It seems like each update starts with how much the market has changed direction from the previous update. As this is written, the stock market has completed a horrible week as investors contemplate what the drastic decline in oil prices portends. (See Figure 1) CNBC wants us to think of this as a great blessing as lower gasoline prices will have a positive effect on consumer wallets. In time, they are possibly correct. In the short run, however, we are concerned about two things: one, what this says about the world economy in that global energy demand continues to decelerate; and two, what will this mean to those countries, companies, and traders whose “portfolios” were geared to much higher oil prices. Can Russia, Venezuela, and other oil producing countries survive economically if this continues for another year? What damage will be done to Iran or Brazil? Beyond this, what banks might be on the wrong side of hedge contracts at $90 per barrel? What global macro fund bought weakness in oil prices as it slid to $75, then $70, $65, and recently under $60? What might they have to sell to meet margin requirements? Rapid price changes in heavily traded commodities throw a certain degree of chaos into markets even if on balance they are positive to most participants.
Figure 1
Source: Stockcharts.com
The other concern is that this is coming at a time when global economies were also adjusting to the sharp rise in the dollar. This was playing out largely in emerging markets, where there has been capital flight this year since the carry (borrowing the dollar to invest in higher yielding currencies) trade is being rapidly unwound. As local currencies decline relative to the dollar, the price of imported goods rises and this inflation erodes living standards. Political instability is the result, and it often arises without much warning.
Europe should also be on investors’ concern list. Greece has recently seen a sharp decline in its stock market. Europe has a currency problem of a different sort – the Euro has risen against most world currencies (just not the dollar). This is making their products less competitive at a time when they desperately need to export. Germany, as Europe’s largest exporter, is the country being affected the most. Germans would be probably less able and willing to step in and help the Greeks if it came to that.
Corporate Bonds
By now it is apparent that the sell-off in oil has also had an impact on the corporate bond market. High yield bonds have been pounded as investors note that approximately 15% of U.S. junk bond debt<1> is energy related. Firms have borrowed heavily to develop shale gas plays from the Bakken in North Dakota to the Marcellus in the Appalachians down to the Haynesville and Permian formations in Arkansas and Texas. Some firms may not be in a position to cut production even if it is below breakeven because they need to service this debt. This debt sell-off has been a huge wake up call to many investment advisors – in a deflationary environment only high quality debt provides diversification. A five-year treasury note, even at 1.55%, is going to perform much better than a 6.25% five-year bond from a CCC-rated energy exploration and production company. On the whole, says Societe Generale’s Albert Edwards, U.S. corporate balance sheets are much worse than you would expect given the absurdly low borrowing rates of the past several years. Why? Corporations did shore up their finances between 2009 and 2011 as the economic outlook was cloudy. Over the past three years, however, they went on a borrowing spree in order to finance stock buybacks that would boost their earnings per share (EPS). The result is higher stock prices than fundamentals warrant because EPS is artificially inflated and because more leveraged balance sheets merit lower P/E (stock price to earnings) ratios.
Santa Claus Rally?
Normally as year-end approaches investors buy companies and industries that have done well on the year, hoping to capitalize on the momentum effect (which is typically strongest at the end of the year). This year there seems to be a trend of selling more volatile securities not likely to bounce back before year-end. It may be worthwhile for patient investors to consider the energy, mining, and machinery sectors that have been hit the hardest this year. I do not expect any kind of a fast economic recovery in these sectors, but all it would likely take is a sentiment change, say from loathing to indifference, to give their stock prices a boost.
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.
<1> Jennifer Ponce de Leon, Seeking Alpha, 12/8/2014
Summary
Stocks posted another gain last quarter as measured by the two major indices (the S&P 500 and the Dow Jones Industrial Average, see Figure 1), but it really didn’t feel like a good quarter, did it? With the small stock Russell 2000 Index falling -7.4% and the MSCI World ex-US Index off -5.7%<1>, diversified portfolios did not have much of a chance to finish in the black. See Figure 2.
Figure 1
Source: Stockcharts.com Figure 2
Source: Stockcharts.com
The proximate cause of the overall weak stock market was the global economic slowdown. First, the economic malaise in Europe appeared to spread to Germany, leaving that region with no remaining growth engine. Mario Draghi, president of the European Central Bank, who famously started the European recovery in 2012 by saying “we will do whatever it takes” to ensure that no EC member state would default, seems to have no solution for the recent slump. This has led to a steep decline in the Euro against the dollar. Measured in Euros, European stocks lost only -24 basis points (-0.24%) last quarter, but translated to US dollars that loss ballooned to -7%.<2> By and large, as unease about global growth spread, investors turned to the strongest and deepest world market (the U.S stock market), and bought those sectors they felt would be most immune to a cyclical slowdown (health care and technology). Energy stocks were by far the worst performers (-8.6%)<3> as not even significant unrest in the Middle East could offset the twin negatives of falling global energy demand and rising supply out of North America.
Risk aversion also spilled over into the bond market, which rose just 0.2%.<4> Despite all the warnings we’ve been getting about rising inflation, the best areas of the bond market to be in last quarter were interest-rate sensitive – long term municipal and government bonds. Foreign bonds had to contend with the strong dollar, which more than wiped out the interest rate-related gains (currency-hedged foreign bond funds performed well). High yield corporate bonds declined due to economic and liquidity concerns; investors grew concerned that bidders wouldn’t be there if the economy continued to slip.
Activity
The performance difference between large company stocks (up 8.3%) and small company stocks (down -4.7%) this year has been staggering.<5> We made some good decisions at the margin. We trimmed small company stock exposure in favor of larger cap funds. We bought municipal bonds in taxable portfolios. We sold out of high yield corporate bond positions such as Ivy High Yield. That said, some of our “good” decisions did not work out as well as we would have hoped. We selected Aston Independent Value for its willingness to go to cash if valuations got too extreme (the manager had skillfully navigated through the down markets of 2008 and 2011). Unfortunately, it declined more than -4% last quarter despite having over 70% of its portfolio in cash. First Eagle Global, a global fund with a stellar down market track record, failed to lose less on the down side this time. Past performance really is no indication of future performance, unfortunately.
Outlook
Last quarter we suggested that we were in a kind of best-of-all-worlds where the economy is growing enough to ensure profit growth but not strong enough to put upward pressure on interest rates, and that this allowed for modestly favorable stock and bond market performance. Recently this equilibrium was upset as world economic growth turned meaningfully lower. A weaker global economy is positive for bonds but not so for most stocks. We have been dealing with those global market dynamics since the fourth week of September. Once again the markets seem to be asking central bankers for a solution, but it appears their quivers are out of arrows. Perhaps there are limits to the power of the world’s central banks. Maybe if debt burdens are too high people simply can’t buy as much no matter how low interest rates are. Perhaps the world went on such a buying binge between 2003 and 2008 that flooding the capital markets with liquidity – as the Federal Reserve, European Central Bank, Bank of Japan, and others have done since 2009 – only delayed the inevitable. It looks like our luck might not hold after all.
That said, one good thing to come out of a weaker global economy is lower energy prices. Traditionally this helps the economy because consumers have more money left to spend after accounting for their energy needs. If we get a recovery in stocks over the next several weeks, it will likely be in the consumer discretionary sector as investors begin to bet on a stronger holiday shopping season.
Commentary – Is it the Golden Age of the Index?
I alluded earlier to two funds where we have done quite well in the past having failed to perform well during this market downturn. The list of funds meeting that description is unfortunately much greater than two. Some we owned and some we did not. The common denominator is that each of these funds has a high “active share” which is money manager speak for the degree to which the fund deviates from its benchmark. Over time, studies have shown that funds with a high active share add value.<6> That said, they do not always and at all times add value. We have been going through a period, obviously, where they by and large have not. The question then becomes, is this approach still valid? Should portfolios be run much more like market benchmarks?
We are always asking ourselves how we can make portfolios better. Can we squeeze out more return for a given amount of volatility? Could we actually get better returns taking less risk? According to an academic theory called Modern Portfolio Theory, the answer is no (because return and volatility are positively correlated). And yet in the real world the answer has been yes. Researchers have documented what is called the Low Volatility Anomaly which shows that low volatility stocks have actually outperformed the market.<7> Many funds have been created over the last couple of years to try to capitalize on this anomaly and have thus far done fairly well. I have to wonder, however, if we are not witnessing an over-reaction to a previous investing fad.
I remember managing money in the late 1990s. Academic literature and the success of Warren Buffett had long since established the supremacy of value investing (again, for the non-practitioner, the idea that one could earn superior returns by investing in statistically cheaper companies as measured by price-to-book-value, price-to-earnings, and/or price-to-cash flow). From 1993 through 1999, however, value investing most emphatically did not work! A portion of the underperformance during that time period could be attributed to the fact that many investors got caught up in technology mania. That said, I suspect another part of the underperformance problem may have been that value investing’s advantage was well known and by 1993 too many people were pursuing that investment style at the expense of faster growing but more expensive industries like technology which were poised for takeoff.
The point I’m trying to make is that good ideas can be taken too far, creating (temporary) anomalies in the opposite direction. Maybe some very good fund managers allowed themselves to venture too far from the benchmarks on the idea that the more “active” you were the better. I just find it hard to believe that so many great fund managers have lost their “touch” at the same time. Perhaps another explanation is possible.
We are going through another golden age of the index. By this I mean a time period where the major indices are very difficult to beat. Part of the reason is obvious – with very low expenses (including miniscule trading fees), they have a built-in advantage. That said, are markets really so efficient that no active manager can hope to outperform them over the long term? Increasingly index proponents are saying so. I just have a hard time believing that for two primary reasons. One, I know that almost all indexes are capitalization-weighted, which means that the more a component of the index (Apple, for instance) goes up in price the more of it the index has to own. The reverse is true with falling stocks. Therefore, at the margin every day the index buys high and sells low. That just cannot be a successful strategy over the long term. The other reason is that active foreign managers have done well over time relative to foreign indices. This is largely the result of Japanese stock having ballooned to a huge percentage of the MSCI EAFE<8> index by 1990 and then gradually fizzling lower ever since. Just about every active international manager was underweight Japan over the last two decades which helped them beat the EAFE. The same thing on a much smaller basis happened in the U.S. from 2000 through 2005. Microsoft and General Electric were valued at $586.2<9> billion and $475 billion respectively at the end of 1999. By the end of 2005 they had shed a combined $384 billion, and this contributed to the average active fund having beaten the S&P over those six years.
Since 2008 the S&P 500 looks exceptionally strong relative to the average stock fund. Much of this, I contend, is due to the superior performance of Apple, Inc., the S&P’s largest stock. Apple, with a market cap of $84.5 billion<10>, wasn’t even in the top ten at the close of 2008. Today it’s market capitalization is north of $600 billion. The S&P 500, therefore boosted its relative Apple stake sevenfold. Any fund manager not buying Apple with both hands over the last five years was at a significant disadvantage. I’m happy for Apple (and by extension the S&P 500), but I remember how Japan worked out for the EAFE.
The point is, no approach to portfolio management, be it active or passive, value or low volatility or otherwise, gives you an advantage that can be counted on at all times. There are factors that over the long sweep of time do appear to offer a modest advantage. However, at any given time the popularity of one or more of these factors may cause mispricing to the extent the advantage is negated or even temporarily reversed. Apple will not be the most valuable company in the world forever, and when it inevitably regresses towards the mean the S&P 500 will suffer on a relative basis. Active managers whose long term track record suggests some level of skill may once again prosper. Meanwhile, we will continue to do our best to combine those managers who have historically added value with indexes in areas where efficiency and low cost offset manager expertise. Sometimes it will be obvious that this approach adds value, and other times it will seem like we should have just indexed the whole thing. That’s just how it goes.
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.
As we wrote last month, the most prudent course of action statistically is to assume any particular decline in a bull market is a “correction” and not the start of a new bear market. Bear markets are only revealed over time. As of August 20th, stocks as a whole have recovered the entire -4.1% drop from July 24th to August 7th. The exception would be smaller companies, which have made up only a little over half of the -8% plunge they experienced earlier in the quarter. Through August 20th, the S&P 500 is up 8.8% year to date, while the small cap oriented Russell 2000 is down -2.1%. See Figure 1. Yes, stocks are expensive, but with the economy growing and companies continuing to buy back shares, the path of least resistance is still upward.
Figure 1
Source: Stockcharts.com
Internationally, markets are mixed. Investors are clearly picking winners and losers. Emerging market stocks are up more than 4% on the quarter, while “developed” foreign markets are off 1%.<1> Europe has been the worst performer, as sanctions against Russia have hurt a number of exporting firms. Many emerging markets have been helped by looser monetary policy in China, but that may be a sign of Chinese economic weakness so one should not necessarily see it as a green light. On the other hand, the Persian Gulf region, believe or not, has seen very strong economic performance lately.
Bonds benefitted from the “flight-to-safety” buying in the first five weeks of the quarter, but have cooled off somewhat of late. Of course this applies to high quality government and corporate bonds. Municipal bonds have the best return so far this quarter because they have rebounded with risk appetites this month without having sold off in July. High yield and international bonds dropped considerably in July and their recovery in August has been modest. Gavekal has pointed out the high correlation over the last five years between Federal Reserve policy and junk bond spreads.<2> The more active the Fed is, the narrower the spread gets because financial institutions take the low cost Fed money and buy higher yielding bonds. As the taper winds toward its conclusion, the risky bond “carry” trade becomes less attractive.
One of the worst performing U.S. sectors this quarter has been energy. Energy is almost always volatile, and even with the -2.6% quarterly loss the sector is up 10.3% year-to-date. That said, supplies are quite plentiful these days despite the conflicts in the Middle East. Demand is slipping as Europe-Russian trade dwindles and that is putting downward pressure on prices. With Germany, France, and Italy each failing to grow in the second quarter, I have to wonder how long the Europeans will go along with the Russian sanctions. As long as they remain in place, however, it is hard to be bullish on energy.
Fund Notes
One of the most successful funds over the last one, three, and five years from a risk versus return standpoint is the Deutsch Global Infrastructure Fund. It combines electric, gas, and water utilities, energy pipeline companies, and telecommunications. It has more or less matched the S&P 500 with a standard deviation of just 11, giving it a Sharpe Ratio (excess return per unit of volatility) of 1.59.
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.
<1> As measured by the MSCI Emerging Market Index and the MSCI EAFE Index, 1/1/14 – 8/20/14
<2> 5 Chars Showing the Taper Effect, Advisor Perspectives, August 20th, 2014
Market Perspective
Bear markets are a “when”, not an “if”. The goal is to go into one without being overly aggressively positioned, so you don’t have to sell into a declining market. If you can’t achieve the former, the next best thing is to be able to discern when you are truly in a bear market, as opposed to the far more common short term pullback. Many investors mistake the first 1% drop as the beginning of the next bear market. That is almost always wrong. Markets drop 1% or more frequently. Bear markets are never revealed on Day 1. The subsequent market activity reveals the bear. For example, the last bear market began on October 10, 2007. Investors didn’t really realize a bear market had begun until perhaps June 2008 because stocks had more or less moved sideways from November through May and while financial stocks were clearly signaling distress, other industries (energy for example) had been doing quite well. See Figure 1. In the previous cycle, stocks peaked on March 24, 2000, but the superior performance of real estate and consumer stocks masked the deterioration in the technology sector until late in the year.
Figure 1: S&P 500 August 2006 – September 2009
Source: Stockcharts.com
Stocks have made another very strong run, and investors are understandably worried about getting caught in another bear market that cuts markets averages in half. However, attempts in 2012, 2013, and earlier this year to “call the top” have been unsuccessful because tops don’t happen simply because the market has become expensive. What usually happens is that a long period of higher highs and higher lows gives way to a period where highs are no longer higher – the market cannot meaningfully break above its previous high.<1> Then the declines start making lower lows. Finally, the last rally falls well short of the previous rally high (as if there was simply no buying demand left).
Looking at our current situation, we haven’t had the first lower high yet on any average except the Russell 2000 small company average. Obviously, that bears watching. On the other hand, mid and large company stocks made new highs here in July. I re-iterate my concern regarding the shorter time horizon of today’s investors in comparison to years past. The natural result of a compressed investment horizon means that when the Federal Reserve is forced to remove the punch bowl (so to speak) the market’s reaction could be surprisingly swift and not all that pleasant. That said, neither the Federal Reserve nor the market’s technicals are at this time signaling a change in the bullish paradigm. Therefore, the bulls should continue to be given the benefit of the doubt.
Fund Notes
Emerging markets have been the best performing area of the market this month. China reported June economic growth above expectations, India continues to benefit from optimism tied to Modi’s election victory, Indonesia recently completed an election that the market likes, and the frontier markets of the Persian Gulf region and Africa continue to rise (go figure)! Morgan Stanley Frontier Emerging Market Fund (MFMPX) is a solid frontier fund due to an experienced manager, high active share and a tremendous resource base supporting the team. Matthews Asia has a very good India fund (MINDX) with a long track record. T. Rowe Price New Asia fund (PRASX) is worth a look due to the fund’s consistent long term performance and a low expense ratio. I would increase my exposure in these areas at the expense of Europe, which I believe got a cyclical respite after Draghi’s 2012 promise. The problems in Europe have been largely swept under the rug (I don’t mean you Ireland – keep up the good work) and could resurface at almost any time.
I have used the Sequoia Fund (SEQUX) extensively since it temporarily re-opened in the wake of the brutal market decline of 2008. Its long term track record is highly enviable. I know that if I sell out of this fund, it could be another 20 years before it reopens again. That said, I am extremely uncomfortable with its’ 18% position in Valeant Pharmaceuticals, a Canadian pharma firm with an aggressive growth-by-acquisition strategy. Sequoia now reminds me of Fairholme (FAIRX), another non-diversified fund that doesn’t shy away from controversial positions. All of this may be well and good for the speculator, but I am questioning its place in the portfolios of moderate risk investors.
This has been a fairly rough month for high yield bonds. By the end of June yield spreads versus Treasuries had just about reached all-time lows. Many funds were advising reps to continue to buy them because they still yielded well above Treasuries and default rates would likely remain low. The problem with this “picking up pennies in front of the steamroller” approach is that a small reduction in liquidity can wipe out the yield difference. In July investors started to become concerned about the health of the stock rally in light of the Fed’s continuing taper. High quality bonds are “ballast” – they usually move opposite from stocks on economic concerns, so they reduce overall portfolio volatility. High yield bonds, of course, are pro-cyclical. They typically move in the same direction as stocks. The strong performance of higher quality bonds relative to lower quality bonds this year has nothing to do with inflation expectations and everything to do with ballast; there just aren’t many investments with extremely favorable risk/reward ratios left anymore.
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.
<1> If it does so, it is by a small amount, or on weaker volume, and fewer stocks are part of the advance.
Summary
The stock market rally continued through the second quarter of 2014. There was a brief -4% “correction” in early April but stocks quickly recovered and continued to make modest new highs throughout the rest of the quarter. The market has risen steadily without as much as a 10% pullback since June 2012. Obviously, this can’t last forever. That said, there are few signs that it is about to end.
Figure 1: S&P 500
Source: Stockcharts.com
Overall, the U.S. stock market gained 4.9%<1> in the second quarter (see Figure 1). Large company stocks performed quite a bit better than small caps, with the S&P 500 rising 5.2% and the Russell 2000 ahead only 2.1%. The April correction was much harder on smaller stocks, though they had a very nice recovery in June. Energy stocks soared 12.1% last quarter to lead the way, while financial stocks gained just 2.3%<2>. Stock market performance this year cannot be explained neatly by risk appetite, growth potential, or interest rate sensitivity. Sector specific factors have been the most significant component of returns; for example merger activity has positively impacted the health care sector, while consumer weakness has hurt retailing stocks.
Foreign stocks gained 4.6%last quarter while emerging markets bounced back 6.6% from their first quarter decline<3>. Latin America and Asia performed well for a change, while Europe’s 3.3% gain brought up the rear. Investors seem to have shrugged off earlier concerns about the Ukraine, China, and Iraq, but of course one never knows when they will resurface.
In the bond market, the positive investment climate from the first quarter largely carried over. The Barclays Aggregate Bond Index gained 2.0%, and riskier classes of bonds (emerging market debt and high yield corporate and municipal bonds) performed even better. Short term bonds rose just 0.3%<4>. Bonds investors have been paid well over the last five years by taking extra risk. I am increasingly concerned that investors are looking at non-government bonds as a kind of “free lunch” since their yields are higher. That would be a mistake.
Activity
When things are going well our primary job is to look for funds that are underperforming their benchmark and then to determine whether or not that underperformance is likely to be temporary, and thus recoverable. If not, we replace it with a fund with similar objectives whose managers are navigating the current market environment more skillfully. We made a couple of exchanges in the international and small company stock areas for this reason. We also trimmed the Sequoia Fund. In general, we sought to increase average market capitalization (move from small to large) and from growth-oriented to value-oriented. Both of these moves made our portfolios a little more conservative.
Outlook
At this point, there are two concerns I believe could end the current bull market in the next few months. One is a return of the European sovereign debt crisis and the other is a negative market response to Federal Reserve policy. To be clear, at any given time there are many other things that may negatively affect the market but I believe those two to be the most pressing.
I worry about the European situation because those governments believe the implicit guarantee by the European Central Bank (ECB) to back their debt against default makes it ‘safe’. This strikes me as not too different from believing U.S. mortgage debt was ultra-safe a decade ago because all of the rating agencies said it was. At some point, the ECB’s policy will be a significant problem. However, predicting just when that will occur is extremely difficult.
With regards to the Federal Reserve, the Board of Governors is doing intellectual contortions to justify the continued low interest rate policy. The national Unemployment Rate is now within their stated target range and inflation measures have begun to moderately rise (another policy goal). Thus far, the Fed’s remarkable credibility has been a major determinant in the success of Quantitative Easing (QE). Credibility, however, is a fragile thing and just because QE hasn’t caused a spike in interest rates doesn’t mean it won’t do so in the future. If they lose it and bond investors demand higher rates to protect them from inflation, bond and stock prices will both tumble.
All of that said, however, we remain in a ‘best-of-all-worlds’ environment in which the economy is growing but not too strongly. With such a favorable backdrop both stock and bond investors may continue to make money well beyond the rest of this quarter. Our luck could hold.
Commentary
Those of you that have read past commentaries know that I am interested in the concept of odds. Two quarters ago I wrote about stock valuations (Come On Stocky!) with the idea being that cheap markets put the odds of good returns in your favor and expensive markets stack the odds against you. I qualified this message by stating that valuation does not move markets in the short term (expensive markets can, and usually do, get even more so before they top out), but it is always important in the long term. If it were known, however, that the Federal Reserve was actively trying to manage investor expectations so as to engineer favorable market performance (believing that strong markets will improve the employment situation) then how much attention should one give to stock valuations? Regardless of how cheap or expensive the market might be, in the absence of some major external shock, stocks are going to go up until the Fed changes this policy.
As money managers, we do a lot of research on past market cycles with the belief that such information will be useful in predicting future market cycles. We want to know if there are factors that signal that the market is cresting or about to peak, because that would theoretically be an excellent time to reduce risk. In the past, rising measures of economic performance (capacity utilization, industrial production, raw material prices paid, etc.) were signs that the Federal Reserve would have to begin raising interest rates to prevent a surge in inflation. So too was a flattening yield curve. Today, however, the Federal Reserve seems to want to create an investment climate that is perpetually favorable with its very low interest rate policy and refusal to incorporate any data suggesting the business cycle is actually fairly advanced (rising food and energy prices). Additionally by manipulating the bond market through the purchase of treasuries and mortgages (QE), the Fed achieves an upward-sloping yield curve that suggests a mid-business cycle environment, which is favorable for investors.
You might be thinking; “wouldn’t it be perfect if the Fed could maintain a favorable investment climate forever?” Perpetual growth, no recession, no sustained stock market declines – what’s not to like? The problem is that favorable business and market conditions create economic excesses. Unlimited liquidity (as much cheap credit as a business needs) means poorly run companies don’t go out of business, they just limp along and negatively impact the profitability of their competitors. It means there is no competition for limited credit, so savers earn extremely low rates of interest. It means that leverage is cheap, so the best investment returns go to the most financially reckless.
So manipulating the credit markets is undesirable because it fosters bad financial behavior. Is that the only drawback? Actually, no. The other is that it ultimately fails. Economic and market cycles can be altered but not eliminated. Ultimately the dam bursts. The Fed will ultimately be forced to begin restricting credit, and markets will then lurch from risk-on to risk-off. Valuation will suddenly matter again. When the pain of bad economic decisions finally arrives it’s much more acute because many people didn’t understand the gravity of their past economic behavior. They “just did what everybody else was doing” (think of all those who re-financed into adjustable rate mortgages last decade).
One last idea; I noted on the first page of this commentary that stocks have not had a -10% correction in over two years, which is quite unusual. That may not be a good thing. Small losses enforce the idea of prudence, and prudence helps us avoid large losses.
We are doing our best to navigate this environment. We really don’t see a great deal of near term economic risk, but in an artificially low interest rate environment that may not be the critical factor. We know valuation is not an effective timing tool; rather it is more like a guidepost on a very complicated trail. At the bottom of the market in March 2009 prices were so cheap that success was almost assured if one had a time horizon of more than, say, six months. It was the financial equivalent of needing to roll anything except a “1” on a six-sided die. Today valuations are in the upper 10% of their historical range, which suggests we need to roll a five or a six. Despite the seemingly bad odds, the stock market keeps rising because everybody knows that world central banks have supplied the markets with the equivalent of loaded dice. But as I have stated, they can’t do this forever.
To be clear, I don’t dislike the Fed. In fact I believe their actions in 2008 kept things from becoming a whole lot worse. My concern is simply that by expanding their balance sheet (QE) and keeping interest rates artificially low they may have created a situation where they can’t back away from these policies without creating a lot of turmoil in the markets. Stocks have had a great run since 2009 and are clearly on the expensive end of their historical range. Although the internal market measures we monitor look good right now, this ‘best of all worlds’ environment may present a situation in which we don’t want to wait until the last note played. The race to the exits, when it comes, might be especially rough this time.
Remember, we update our blog periodically with my latest thoughts on the market. (www.trademarkfinancial.us/blog) If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at cynthia@trademarkfinancial.us or 952-358-3395.
We appreciate your continued trust in our management program,
Mark A. 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.
Stocks finally broke out of their trading range after the Memorial Day holiday as investors decided that the economy was in fact growing (and that the -1.0% GDP figure for the first quarter of 2014 was a largely weather-driven anomaly). Bond yields had fallen as far as 2.41% (10 year Treasury) on May 29th, but recent economic reports have indicated that demand is recovering. Last Friday’s employment report seemed to confirm the emerging consensus that the first quarter’s deflationary omens could and would be overcome. It boils down to faith in the world’s central banks, which remains strong. The European Central Bank is willing to push interest rates so low that depositors earn a negative savings rate. The U.S. Federal Reserve continues to signal that there is no unemployment rate at or under which they will be compelled to raise rates. Both Japan and China have signaled market-friendly policies in recent days. It becomes difficult to be short term stock bearish when world central banks are telling investors everything they want to hear.
Breadth has improved as well. I was very concerned three weeks ago that market leadership was narrowing away from small caps and cyclically sensitive stocks, and I said that trend bore watching. Once again, rather than the blue chips following the other stocks down, what we saw was a bounce by the lagging sectors. The Russell 2000 is still behind the S&P 500 by close to 5.5%, but this spread was over 7% four weeks ago. The key fact is that the upward trend has resumed.
There are basically three possible scenarios – rapid economic acceleration, anemic economic acceleration, and economic deceleration. The first would soon lead to fears of inflation since the money supply has been expanded so greatly over the past few years. Bonds (incuding lower rated bonds) would perform terribly from the get-go, and stocks would follow soon after. Hard assets like gold would probably perform best. Economic deceleration, on the other hand, would be bullish for high quality bonds and bearish for almost everything else. A continuation of our anemic economic performance, while it would be politically and socially problematic, is still the best case for investors (both bond and stock). Remember – artificially low interest rates = artificially high stock and bond prices. Anything that would change this environment is market negative.
Emerging markets have done quite well over the past three weeks. Sometimes when a sector is out of favor and cheap you have to hold your nose and buy. We are all aware of the problems in China and Brazil but the the emerging world is a lot more diverse than that. Latin America and India have provided the spark. To me, this is a more attractive play than Europe because the former has performed very well over the last 12 months and the recent election results suggest many Europeans believe the current policies are not working.
There are a few funds whose year to date performance is worth highlighting; in the Large Cap Growth area American Funds (AMCAP) and Parnassus Endeavor (PARWX); in the Large Cap Blend area Oakmark Select (OAKLX) and Putnam Multi-Cap Core (PMYAX). Other funds of note are: Vanguard U.S Value (VUVLX), T. Rowe Price Value (TRVLX) and Dodge & Cox International Stock (DODFX).
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.
Stock prices have leveled off here in 2014. The blue chip averages have recovered from both their January correction (6%) and a smaller one in mid-April (4%), but have not been able to meaningfully break out to the upside. Meanwhile the small cap Russell 2000 has been in a steady downturn since peaking on March 4. It currently stands 8% below its closing high on that day. Mid cap stocks are just two percent below their all-time high on March 7th. So together, the indices paint a picture of a bull market ever-so-gradually losing thrust, much like we saw in 2007. Stocks moved in a narrow range for most of that year but could not push beyond very slight new highs in July and October – before decisively rolling over the following January. Note that this is not conclusive – the stock market looked like it might roll over in June 2012 and November 2012 before embarking on a strong run through 2013. It is just something to watch.
Bonds have had a surprisingly good run in 2014, with the benchmark up 3.4% year–to-date. Terrible sentiment to begin the year allowed bond prices to become attractive. A harsh winter and much weaker than expected consumer activity started the bond rally and this in turn forced managers under-weight duration to aggressively pursue long Treasuries and TIPs. The credit trade appears to have stalled out as investment grade bonds have outperformed high yield bonds since mid-March. Again, not conclusive but another thing we watch to help determine when the market might move into a more serious “risk-off” mode.
That the best sectors so far this quarter and year are either late cycle (energy) or defensive (real estate, utilities, and consumer staples) is also a concern. That said, economically sensitive sectors (industrials, materials, transports) are not at the bottom of the list, which you would expect if a major correction were at hand. Media, biotechnology, housing, retail, and financial services are the worst performers. My conclusion is that the manufacturing sector of the economy is still in the recovery part of the cycle but the much larger services sector is sliding towards recession.
The big question, therefore, is what do we do now? If bond yields are low and the oversold catalyst they had at the beginning of the year is spent and the high yield spread compression trade is also played out, then bonds seem pretty unattractive. On the other hand, stocks are expensive on a price- to- trailing 12 month earnings and price-to-cash flow basis (only price- to-forward earnings estimates provides a favorable valuation level). Earnings from consumer-oriented industries continue to disappoint. Defensive industries had some promise at the beginning of the year because they had been heavily sold in 2H13, but after double digit gains by real estate and utilities and a high single digit return from staples, there is no longer a value argument to be made. Federal Reserve policy has made it cheap and easy to exploit any valuation anomaly to the point where there just aren’t any cheap assets left (at least domestically). Arjun Divecha of GMO put it best at a recent conference I attended: “You make more money when things go from awful to merely bad than you do when they go from good to great”. Awful doesn’t exist anywhere in our markets today. Awful is in certain emerging markets like Brazil, but not much elsewhere. Even Greece isn’t awful anymore, it is merely bad (and had one invested in Greek debt two years ago when it was truly awful, one would have done extremely well). GMO’s 7 famous 7 Year Asset Class Real Return Forecast<1> is presented in Figure 1.
So, to answer the question I began the previous paragraph with, I would be selectively defensive. I would not underweight bonds, because the worst case scenario in bonds is a lot better than the worst case scenario in stocks. I would over-weight foreign stocks relative to domestic stocks and Treasuries relative to corporate bonds. I believe we are a lot closer to the top of the roller coaster than the bottom so I want to minimize the impact of the next down wave. If I am wrong, it will probably be because investors were not willing to venture overseas despite favorable relative valuations, and an early 1970s/late 1990s type bubble broke out in selected large cap U.S. stocks. I am willing to take that risk because I believe my opportunity cost (what gains I might miss if I am wrong) is among the lowest I can remember in my 28 years in the business.
Figure 1
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. 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.
<1> Figure 1 is GMO’s approximation of what we can expect if valuations revert to the mean. This assumes a higher average P/E for equities in line with the more positive experience of the last 30 years. If they were to use the data over the last 90 years (good records were kept only from 1927 on), the return expectations would be worse. GMO’s 7 year forecasts have been surprisingly good (including their famous 1999 call of negative 7-year returns for stocks).
Summary
After a very strong 2013 it was reasonable to expect there would be some period of consolidation in 2014. Stocks gave back about 5.7% through February 3rd before rallying to new highs by the end of that month. March saw choppy sideways trading for the most part, but at quarter’s end the S&P 500 was standing 1.8% higher. This gain occurred despite a looming crisis in Ukraine, much cooler than expected weather here in the United States, and economic disappointment in both China and Japan. The silver lining for investors was that despite the fact that the Federal Reserve did begin to taper bond purchases, the bond market performed very well. In fact, bonds slightly out-performed stocks over the quarter.
Until the very end of the February, it seemed like the same market sectors that drove the market in 2013 would continue to do so in 2014. Biotechnology stocks rocketed up close to 30% in the first eight weeks of the year, on top of a 50% gain in 2013. At some point, however, all speculative rallies end. Almost all of that 30% gain was gone by the end of the quarter, and as this is being written the sector is down 6% year-to-date. Many social media stocks could tell a similar story, as could market darlings like Tesla. As the high fliers began to falter, however, income-oriented sectors came back into favor. Real estate and utilities, two sectors that really struggled when the Fed announced tapering back in May 2013, posted gains of more than 9% last quarter. Other higher yielding sectors – telecommunications, financial services, and energy – also benefited in March from the rotation out of high momentum growth stocks.
International stocks struggled early in the quarter, and that trend got even worse when Russia grabbed the Crimean peninsula. In March, however, emerging market stocks reversed to the upside as very cheap valuations drew in money leaving hot sectors in the United States. Brazil and India were some of the bigger countries that got a boost, but the Middle East, Indonesia, and Vietnam also scored double-digit gains. On the whole international markets gained a little over half a percent on the quarter, but the performance varied greatly<1>. Japan, which seemed poised to end its two-decade-plus economic slide, lost 5.4% last quarter. Russia, for obvious reasons, was the worst performing market (-15%).
All categories of bonds gained last quarter, with the average being about 1.8%<2>. That said, the dynamics of the bond market swung wildly. The first two months were a continuation of 2013 for high yield corporate bonds, which tend to do well when stocks do. This sector cooled off by quarters end. Longer maturity, investment grade debt (both taxable and municipal) rebounded sharply from a horrendous 2013. Emerging market debt surged in March just like emerging market equities. Overall, interest rate sensitivity was a good thing as rates declined during the quarter.
Activity
A very strong trend is a wonderful and dangerous thing. The long term outlook for health care seems very bright with average ages in the developed world continuing to rise. Early in the quarter the concern was whether we were capturing enough of that trend. We added funds like PRIMECAP to more aggressive portfolios to get more exposure to healthcare than we would get from T. Rowe Price alone. By the end of the quarter the correction in that sector was in full swing, and we looked to trim positions in the T. Rowe Price fund that had grown from say 4% to 6% or more.
We also saw the chance to add to our existing international bond positions, as that neglected sector finally began to show some life in March. Lastly, we built up our international stock positions by increasing our holdings in VEU, a low cost foreign stock ETF that includes emerging markets.
Outlook
At the risk of extending the zebras and lions metaphor past its “best if used by” date, it would seem that the lions are back.<3> We have moved into a higher risk environment now, because we have had a taste of the factors that are likely to eventually end this bull market:
The tapering has begun. The Fed is still friendly, but it is gradually becoming less friendly;
China is slowing. The biggest global engine of demand is sputtering;
Geo-political strife. The upside of reducing our commitments in Iraq and Afghanistan is an improvement in our national balance sheet. The downside appears to be emboldened adversaries (Syria, Russia).
It would seem that investors are taking the classic zebra approach, namely moving to less economically sensitive areas such as utilities, real estate, gold, and treasury bonds. Last year’s leaders have fallen from grace recently, leaving markets more volatile. At this moment, it remains to be seen whether investors will be content to rotate (move money from one area of the market to another) as opposed to selling outright. It should be noted, however, that the market “traffic signals” very frequently go from green to yellow and then back to green. Red lights are thankfully uncommon.
Last quarter’s Commentary, entitled “Come On Stocky”, tried to convey that stocks had risen to a level where even if everything was to go right in 2014 it still would be very unlikely to see another 30% gain. Obviously, everything isn’t going right and stocks are struggling a bit. I am not too concerned because most of the current activity should be seen as volatility. Stocks fluctuate. Every investor who contemplates a stock investment should be aware of this. Risk, on the other hand, is the possibility you will buy something at a price that once lost will never be recovered. In the parlance of finance we call that phenomenon a permanent impairment of capital. In a diversified, un-levered mutual fund or ETF, you are almost always dealing with volatility rather than risk. Risk comes in when you buy into a situation where valuation and expectations reach a level that economic reality cannot justify (like technology stocks in 1999 or real estate in 2006). Social media and biotech stocks were beginning to look that way back in late February. We always try to limit exposure in any area of the market where the risk of permanent impairment of capital is present.
Commentary – Party Time!
One of the keys to understanding stock market movements is that sentiment changes drive prices. Let me explain. If I polled all stock market investors and discovered that 80% said they were long the stock market and 20% said they were short, you might assume that stock prices were heading higher. You are probably going to be wrong. In fact, given those results, there are vastly more potential sellers than potential buyers. Put another way, the expectation of higher prices is too great. Stocks will only go higher if the ratio gets more lopsided. The fact is, markets cannot accommodate everybody being right. They can accommodate a majority but not a consensus. Once confidence levels in any market event get above 70%, the risk of reversal becomes statistically greater than the potential for further profit. This is why experienced professionals become very uncomfortable when their position becomes the consensus.
Perhaps the best analogy is to think of investors as party goers. Every party has a “cover charge”, or a cost to get in, but in return you get a little piece of the cover charge that every subsequent party goer pays. Therefore the cover charge rises for every new party goer. If you get there early the cover charge is low but it may turn out that very few party goers show up. In that case, you don’t recover the cost of entry and you miss out on a better party. At least when the party ends (as all parties invariable do) the cost of the cleanup will be minor.
As you can see, investors do well when they get to a big party before a substantial amount of other investors. If you are the last to arrive, you will pay a lot to get in, collect nothing from those that come after you, and bear a huge cleanup cost. This is where strategy and nerve enter in. Do you have enough confidence to be the first person to show up? Most people don’t. They fear no one else will show up, and they don’t want to miss out on a big party somewhere else. Ultimately, every asset class is going to host a party. The difference is, some of these parties get a lot bigger and some parties last a lot longer than others.
The Biotechnology “party” has really taken off since mid-2012. Figure 1 shows the Biotech sector’s performance since that time. New product introductions had soared, and earnings exceeded expectations. By this past January it became a blow-out. Everybody wanted in. It was just too hard for the investors over in financial services or home construction or emerging markets to see that big party across the street. At first they resisted because they didn’t want to pay the cover and they feared maybe that party was about to end and the party goers just might come over here. But you can only watch other people have a great time for so long – “They sound like they are having so much fun. More people keep showing up – I’m sure that more will come after I get there”. When sentiment gets that strong, you know the end is near.
Figure 1
Source: Stockcharts.com
What makes a great party is a narrative, or a reason why the party should last a long time. That is how you get people to leave other parties to come to yours. Growth investors have an ear for narrative. They seek to determine which parties are going to turn into all-night bashes. Value investors will only go to parties if they can get there early and pay a low cover. That way they can still come out ahead if only some of the parties turn out to be big successes. Indexers try to attend every party for at least a little while. It is more important to them to avoid having the worst results than it is to try to have the best results.
No party going strategy always works. This just makes sense – if any one strategy always worked everyone would practice it and everyone would earn above average returns (which is impossible). If it were possible to show up when you knew the party was already a smash but pay the same entrance fee as the first one there, everybody would try to be fashionably late (again, by definition, impossible). That said, the strategy of going to the biggest party and paying the highest price of admission is one that almost never does.
We try to diversify all our approaches because again, no one strategy works in all environments. We participate in the big parties to some extent, but only moderately with medium risk investors and not at all with low risk ones. We pay a lot of attention in all portfolios to what we might lose (our cleanup costs, if you will) if the party we are at should immediately end. To that end, we strive to determine whether our market beliefs are becoming consensus (in which case there are too few left to come to the party). It is important to understand the trends and narratives that drive the market, but even more so to know to what extent those things are already priced in.
We appreciate your continued trust in our management program,
Mark A. 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. 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.
<3> See our 3Q13 Quarterly Commentary for a detailed discussion of the lion and zebra metaphor. Feel free to contact us for a copy.
Market Leadership Rotation
Last week saw one of the biggest asset allocation reversals I have ever seen. Going into last week, the quarter had been led by gold and health care (especially biotechnology). Small company stock had performed better than larger companies, growth stocks had outperformed value stocks, and domestic stocks handily out-paced foreign stocks. Emerging markets were the worst of all. Until last week. The last five trading days saw biotechnology give up more than half of it’s year-to-date gain, slipping from roughly 11% to 4% up. Gold has gone from a mid-20% quarterly advance to 16%. Growth stock funds across the board have all but surrendered what once were 2-5% gains, especially those that focus on momentum-oriented high flyers like Facebook and Tesla.
On the other hand, the last are trying hard to be first. Emerging market stocks had been down 6.5% a few days ago; now they are down less than 2% (thanks India and Brazil!). International developed markets were down 3% and now they are close to break even. U.S. value stocks managed to lose very little last week and with a gain of just under 1% are now ahead of growth stocks. It would be hard to imagine a better lesson on the importance of diversification and the virtue of patience.
It appears that investors are coming back to income oriented securities too. As you recall, income was a big casualty in the wake of last May’s Federal Reserve tapering fiasco, with REITs, utilities, and pipeline stocks all losing more than 10% between the end of May and July. Bonds had a tough time of it as well. This quarter each of those areas has done well on a relative basis. REITs are up 8%, utilities close to 6%, and infrastructure and pipelines around five percent. Bonds are up 2%, which is surprisingly good given that everyone was sure interest rates could only go up in 2014.
Generally, when the leading industries in a rally falter, you have a period on instability and higher volatility as the market seeks new leadership. So far we have been very lucky, because money has largely rotated on a sector, size, and geographic basis, instead of coming out of the market altogether. On the whole, the sectors being rotated out of are more aggressive (more tied to economic growth) than the ones where money is flowing in. This is not a healthy sign. That said, the money flow on an international basis is not nearly as much risky-to-safe as it is here, so perhaps the foreign stock rally will have legs.
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. 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.
Market Activity
We got off to a bit of a bumpy start in 2014, but we seemed to have stabilized in the last week. Emerging markets have been the focal point of the concerns that have the market under pressure so far this year. There are concerns about liquidity, specifically that investment funds are being withdrawn from the emerging market as investors digest the impact of Federal Reserve tapering. Some of this was predictable. If you consider that the U.S. trade deficit is narrowing significantly due to our boom in domestic energy production, you would realize that the surplus the rest of the world runs with the U.S. is therefore shrinking. Certainly there are fewer U.S. dollars swirling around the Middle East. If an expansion in the U.S. economy does not translate into a widening trade deficit, the world is not getting the dollars they need. (This is especially true for those countries that use dollars to subsidize domestic fuel costs. Their choice is to raise fuel prices – hurting the economy and possibly provoking unrest – or allowing their currency reserves to dwindle and invite more capital flight). Emerging markets are the cheapest they have been since the summer of 2011, but still considerably (85%) above their 2009 lows.
Something to keep in mind – we are seeing many more days where the market gains or loses more than 1%. That is a warning sign. Before a bull market turns into a bear market, volatility always increases. The word market professionals use is distribution, meaning that “smart” money is a net seller of stocks, distributing them to newcomers with the idea of buying them back after the sell-off at lower prices. Markets tend to top out over a period of many months. In 2000, stocks peaked in the first quarter and went sideways with increasing volatility until Labor Day, when the bear market really got going. In 2007 stocks peaked on a broad basis in May, but the market made a nominal new high in October and even into May 2008 looked poised to challenge the 2007 high. Mutual fund strategists are bullish as they always are (that is their job). Portfolio managers are a different story. They are the ones complaining about the lack of attractive opportunities and asking for their funds to be closed to new money.
Real Estate
Real estate has been a pleasant surprise so far this year. The year-to-date gain of more than 7% is ahead of all sectors except precious metals. The recent tepid job reports have really helped income –oriented securities because investors are a lot less concerned about a sharp increase in interest rates. (It was assumed that if the Fed bought fewer bonds, interest rates would certainly go up because by definition supply would be greater. That has not happened). REITs prices are still 10% below their May 2013 highs, so valuations remain reasonable.
Gold
I am not as enthusiastic about gold even though it has made a very strong move so far this year. Gold fell a stunning 38% from its 2011 peak to last December. It is up roughly 10% since, and may go up another 10% before stalling out. I’m just wary since gold’s bear market has been so short relative to the bull market that lasted almost ten years. Gold trades at a price it first reached in late 2010; by contrast real estate trades at a level it first reached in early 2006.
Bonds
It is interesting to me that the best performing sector of the bond market is high yield municipals. Long term bonds have done well (in relative terms) because everybody expected higher rates and shortened maturities. You always have to remember in this business that whenever investors reach a consensus (about anything), THAT CONSENSUS WILL BE WRONG! I like longer maturities because they are under-owned at this point, and I prefer to get them through muni bonds because they were over-sold on the Detroit bankruptcy and Puerto Rico debacles last year. Too many bond investors have focused on interest rate risk these days and not enough are worried about credit risk. Next economic downturn we are going to see a very powerful flight-to-quality.
-Mark Carlton, CFA
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