treasuries for capital appreciation and stocks for yield<3>.

Chart 2

Despite the obvious risks in buying securities that have already rallied substantially (referring to income-oriented stocks and treasury bonds), buying into any market decline is just too tempting in a world where too much money is chasing too few opportunities. It appears that the interest rates bears have capitulated. The consensus now seems to be that AAA yields are heading toward zero. It’s been my experience that consensus is rarely correct. I’m not calling a top, but this just makes me nervous.

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.<1> Article 50 of the Lisbon Treaty spells out how an EU country might voluntarily leave the Union.

<2> World stocks are 4% below their June 23rd close, but at more or less the same level as June 14th when polls showed that “Remain” had retaken the lead.

<3> Barrons, July 2, 2016. Page 9.

Markets and the Dollar

Stocks rallied in recent weeks, until the looming “Brexit” vote in England stopped the upward momentum in its tracks. Markets participants had assumed the British would vote to remain in the EU, so they had simply shrugged off the vote until last Thursday when the polls show the “exit” side ahead. European stocks got crushed, more so on the continent than in Britain itself. Investors figure an exit would mean uncertainty in England but ultimately they wouldn’t suffer too much. The real worry is that a British exit would prompt calls for an exit vote in other nations, hastening the end of the Union. Political scientists will tell you that the failure to effectively deal with crises in Greece and Cyprus, coupled with the “every-country-for-himself” response to the Syrian and Libyan refugee crisis, has showed everyone that halfway integration does not work. The fact that savers in many of these countries receive nothing (or less!!) on their deposits just adds to the sense of “there has got to be a better answer than this” that pervades Europe right now. No government wants to give their people a vote at this point.

The stock rally had been primarily due to weakness in the US dollar. When the dollar weakens relative to other currencies, it reduces the burden on countries that have debt denominated in dollars. This primarily means emerging markets, and that is why emerging market performance has improved this year relative to their disastrous declines from 2011 through 2015. Latin America has been the biggest beneficiary of the suddenly-weaker dollar, since a rebound in commodities has coincided with the decline in the dollar. Lately when the dollar falls, the market displays “risk-on” behavior – meaning economically sensitive and/or more leveraged companies & industries tend to perform better, as do higher interest rate countries. On the other hand, when the dollar rises, the ”risk-off” winners are much fewer -typically only utilities, real estate and consumer staples, and also usually the Japanese yen.

Gold has been a huge beneficiary of the change in expectations regarding the dollar. 2015 basically saw gold in a death spiral. Prices were falling due to the strong dollar, and mining firms had little or no access to capital since nobody likes to finance companies they expect to go out of business. Valuations understandably became dirt cheap. With the recent dollar weakness, investor demand has improved considerably – which also reopens the capital spigot. The Gold Miner ETF (Ticker:GDX) is up roughly 95% so far this year. See Chart 1. However, even with that incredible year to date performance gold miners aren’t even close to break-even on a five year basis. The point being that gold mining stocks are EXCEPTIONALLY volatile, but even after 95% gains are not necessarily expensive. ETFs that invest in gold bullion (Ticker: GLD) are up roughly 20% so far this year, but their five year annualized losses are less than half that of miners. See Chart 2.

Chart 1 – YTD

Source: YCharts.com
Chart 2 – 5 Year

Source: YCharts.comThe Fed

Yesterday’s Federal Reserve decision to keep rates unchanged was completely expected. The only surprise was the forward guidance. After the last meeting, six governors expected two rate increases before the end of 2016. After this meeting that number was down to one. I interpret this as the Fed has seen more data than just the shockingly poor May unemployment report to conclude that the economic expansion is not accelerating, and therefore they are loathe to do anything to put it at risk. The behavior of the bond market continues to suggest that desire for safe, positive yield is overwhelming greater than fear of inflation. Stocks should continue to see this as a net positive. So should gold investors.

Perhaps yesterday’s biggest loser was the Bank of Japan. The yen just keeps rising, increasing the deflationary pressure. I think you just have to avoid Japan right now from an investment standpoint.

That doesn’t change my feelings about stock prices being well above what their earnings can justify in most cases, but valuation is a very poor timing tool in the short and intermediate term. In the long run, however, it is an excellent tool.

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.

Yesterday the Federal Reserve suggested that it was considering raising interest rates. It cited employment strength (the unemployment rate is below 5%) and the recent surprisingly strong consumer price index report, which showed CPI running north of 2%. One Fed governor already dissented in March in favor of hiking rates, and more are said to be in favor now. This has the market in a state of concern right now. Everyone recalls the environment after the previous hike (December 16th, 2015) to the announcement that the Fed was on hold (February 11th, 2016). It was not very good for risk assets. Some are going to say that the Fed was floating a trial balloon for June, seeing what kind of a pushback they’d get from the stock market, bond market, and perhaps most importantly, the People’s Bank of China. Why the PBOC? Because the Chinese currency is more or less tied to the dollar, and if we tighten, they are forced to tighten. If anything, they would prefer us to ease right now, given the difficulty they are certainly having reaching their GDP forecasts. They could break the peg and devalue the yuan, but that could trigger a trade war and make everybody a loser.

It is my guess that over the next week the market will decide that the Fed really can’t afford to risk raising rates in June, and the markets will trade much like they did prior to the meeting in terms of price level and industry leadership. Expect market leadership to come from defensive, dividend oriented securities.

Of course, I could be wrong and in the alternative scenario the market begins to price in a June or July rate hike and perhaps another in December. In that case, market leadership would swing toward financials (which benefit from higher rates), technology and health care (both are rate neutral). The dollar should also be a winner. In this scenario the list of losers would be long – foreign currencies, commodities (most definitely including gold), emerging markets, utilities, and REITs. Expect anything economically sensitive to be a loss leader as the broad market trades lower.

It seems to me the right thing to do is to get a little more defensive, just in case.

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

It was a tale of two half quarters. The first six weeks saw equities sell off on fears that the Federal Reserve would continue hiking interest rates in 2016 and the result would be a global recession led by the emerging markets. The last seven weeks of the quarter produced a spectacular rally as the Fed backed away from its planned rate hikes and risky assets began to recover. As the dollar fell, the pressure on global currencies was reduced considerably. Emerging markets (particularly Latin America) soared. Oil prices began to recover. Such is the power that monetary authorities wield today.

Putting the two pieces of the quarter together, stocks put in a mixed performance overall. The S&P 500 rose 1.42% for the quarter, while the Russell 2000 small cap stock index was off -1.47%. The technology-heavy NASDAQ Composite fell -2.09% as “growth” stocks under-performed “value” stocks for the first time in two years.<1> See Figure 1. The strong decline early in the quarter caused investors to prefer high dividend paying stocks to rapidly growing companies, and that bias persisted even as stock recovered. The utility and precious metals sectors performed the best last quarter, which makes little sense if you consider gold an inflation hedge. Financial stocks did the worst once again, as investors remain wary of a sector so sensitive to government interference.

Figure 1

Latin America finally posted a sharp rally after five years of absolutely hideous performance. A modest recovery in commodity prices and the possible impeachment of the Brazilian president was behind the surge. Despite the 6.40% gain from emerging market, international stocks as a whole posted another quarterly decline (-0.33%). Japan was the leading culprit as even negative interest rates don’t seem to be able to spark inflation or depress the Yen. Europe was down -2.75%.<2> See Figure 2.

Figure 2

The aggressive use of monetary policy to combat weak global growth was again positive for bonds, especially high quality bonds. The interest rate sensitive Barclays Aggregate Index gained 3.03%, its best quarterly performance in several years. Anyone who has warned investors over the last five years not to invest in bonds has done them a great disservice; yields have gone lower (not necessary in a straight line of course) and prices have gone higher. Even sectors that struggled mightily in 2015 – high yield corporate bonds, emerging market debt, and inflation protected bonds – each posted solid returns.<3> Activity

Our trend-sensitive indicators led us to reduce stock exposure in January and begin to build it back up in March. Since we bought at a higher price than we sold, this hurt performance modestly. Our key objective is to make sure we are on the right side of the big moves. Had the -11% decline early in the quarter persisted or turned into a 20% or 30% decline, we would have lost quite a bit less. When the market began to recover we had to become buyers to make sure we didn’t fail to participate if stocks rallied 20% or 30%. The process of selling and later buying, even if the buys turn out to be at higher levels, has the benefit of allowing us to sell weak relative performers (in January this was mid- and small cap growth stock funds and certain international funds) and eventually buy into areas with better relative strength (dividend payers and low volatility stocks).

Outlook

The market clearly likes the idea the Federal Reserve is not going to increase interest rates for at least the next two months. Many strategists think the Fed is on hold for the rest of the year. It may be hard to justify current U.S. stock prices based on earnings or cash flow growth, but there is no questioning the fact that Fed induced momentum is currently positive. Moreover, many people who sold stocks late last year or early this year have missed the rally and are hoping for a pullback in order to buy. This is what has kept stocks from declining more than a percent or two over the last nine weeks. That said, bears are counting on the following factors to ultimately push stocks lower:

Weak corporate earnings and falling future earnings expectations;
Seasonally, late spring and summer are weak periods for stocks (especially in an election year);
None of the remaining four U.S. presidential candidates is viewed as market friendly;
Central bank policies to stimulate the various economies have shown little results other than to transfer money from savers to investors/speculators. Political developments in the U.S. and Europe strongly suggest that the public has lost patience with these policies.
The upshot is that in the very short term, technical and seasonal factors suggest that the upward trend continues. Looking toward the rest of this year, however, if people in the U.S. and Europe don’t start to see tangible signs of their economies picking up (i.e. higher wages, more interest on savings), they may force political changes that would not be market friendly.

Commentary – Let’s Play Twister!

We prepared for the worst three months ago as U.S. corporate earnings were set to fall for the fourth consecutive quarter and the rising dollar made the global market scenario even worse. In February action by the European Central Bank and non-action by the Federal Reserve completely changed the tone of the market. Whether or not this should have produced such a rally is beside the point – for the last six years investors have been rewarded for dancing to the central banks’ tune, regardless of what they think of the underlying economy. More than a few veteran market participants are concerned that this is not the way that investment markets ought to work and at some point central bank activities will lose their effectiveness.

U.S. stocks, as measured by the S&P 500, have done quite well over the last several years. In fact, they have more than doubled (counting dividends) since the summer of 2010.<4> See Figure 3. The pattern is familiar. We rally for a few months in anticipation of an economic recovery but the recovery comes up short of expectations and stocks sell off. Each time, in the face of a slumping market and lackluster economy, the Federal Reserve has stepped in. As nice as this is for investors, one has to question whether this is the proper role of the Fed. There are some very sharp minds out there – John Hussman, Ben Hunt, Vitaly Katzenelson, and John Mauldin come to mind – who warn that central bank actions are not sustainable. At some point a market driven by price discovery and fundamental analysis, rather than central bank liquidity, needs to be restored. If not, investors have to allow for the possibility that there will be a time when the central bankers make a move and it doesn’t work. At that point, faced with dependence on an institution that has no arrows left in its proverbial quiver, we could be in for a significant decline. This is the basis for most of the dire warnings you see on the right margins of your internet browsing.

Figure 3

Until that day comes, however, if we want to keep up with the market we have to play what amounts to be financial Twister<5>. Investment strategist David Zervos has been the most successful market strategist over the past several years by repeatedly telling us to forget the fundamentals and watch the central banks. The ECB is pushing rates further into negative territory? Left hand blue! Buy gold and global equities, sell the Euro and European bank stocks. The Fed has put interest rate hikes back on the table as early as June? Right leg yellow! Sell domestic and emerging market bonds, buy defensive stocks. It doesn’t matter what any individual security might be worth. Stocks, bonds, and currencies are all asset classes to be bought or sold as a play on what any particular central bank is doing. And incidentally, this is killing active value managers. You found a small cap auto parts company growing at 12% annually and trading at 10.5 times earnings? Nobody cares, unless the stock can get itself into an index that will rise on the “risk-on” trade the next time Janet Yellen says the Fed remains “on hold”.

It has always been our preference to have good fundamental support (either reasonable stock valuations or the expectation of higher earnings) when we buy stocks – as opposed to low interest rates and the promise of a friendly Fed, which is what we have now. U.S. stock prices, at over 20 times trailing earnings, are fairly expensive by historical standards. Investors really need to see a sharp earnings recovery to justify current prices, but so far companies are not indicating that this is likely. That encourages us to build in a little extra margin of safety in the form of a higher than normal cash position. We aren’t doing it because we think we know when the next market decline is coming – I can assure you that we don’t. We are doing so because the scope for investor disappointment seems unusually high. It’s a long way from here to normal valuations.

In the end it comes down to what you believe your role as an investment professional to be. If it is to squeeze every dollar of potential return from markets, then we certainly should follow Zervos and fully embrace the central bank following game. However, we tend to agree with Hussman, Hunt, Katzenelson and Mauldin that central bank policies are ultimately destabilizing and cannot last. Therefore, we believe caution is warranted. We have to take seriously each market decline (in other words, we sell stocks to raise cash at the margin – as we’ve stated in the past we’ll never move to 100% cash) on the thought that this time maybe Janet Yellen or Mario Dragi and the other central bankers have nothing left up their sleeves. If they do engineer the turn-around, then we’ll buy stocks back and suffer only modestly for our caution. That’s okay if its helps us avoid fully participating in a 2008 style loss. I believe this is what our clients are really looking for us to do.

Thanks for your continued trust in our management program,

Mark Carlton, CFA

<1> Total return as measured by the following ETF proxies: iShares Core S&P 500 (IVV), iShares Russell 2000 (IWM), PowerShares Nasdaq QQQ (QQQ). Source: YCharts.com

<2> Total return as measured by the following ETF proxies: iShares MSCI Emerging Markets (EEM), iShares MSCI ACWI ex US Index (ACWX), iShares Core MSCI Europe (IEUR) Source:YCharts.com

<3> Source: Morningstar Adviser Workstation

<4> Source: YCharts.com as measured by iShares Core S&P 500 ETF

<5> A game popular in the 1960s and 1970s in which players placed arms and legs on the colored dots as specified by a spinner. If you could not contort yourself in such a way as to touch the right dots, you were out.

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.

Notes on The Fed

The Federal Reserve decided on March 16th not to raise interest rates. This came as little surprise, as that is exactly what Federal Funds futures had predicted. The surprise was the statement from the Fed that accompanied the announcement. In it, the Fed suggested that it was not particularly worried about inflation pressures, and in fact they expected that they’d only hike rates two times this year instead of the four hikes they forecast back in December 2015. They cited world credit conditions as a motivator. All of this had a big impact on global markets. It reinforced the current “risk-on” atmosphere by giving market participants the confidence that the Fed would not act prematurely – precisely what many feared after the December hike. Furthermore, it negated the argument for being long the dollar (widening interest rate spreads), which took pressure off emerging market currencies. This has driven a surge in emerging market debt prices this month.

These are the trading implications as I see it:

Bullish for emerging markets and risk assets
Bullish for gold and economically sensitive commodities like base metals
Favoring inflation protected securities (TIPs) over regular coupon bonds
I believe the Fed will have to reassure markets that they have not gone too soft on inflation if not at the next meeting then certainly by the one in June. Continued improvement in the labor markets and rising consumer prices could put pressure on high quality bonds. Because the recent rally in risk assets has been very sharp, I would wait for a pullback. Almost all are technically overbought.

Other Things of Note
One of the most important things about the stock market’s performance in 2016 is that value has sharply outperformed growth for the first time since the first quarter of 2014. This reflected a preference for dividends and defensive sectors earlier this year when the market was very weak and also the poor relative performance of the health care sector. At this point, I would make sure my portfolio was not over-weighted toward growth, but I would resist having more than a slight overweight to value. One quarter does not make a trend change, as 1Q14 showed. Value typically asserts itself after a correction has begun and lasts through the early stages of an economic recovery. That might be going on in the short term as a “mini-cycle” but certainly not in the larger, business cycle sense.
It is interesting to me that in March (clearly an “up” month with S&P 500 up 6.1%) that the Dow Jones Utility Average is up 5.8%. This brings its year-to-date return to 12.63%.<1> See Figure 1. Essentially, utilities rose when the overall market was falling and continue to rise as it recovered. I would have expected utilities to lag this recovery badly as they typically do during strong market phases. Does this reflect the market’s lack of conviction in the stock rally, or is it due to investors piling into low volatility strategy ETFs? I’m not sure at this point, but it is one of those things I’m keeping a close eye on.
Figure 1

The most recent move from the European Central Bank is being interpreted as a “pay ‘em to lend” program. Apparently, banks are going to be paid up to 40 basis points to lend money to non-financial companies. This removes the negative interest rate penalty that was hurting European banks (previously, they were earning a negative 30 basis point yield on money they had to hold on to in order to meet capital requirements). This is expected to be very stimulative, so European stocks have responded. Let’s see how it plays out in the real world.
High yield spreads have contracted to 3.92% (BB) from a high of 5.82% on February 11th.<2> That tells me that a great deal of money came in to buy the dip. BB credits now strike me as distinctly not cheap, especially since CCC bond yield spreads exceed 12%. At this stage of the market cycle, high yield bonds are a trade in my opinion. The window has closed unless you are willing to go further down the credit spectrum, where risk is higher but you are at least being adequately compensated for taking it.

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. <1> Source: YCharts.com, 1/1/16 – 3/23/16

<2> Source: YCharts.com

Updating the January 18th post:

Low volatility strategies continue to lose less. They are down roughly -1.79% so far this month, versus -3.63% for the S&P 500 and -2.65% for the Dow.<1> See Figure 1. The Dow is outperforming the S&P 500 because it benefits from having a higher dividend yield, and high dividend stocks are performing relatively better.
Figure 1

Source:YCharts.com

The best performance this quarter has come from gold mining stocks which continue to benefit from declining faith in world central banks and from a surprisingly weak dollar. Currency markets priced in multiple rate hikes by the Federal Reserve in 2016, and that looks less likely every day. Dollar sentiment was fantastically bullish at the end of 2015, so in the absence of aggressive action by one of the world’s other major central banks, it was set up to fall.
The surprising global economic weakness to start 2016 led to a sharp decline in interest rates. The U.S. 10 year yields 1.75% but last Thursday’s low was around 1.55%.<2> The massive compression of yield spreads has really hurt financial stocks, most of which depend on the ability to borrow at short term rates and lend at intermediate or long term rates. Next to health care, financial services stocks have been the worst performers in 2016.<3>
The other problem with the sharp fall in interest rates worldwide is that more debt is trading at negative interest rates, which punishes the debt holder. In Europe this means banks must hold high quality paper to meet capital standards. I don’t believe it has worked anywhere, anytime in history to try to achieve prosperity by abusing one’s financial services industry. The ability to extend credit where it is needed and at prices and terms that are mutually beneficial is so critical to a country’s economy that most advanced nations have long understood that no one government agency or bank has the capability to get it right. We need a financial system where more decisions are made by empowered but competently regulated local entities. Unfortunately, post-2008 developed nations have been moving toward greater centralization of credit decisions in reaction to frustration over the inability to hold anyone responsible for the widespread malfeasance that caused the financial crisis. Oil

Oil prices have fallen under $30 per barrel. Obviously, this continues to be an existential problem for many smaller and/or more poorly capitalized entities in that industry. That said, the decline might be close to over for the major players. Perhaps on the idea that big oil can pick up assets cheap during the bankruptcy process, ExxonMobil is up 4.08% in February and Chevron is only off -1.19%<4>. At the very least, I would suggest underweighting energy will not in and of itself lead to outperformance going forward.

Growth vs. Value

Growth’s relative strength to value is slipping as value is a superior performer on a year-to-date basis.<5> We are seeing portfolios heavily tilted toward growth move rapidly back toward style neutrality. The traditional value sectors that investors normally gravitate toward when growth goes out of favor have been a mixed bag; some have been good some have been terrible. Financial services are typically the biggest sector weighting in value portfolios and, as explained above, this year has been a disaster. Real estate is very weak this month and energy is just starting to bottom out. The biggest winners from the growth to value shift have been utilities, consumer staples, and telecoms. While this is understandable given their dividends, I’m not confident those sectors can sustain outperformance. Those are very slow growth sectors whose fundamentals suggest they’re quite expensive. Everything else that was once expensive – health care, retail, online services, etc. has been dealt with harshly.

Credit Spreads

Credit spreads continue to widen this month. We have be inundated with calls and emails from firms pounding the table on how cheap high yield credit is right now. I will absolutely grant that prices are the most attractive since at least the summer of 2011. If this turns out to be a garden variety economic slowdown and default rates don’t climb much above 6%, this will have been a good opportunity to buy high yield. I’m just not sure I believe things won’t get worse, given the almost complete lack of good news outside of the United States and the continuing lack of corporate bond liquidity. I will say this though – the risk-reward on high yield debt may well be more attractive than that of large cap U.S. stocks due to better valuation and much higher yields.

Gold

As noted above gold has been the best performing sector this quarter. If stocks put together a strong bounce off support (1815 on the S&P 500; see Figure 2), gold will almost certainly lag. That said, the crisis of confidence in central bankers might well be in a secular bull market as no-one considers negative interest rates a sustainable long term policy. A modest position as a hedge may be a good idea.

Figure 2

Source: Stockcharts.com

Valuation

We write a lot about valuation in these updates. The purpose is to establish where the market is fundamentally trading as a way to determine what the magnitude of a potential move in either direction might be. If markets are cheap, for example, one should have less concern if the next move were be to the downside (as upside potential is far greater than downside risk). This year’s pullback makes the market look much less expensive and I believe overvalued securities now make up less than 10% of the broad market. An undervalued market eventually tips the performance pendulum back towards active managers, but I’m not ready to make that call yet.<6> <1> As measured by the following ETF’s: SPDR Dow Jones Industrial Average (DIA), SPDR S&P 500 (SPY), PowerShares S&P 500 Low Volatility (SPLV)

<2> Source: Barron’s Online, as of 12/12/16

<3> As measured by Select Sector Spiders. Source: YCharts.com

<4> Source: Google.com/finance. Period: 2/1/2016 – 2/12/2016

<5> Large cap growth is down -9.69% compared to values -8.85%. Source: Goldman Sachs February 12th Market Monitor.

<6> The dramatic outperformance of the “Nifty 50” leading up to the 1973-74 bear market resulted in spectacularly better returns for the broad market from 1975 to 1984. This was largely repeated between 1995 and 2000 as large growth stock returns dominated. Large cap indices were then then the worst performing area of the investment spectrum from 2000 through 2009.

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

In a way, 2015 was a lot like 2011. Markets muddled through the first half of the year, then plummeted in the third quarter before staging a modest recovery in the fourth quarter. Like four years ago, large stocks rallied enough to close the year with a gain while mid and small cap stocks had a much smaller bounce and finished with losses. The difference was that in 2011 the dividend paying blue chips were the winners, while this time around it was a handful of technology and consumer names that led the market. And handful really is the correct word. Factoring out just Amazon.com, Netflix, Facebook, and Alphabet (Google), the S&P 500 would have been negative on the year.

With the S&P 500 stock index gaining 1.28% in 2015 and the Barclays US Aggregate Bond Index up 0.48%, simple diversification would’ve resulted in a return somewhere around 1%. If, however, you diversified by size, geography, credit quality, and asset class, your returns in 2015 would have been quite a bit worse. Small cap U.S. stocks lost -1.84%. International developed market stocks as measured by the MSCI EAFE (think Europe and Japan) fell -0.99%. Emerging market stocks plunged -16.20% as measured by the MSCI Emerging Markets index. Commodities crashed -27.6%. Gold dropped -10.7%. High yield U.S. bonds were down -5.02%.<1> See Figure 1. As you can see, last year was very difficult, even if you were underweight all of those diversifiers. In fact, economist Zachary Karabell noted that 2015 was the hardest year to generate returns since 1937, since it was the first time in 78 years that no asset class gained 10% or more.<2> Figure 1: 2015 Annual Returns by Asset Class

Source: YCharts.com

There was just one way to make money last year in foreign markets, and that was to own European or Japanese stocks on a currency hedged basis. Every region declined in U.S. dollar terms, but as noted above, one was a lot better off in developed markets than emerging markets. China continues to be the biggest driver of the global economy, and unfortunately they are not currently driving in a helpful way as their economy slows.

On the bonds side there were basically two ways to come out ahead – municipal bonds and mortgage securities. To be sure, returns were modest – muni bonds were up 3.30% and mortgages 1.13%.<3> Taking any kind of risk to try to earn a higher yield was in most cases punished last year, as investors become nervous about a slowing economy and rising defaults.

Activity

We were more active than usual in the fourth quarter of 2015. We made use of new exchange traded funds (ETFs) that sorted the universe of stocks for factors that were currently in favor. The three that we used most frequently were low volatility (choosing stocks with lower than average daily fluctuation), momentum (stocks whose prices had been showing relative strength when compared to the market as a whole) and quality (stocks of companies whose financial strength was superior when measured in several different ways). As investors grew more defensive, it was the low volatility strategies that performed the best relative to their respective categories. We used them both domestically and internationally. Also, given the tough sledding the market encountered in the second half of the year, we had a larger amount of capital losses to harvest for tax purposes in taxable portfolios.

Outlook

Three months ago, amidst a rebound in October after a very rough third quarter, we wrote that we didn’t expect that rally to lead to new highs. The first quarter of 2016 is obviously off to a poor start, perhaps confirming that the May 2015 all-time high was the peak for this cycle. Oaktree’s Howard Marks likes to talk about asset prices being more a function of psychology than any kind of hard science.<4> Investors tend to overlook negatives for a long time, then suddenly over-react to them. We have expressed our concerns about high stock valuations relative to modest economic growth for quite some time, but only recently have those concerns been borne out. Market leadership has been narrowing – health care is clearly no longer a leading sector, and there just aren’t enough consumer growth stocks to carry the market by themselves. Even some of those companies – Apple and Disney, for example – are now 15% or more off their 2015 highs.

The combination of a weak global economy and a Federal Reserve in credit tightening mode is probably too great a headwind to allow the market do much more than tread water at best over the next few months. As a result, we expect to maintain higher than normal cash positions and to continue to rebalance portfolios so as to reduce volatility.

Commentary – And Again…

“Wait a minute, Mark. If you are concerned about the stock market, why don’t you just sell everything and go to cash?” I hear this every time the market declines, and I have answered it before, but since it is topical I want go over it again. There are three reasons we don’t sell everything when the stock market starts to fall:

One: Because we don’t know if the current decline is temporary or whether it will last for a long time.

There is certainly fear out there, but nobody knows how long it will last and what the magnitude of the current decline will ultimately be. I do know that the stock market decline in 2016 has been pretty much in lock step with the price of oil. Falling oil prices hurt certain entities – oil producing firms and countries and the companies that supply them and anybody invested in them – in a very real way. It does not, however, hurt everybody. The average U.S. consumer is getting a dividend in the form of a lower gasoline bill and lower heating bills. At some point the market may focus on this. Right now, however, we are doing the equivalent of seeing the house across the street on fire and worrying that our house is going to be next. At some point, oi prices will bottom. That may or may not coincide with an overall market bottom.

Worry is something, unlike cash flow or return on equity, for example, that we as investment analysts can’t forecast. It grips the market for a time and then it goes away, sometimes gradually and sometime not. Historically, most 10% declines in the market do not turn into 20% declines and most 20% declines don’t turn into 40% declines. And yet some do. It is the lack of certainty about markets that creates volatility, but it is volatility that creates opportunity.

Two: Because there are many assets that do not necessarily decline when stocks do.

The first two weeks of 2016 have certainly been rough on stocks all over the world. Would it surprise you to know that most bonds are up this year? Government and municipal bonds more often than not rise in value when stock prices fall sharply. This is what is called negative correlation. There are other asset classes that often have negative correlations with stocks. Gold, for instance. Gold is up a little over 2% year-to-date. There are also certain type of funds that that will invest on trends in asset classes or commodities. These are called managed futures funds. They have the ability to profit from a decline in stocks, or oil, or copper, etc. As a whole, these types of funds are ahead in 2016 as well. The point is, one should not assume that just because stocks are down that everything in one’s portfolio is also declining.

Three: Because moving in and out of the stock market has a poor track record.

We know that psychologically the most comfortable place to be when the market is going down is out of stocks. That said, from an investing standpoint what is psychologically easy is seldom profitable. The herd does not get rich. It is often said that stock climb a wall of worry, because while there are always reasons to fear that stock prices will fall, most of the time they don’t. Just looking back over the past several years – a time period in which the S&P 500 more than doubled – there were plenty of reasons to have bailed out of stocks. The Federal Reserve embarked on an unprecedented expansion of its balance sheet (2009). The U.S. credit rating was downgraded from AAA to AA+ by Standard and Poors (2011). Greece has a credit crisis (2011) and ultimately defaulted (2015). Commodity prices began a sharp fall as China began to re-orient its economy away from massive capital spending (2012 to the present). Syria disintegrated into a war zone, throwing the Middle East into chaos (2013 to the present) and creating a refugee crisis in Europe (2015). The list goes on. And yet, General Mills still sells cereal and yogurt and Amazon still sends you nearly any material thing you could want in a day or two. Profits are still being earned all over the world.

More often than not, selling stocks on the basis of fear leads to buying them back later at higher prices. Vanguard, Morningstar, Dalbar and JP Morgan have all done studies showing that people’s actual returns are much worse than that of the mutual funds in which they invest because investors have a strong tendency to buy into rising markets and sell into falling markets. Wall Street even has a saying “bear markets are when stocks return to their rightful owners” that refers to the fact that any idiot can buy a rising market but only the savvy investor buys when prices are low. See Figure 2; the yellow bar represents the average investor return between 1995 and 2014 as calculated by J.P. Morgan Asset Management.

Figure 2: 20 Years Annualized Return by Asset Class (1995-2014)

Source: JP Morgan 1Q16 Guide to the Market

If we thought we could be more effective jumping in and out of the market we would. We’ve been doing this long enough that we remember the names of those who got one major market call right and never did it again. We don’t know of anybody that has consistently made that work.

The point is, we believe that all market conditions require intelligent, experienced management. Nobody rings a bell at the top or at the bottom. Market movements constantly confound expectations. One has to continuously evaluate one’s holdings in light of the current circumstances and be ready to make changes if necessary. The investment world is fortunately very diverse, so alternatives exist for just about any type of market condition. Going to 100% cash is not the only way to protect a portfolio; in fact it tends to reduce one’s returns over time due to the difficulty of timing one’s re-entry. All we really care about is being effective on your behalf; that is why we spend a considerable amount of time on research, analysis, and portfolio monitoring.

Thanks for your continued trust in our management program.

-Mark Carlton, CFA

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. <1> Source: YCharts.com. As measured by the total return of the ETFs tracking those indices from 12/31/2014 – 12/31/15: S&P 500: IVV, Barclay’s US Agg: AGG, S&P 600: SLY, MSCI EAFE: EFA, MSCI Emerging Markets: EEM, DB Commodity Index: DBC, Gold: GLD, High Yield Bonds: HYG. We’ve listed ETF returns because they represent an investible way to access the referenced index.

<2> Source: A Most Challenging Year, Zachary Karabell, Investpmc.com

<3> As measured by the Barclay’s Municipal Bond Index and the Barclay’s U.S. Mortgage Backed Securities Index. Source: Morningstar Adviser Workstation

<4> Latest memo from Howard Marks: On the Couch, January 2016, oaktreecapital.com

<1> As measured by the SPDR S&P 500 and iShares MSCI ACWI ex US Index ETFs. Source: YCharts.com

<3> Central bankers are responsible for monetary policy. Political bodies are responsible for fiscal policy.

<4> S&P Global Index Dashboard, July 2016

<5> MSCI ACWI EX USA NR $ (4.95%) versus Russell 3000 NR $ (3.93%).

<6> Russell 2000 Index (the smallest 2000 of the Russell 3000) gained 5.95% while the largest 1000 rose 3.77%.

<7> The Russell 3000 Growth Index gained 4.86% in July, beating the Russell 3000 Value Index (3.09%) handily.

<8> Source: YCharts.com as measured by GDX

Source: YCharts.com Chart 2 – 5 Year

Source: YCharts.com
Chart 2 – 5 Year