Summary

Sometimes a quarter passes and nothing much happens.  Other times, so much happens in a quarter that it seems like a full year.  The first quarter of 2022 falls into the latter category.  Supply bottlenecks and then, of course, the inflationary implications of the war in Ukraine brought large price changes to bonds (negative) and commodities (positive).  Energy and resource-related stocks were the biggest beneficiaries because supply disruption translates to higher selling prices.  Other sectors could not as easily pass on their higher costs.  Technology and consumer discretionary stocks were the biggest losers in the latter category, dropping around nine percent.

The S&P 500 large company stock index, down more than -10% on March 14th, managed to recover over half of that by quarter end to finish off -4.6%.   The late quarter bounce was driven by the desire for safer, larger, dividend paying stocks, thus small caps had a much smaller bounce and finished -7.5%.  The technology-driven NASDAQ Composite Index was off -8.9%.  As we shall see below, there was no help from foreign stocks or bonds last quarter; only utilities and commodity-oriented funds managed to post a gain.  Energy was far and away the best sector last quarter, but as it represented less than 4% of the S&P 500 at the start of the quarter, it could hardly offset the negative impact of technology (almost 25% of that index).

As a whole, international stocks were down -5.9% last quarter.  Again, there were bright spots.  Latin America, on the strength of soaring demand for Brazilian oil, Argentinian agricultural products and Chilean copper (among other things) roared ahead 27.3% last quarter.  That said, Latin America accounts for less than 2.5% of the total international index, so the drag from Europe (-9.6%), China (-14.5%) and Japan (-6.6%) was just too strong.  Most international markets were not helped by ongoing strength in the U.S. dollar.

Bond investors experienced their worst quarter in more than 40 years.  The benchmark Bloomberg Aggregate Bond Index fell a staggering 5.9%.  Considering that the index yields around 2%, roughly three years’ worth of coupon payments were lost last quarter.  The bond market had been telegraphing weakness for quite some time, so we were able to substantially reduce interest rate sensitivity before bond yields had their big post-invasion spike.  Other than short term floating rate treasuries (+0.2%), one could not have made money in bonds this past quarter.   Municipal bonds performed especially poorly (-6.2%) as very low yields and overbuying in 2021 made them particularly vulnerable to rising interest rates and investor flight.  High yield corporate bonds lost -4.8%.

Activity

Since this was a very eventful quarter, there was much more activity than usual.  As interest rates rise, future earnings become less and less valuable relative to current earnings.  If the rise in interest rates is gradual, the stock market tends to take it in stride.  If rates rise sharply, as they did this past quarter, the stock market gets alarmed.  In fact, the whole valuation paradigm of the market can be thrown into question.  Specifically, if the prevailing environment is low and generally declining interest rates, as it had been the great majority of the time between 2009 and 2021, it makes sense to pay up for rapidly growing companies even if that rapid growth is still in the revenue stage and had not progressed to actual net profits.  If, however, interest rates begin to soar and funding costs climb, investors quickly tire of rapidly growing, unprofitable, companies that need to spend every dollar of revenue to fund growth. Not when they can buy a company that is already profitable and seeing demand for its products grow such that it is able to raise prices faster than its input and labors costs are rising.  This is how natural gas and coal investors make 35% in a quarter while biotechnology and software-as-a-service investors lose 35%.  Growth is out, value is in.  Small caps, especially if they are growth-oriented and outside the U.S., are especially vulnerable when the paradigm changes back to “bird-in-the-hand” companies and away from “two-in-the-bush”.

The number of changes necessary for most portfolios required a complete re-balance.  Because we had already reduced the duration (interest rate sensitivity) of the bond portion of portfolios in 2021, the biggest change on the bond side last quarter was the outright substitution of alternatives like commodities, real estate, or merger arbitrage for coupon paying bond funds.

Outlook

In my investing career I have never seen a wider range of possible market and economic outcomes than exist today – Doug Kass, President, Seabreeze Partners

First of all, bond yields have moved up a considerable amount in a very short period of time, so I expect yields to stabilize in the short run.  That should be a positive.  I am concerned that the Federal Reserve has, because it was overly accommodative in 2019 and again in 2021, put itself in a position where it probably needs to err in the other direction over the next few months.  The resulting contraction in liquidity is probably not going to do markets much good.  With an ongoing crisis in Ukraine and the midterm election coming up, it just feels like the headwinds exceed the tailwinds this year.  Allocating a higher percentage to hard assets like industrial and agricultural commodities, precious metals, and energy seems like a prudent way to get through what promises to be a prolonged period of above average inflation.

Looking farther out, the recent correction in growth stock prices has made this sector of the market much cheaper.  Strong companies that sported eye-watering P/E multiples last year such as Adobe, Chipotle, Nvidia, and Intuitive Surgical are down 20%-40%, so while not cheap per se, they are at least much more reasonable.  They have a good chance of rallying once investors believe that the end of the Federal Reserve rate hiking cycle is in sight.

Commentary– of Trends, Wolves, Torches and Lebron James

It’s a tough quarter when somewhere around 96% of one’s investable universe declines in price, but that happens sometimes.  I’ve certainly gone through many quarters when 96% or more of everything we track went up in price.  When the interest rate and liquidity trends are at your back, investing is fairly easy.  On the other hand, if those trends are working against you, investing is much harder – with the only reward sometimes being that one loses less.  That doesn’t have to be a bad thing.  Investing is cyclical.  Bad periods set up good periods, and vice versa.  You cannot survive as a money manager projecting current trends into infinity.

I remember when the yield on the 10-year bond fell to less than 0.6% back in August 2020.  That was great if one had been a bond buyer in any of the previous 40 years, but where do you go from there?  Inflation was running at about 2%, so buyers at 0.6% were getting no inflation protection.  The only chance of a positive real return was that interest rates went even lower.  You didn’t need to know that interest rates were going to soar in the first quarter of 2022 to know that buying the 10-year at that point was a terrible bet.  It was like watching Lebron James score 55 points in a basketball game and betting that he will score 60 points in the next game.  It’s not impossible, but the odds are not in your favor.  The odds were also not in your favor if you paid $500 per share for Zoom Video in October 2020 or $160 for Zillow in February 2021.  You were betting that an explosive trend (in this case, shop from home) would continue to grow at exponential rates.

The nature of trends is that the longer they last the more powerful they tend to be, but that all trends eventually end.  Stocks with a high and consistent rate of annual earnings growth (growth stocks in the parlance) performed extremely well in the low interest rate environment of the past decade.  On one hand it was a mistake to assume their outperformance would end simply because they had become expensive (in some cases very expensive), because bull markets are generally not killed off by valuation.  On the other hand, it was a mistake to assume the growth stock run would never end.   Rising rates and tight credit are like kryptonite for growth stocks.  There were two periods – late 2015 into 2016 and late 2018 – where worsening credit conditions led to 15-20% drops in growth stock prices. In each case, the economy slowed, the Fed reversed itself, and these stocks were off to the races again.  Therefore, an experienced manager doesn’t panic when growth stocks hit an 8-10% skid as they did in February and again in October of 2021.

The decline that began on December 28th of last year was not a concern until the rally attempt at the end of January quickly failed and lower lows were made – even before the Russian invasion of Ukraine.  This was new.  As the market began to digest the impact of wage inflation driven by the difficulty finding qualified available workers and of goods inflation driven by raw materials shortages and shipping bottlenecks, it was suddenly confronted with a regional war.   A significant amount of energy and agricultural commodities were effectively taken “off-line” through a lack of available workers (Ukraine) or embargo (Russia) – which only makes the goods inflation situation worse.  At this point we had not just a sell-off but a change in the narrative driving the market – that rising inflation wasn’t a transitory event but in fact a structural change that would usher a new group of companies into market leadership.

The point here is that the first perhaps 5-8% stock market decline is noise.  Markets fluctuate.  If you aren’t conformable with that, you should probably buy a CD or a fixed annuity instead.  Most declines of this magnitude don’t last very long. The proper course of action in most cases is to do very little.  Every so often, however, the market will cry wolf and there will actually be a wolf.  Those are the times where you have to be prepared to act.  As a manager, I really don’t expect to add value in a 5% decline.  I’m not going to radically change a portfolio for a decline that small or else I’d constantly be buying and selling.  I also know that it is hard to add value in a crisis decline like March 2020 because that situation was completely emotional and nearly impossible to model.    Where managers can add the most value is in a prolonged decline.  The more the market loses, the less I expect to participate in that decline because I can discern what the new narrative is and I can re-position portfolios away from the most vulnerable areas.  The bear market that ran from March of 2000 through October 2002 was much easier to outperform after the Autumn of 2000 because it had become clear that the growth narrative had been broken and the technology sector no longer carried the torch of market leadership.

Periods of strong performance almost always lead to periods of low performance, because as asset prices rise in excess of the increases in their intrinsic value, valuation deteriorates.  Happily, that process also works in reverse.  If we have to endure a multi-year period of poor bond returns while bond yields rise to a level that better compensates us for taking inflation risk, that’s fine.  We’ll get through it by underweighting bonds and overweighting hard asset alternatives.  After a decade of fairly poor-to-terrible returns, most commodity producers are undervalued despite having done very well this year.  The conditions they required in order to thrive have finally come to pass.  Energy stocks are about 4% of the S&P 500 and Basic Materials stocks are less than 2.5% today – less than half of where they were at their peaks in 1980.  That’s kind of like betting on Lebron the game after he’s just had a 15 point game; not a guarantee but attractive from a probability standpoint.  At the end of the day, as investment managers, that (putting the odds in your favor and watching carefully to see that they remain there) is one of the most impactful things we can do.

Updated Statement Benchmarks

Please note that we updated the benchmarks on our quarterly statement to be in greater alignment with industry standards. We believe the updated benchmarks better highlight the broad array of investment possibilities as they more clearly delineate the asset classes in which we invest. A brief explanation of our new benchmarks is below. Please don’t hesitate to reach out with questions.

S&P 500

The S&P 500 is used to track the performance of the United States stock market. The index covers the 500 largest companies by market capitalization.  This represents a little over 80% of the total capitalization of the U.S. stock market. These companies vary widely across the sector spectrum, covering both manufacturing and service companies.

Russell 2000

The Russell 2000 is used to track the performance of smaller companies in the United States. It tracks the roughly 2000 securities considered to be among the smallest US companies. It is a capitalization-weighted index made up of the smallest 2,000 U.S. common stocks as measured by market capitalization included in the Russell 3000 Index, which consists of the largest 3,000 U.S. common stocks based on market capitalization.  There are between 3700 and 3800 listed companies on U.S. exchanges right now, so the Russell 3000 covers more than 99% of total U.S. market capitalization.  This gives you some idea of how small the smallest 700-800 companies must be.

MSCI ACWI Ex-US

The MSCI All Country World Index Ex-US is used to track the performance of stock markets around the world, excluding the United States. It captures large and mid-cap representation across 22 or 23 Developed Markets (DM) countries (excluding the US) and 25 Emerging Market (EM) countries. With 2,300 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.

Bloomberg US Aggregate Bond Index

The Bloomberg US Aggregate Bond Index is used to track the performance of the United States investment grade (BBB-rated or higher) bond market. It is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).  In May 2019, 72% of all U.S. bonds were investment grade.  This number fluctuates due to economic conditions and investor preferences.

Over the course of 17 days (March 6th to March 23) the market discounted the absolute worst-case scenario and then began to walk it back, slowly at first and then rapidly by June.

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.

Source: Morningstar Advisor Workstation

Source: MSCI ACWI-EX US, Morningstar Advisor Workstation

Summary

The stock market shrugged off several attempts at a broad sell-off last quarter to eventually end up about 11% higher.  Both November and December saw drawdowns of more than three percent before sharp reversals led to new all-time highs.  Of course, this is only true if we consider the largest U.S. companies as “the stock market”.  If I were describing last quarter’s performance by small and mid-size companies, I could have written the following: “the stock market ran up sharply in October only to decline even faster in November.  A modest early December rebound quickly failed as did a late December bounce.  The Russell 2000 small cap stock index gained only 2.1%¹ on the quarter”.  Likewise, discussion of international stocks would have looked strikingly similar; a lot of choppiness and a modest gain (up 2.7%).  The utterly massive performance of just a few stocks has distorted everything.  Semiconductor chip-making powerhouse Nvidia was up 42%² last quarter, while Tesla soared 36%, Apple 26%, and Microsoft just under 20%.  Mega-cap health juggernaut UnitedHealth Group rose 29% and Home Depot climbed 27%.   More on this below.

Bonds continued to struggle in the face of rising interest rates.  The Bloomberg Aggregate Bond Index gained exactly 0.01%, which lifted its return for the full year from -1.55% to -1.54%³.  Ouch.  By reducing interest sensitivity, either through buying shorter maturity bond or lower credit debt, it was possible to reduce or eliminate losses in a bond portfolio, but even the very best bond category still paled in comparison to most stocks.  The positive in terms of bond ownership is that as yields rise, newly issued bonds have higher coupons.  That means future bond market returns should improve.

European stocks were the next best performers last quarter, gaining 5.1%.⁴ China continued to drag Asia lower.  China lost a little over 6% as investors continued to question Chinese economic policies and the real estate sector was reeling from the Evergrande crisis.  Japan also fell almost 4%, but international analysts tend to regard that country as very cheap.  It is easy to write off non-U.S. markets because of their poor relative performance over the past decade, but investors cannot invest in past returns.  Going forward, the vast valuation discrepancies in foreign based stocks versus U.S. stocks make foreign markets attractive – if not immediately then at least on a 5-10 year basis.

Activity

We have been more active lately as financial markets show signs of succumbing to the pressure of rising interest rates.  When interest rates rise, several things happen:

1. Existing bonds decline because their coupons become less attractive relative to new bonds with higher coupons;

2. Stocks decline, because the value of their future dividends and/or future cash flows are worth less when discounted to the present; and

3. Gold may also worth less if interest rates increase faster than underlying inflation, such that they (interest rates) more fairly compensate investors from inflation.

As investors, we really don’t want to see inflation.  It is almost never helpful.  The problem is, if interest rates are kept artificially low, inflation eventually results.  For years the Fed has kept inflation largely confined to the stock and real estate markets.  The Covid crisis ended this, because the pandemic forced production shutdowns because of the unavailability of labor and/or materials.  The obvious consequence of scarcity of materials and labor is higher prices and wages.  

In bond portfolios we have been reducing interest rate sensitivity by exchanging into shorter duration bonds with higher yields.  In some instances, we have substituted alternatives such as convertible or merger arbitrage for some of our bond exposure.  In stock portfolios we have reduced exposure to the highest volatility stock positions.  For the most part these were funds that focused on disruptive technologies which, while promising, will generate most of their profits in the distant future and as such cannot be valued as highly when interest rates are rising.

Outlook

What we’ve seen so far in January is either a needed correction that will set the stage for the next leg of rally once interest rates stabilize, or evidence that the speculative post-covid liquidity bubble has popped in which case stocks will not stop falling until all the speculative excess has been wrung out.  Corrections caused by excessive valuation running into more restrictive monetary policy are not rare – we saw two in 2018 and one in each of the preceding eight years (except 2013 and 2017).   Full fledged paradigm shifts tied to a crisis in one or multiple sectors of the economy are far more rare, and indeed, not what we expect this time either.  Still, it can be unpleasant to go through these periodic downturns.  

We are seeing some very strong companies starting to be sold off lately.  We didn’t take it as a general warning when some of the highest post-Covid flyers like Zoom and Roku and Zillow ran into trouble last year because they are not very representative of the market as a whole.  If a correction would come along that impacted Apple, Microsoft, Nvidia, Adobe, and the like – then you’d know investors were finally starting to care about inflation.  That is where we stand today.  Again, I believe this dip will be bought much like the others in this long bull market.  The economy isn’t slowing at this point and interest rates are still low (the 10-year bond still yields less than 2%).  Again, I believe this decade we will see a paradigm shift that causes U.S. interest rates to move to a higher range and makes non-U.S. assets more attractive, but this will take years to evolve.

Commentary

One good thing about analyzing very large companies like Apple, Microsoft, and Nvidia with hindsight is that you can say conclusively that none of them deserved their huge stock price surge.  Their size is such that their profits could not possibly have grown fast enough to justify a 20% quarterly gain on top of their gains of the first three quarters of 2021.  If we know, therefore, that the prices of U.S. mega-caps are not justified by their economic performance, why are they so high?  Because they have pulled in capital from all over the globe seeking growth and safety in a world where growth has largely (but not exclusively) been confined to American companies and safety has meant that the earnings yields on blue chip U.S. companies (even with price-to-earnings ratios above 35) exceed what one could earn from the bond market, many regarded them as being bond substitutes.  Years ago we even coined an acronym – TINA – for the idea that as far as U.S. stocks are concerned, There Is No Alternative. 

Over the past decade or so, U.S. investors have been rewarded for behaving as if there was no alternative to U.S. stocks.  It is my belief, however, that the “TINA Era” is in the process of ending.  Imagine the Pacific Ocean at rest.  Waves aren’t cresting in Japan, nor are they high in Oregon, Peru, or Australia.  Now imagine the strongest hurricane force winds ever recorded blowing due northeast.  The entire Pacific Ocean is being pushed toward the U.S. west coast, hard.   The hurricane in this allegory is the combined forces of U.S. economic and taxation policy (a 40-year shift in tax policy away from corporations and toward individuals, chart 2), the U.S. dollar’s global reserve currency status, and the global oil payment system.  All of this combines to drive money into the U.S. stock market and especially to biggest and the most liquid companies therein.  The winds may fluctuate in intensity, but they never completely let up, so the world gets used to what would normally be regarded as very unusual circumstances.  The U.S. dollar is expensive relative to all other currencies because everyone needs it to buy oil and U.S. equities (which have been at multi-decade highs, at least until recently).

Americans are disproportionally enriched by this system, which allows them to consume more and more, which makes their trade deficit with the rest of the world larger and larger (see Chart 1).  The catch is this – the benefits to Americans are not evenly distributed.  For the most part they are realized by stockholders, so the wealthiest get ever wealthier.  Over time, the U.S. has developed a wealth gap that is more befitting a third world country (see Chart 3).  At least somewhat as a result of this, our political system is as fragmented and contentious as it has been since the Civil War.  This decade cannot, and I believe will not, just be more of the same, because a rising percentage of younger (and statistically poorer) people don’t believe the systems works for them.  As economist Herbert Stein once said, “If something cannot go on forever, it will stop”.

Change is always difficult to forecast.  On any given day, odds are that politically, economically, socially, and geologically things will change very little from the previous day.  Then there are those days where something snaps and everything changes.  In light of the extreme level of imbalances, it seems prudent to begin to invest as though there are alternatives and to use them more actively, rather that wait for market conditions to force this upon us.  No one is going to ring a bell to tell investors that the great TINA era is over, but at some point in the future we will all know that it is.   As I said in the Outlook, I expect a near term rally off last Friday’s (1/21/22) lows, but I also expect a more difficult decade for investors than the 2010s were.

1.  [1] U.S. Index performance courtesy of S&P 500 via Morningstar Workstation
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2. [2] U.S. individual stock performance courtesy of Morningstar Workstation
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3. [3] Bond index performance courtesy of Bloomberg via Morningstar Workstation
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4.  [4] International Index performance courtesy of MSCI Global via Morningstar Workstation
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Disclosure

Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.  Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio.  No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them.  Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy. 

Summary

While it is technically true that the S&P 500 stock index added 0.58% in the third quarter, it really didn’t feel that way.  Small cap U.S. stocks declined, midcap U.S. stocks declined, and foreign stocks declined – both developed and emerging markets.  Seven of the largest ten stocks in the U.S. advanced, led by Alphabet, Tesla, and Microsoft, which was enough to turn the major index positive despite most stocks losing ground.  For most companies and countries, however, the big news on the quarter was the surge in inflation caused by significant supply disruption, both of goods and of services.  The world continues to emerge from the Covid crisis, but mostly in fits and starts.  The global economy that is emerging seems to be profoundly different than the one we had before.  That said, the Federal Reserve has maintained a very accommodative monetary policy, so enough liquidity exists to allow the market to “tread water” more or less.  Inflation may be rising, but companies seem to be able to pass on their higher costs because their customers are in better financial shape.  That means corporate profit margins can remain at or near all time highs.  Whether one believes Fed policy has been wise or not, this is not the environment in which one should expect a major decline.

The first two months of the third quarter were marked by a concern that the economy was slowing.  Utilities, real estate, and communications, three of the most defensive sectors, performed the best while those that are the most economically sensitive – energy, materials, and industrials – lagged.  September saw a surge in energy prices amid a pickup in the economy, so the roles reversed.  Financial services stocks had the best quarter of all in that very low interest rates promote the “game-ification” of financial markets.  With IPOs, mergers, and other financial activities at record levels, there were nice fees for Morgan Stanley, Goldman Sachs, and their peers.

Emerging markets drew most of the attention this past quarter.  Everybody was trying to determine whether China was still a reasonable place to invest with all the new regulations imposed by Xi Jinping.  China’s -13.34% quarterly return dragged the MSCI All Emerging Markets index to a -8.09% loss.  International stocks as a whole were only down -3.02%, because Japan gained 4.56% and Europe and Canada were only modestly lower.  The best performing international stocks last quarter were actually in what are known as frontier markets.  This encompasses countries in Asia, Africa, South America, and eastern Europe that do not qualify for EM status.  Think places like Columbia, Nigeria, Qatar, Austria, and Vietnam.

Bonds were about unchanged last quarter.  Yields are very low, but until recently they have been relatively stable.   Low prospective returns have led many investors to take the extra risk of high yield corporate, floating rate, high yield municipal, or emerging market debt in order to earn higher income.  In all cases but the latter, it paid off during the third quarter.  With interest rates rising this quarter, taking that extra credit risk may pay off again this quarter.  The risk in doing so is a sudden economic downturn which increases fears of default, but I just don’t see that happening in the near term.

Activity

Because the biggest concern this quarter was emerging markets (China most specifically), that was the area we spent the most time on.  We reduced exposure to China either by trimming the overall emerging market weighting or by exchanging to an emerging market fund with a lower percentage of Chinese stocks.  One didn’t want to avoid emerging markets altogether, because some countries (India, for example) performed quite well.  We also had to address rising inflation and its impact on the bond market.  The largest moves were in shorter duration bonds.  Short term bond yields are so low that even fairly small interest rate increases can cancel out all the income one receives.  We’ve been replacing some of our bond exposure with lower risk securities with less interest rate sensitivity, such as market neutral and convertible arbitrage funds.   We’ve also been adding a small amount of commodity exposure to many portfolios.  Lastly, we continued to reduce exposure in some of the areas that made us a lot of money in 2020 but have spent most of this year working off over-valuation.  Funds (ETFs) focusing on genomics, clean energy, and emerging technologies have struggled this year, so we have reduced our exposure to these more narrowly focused areas.

Outlook

The stock market’s -4.65% decline in September spooked a few people, but we expected a pullback due to the frenetic pace of new highs throughout the summer and the fact that the September to mid-October period tends to be a seasonally weak time for stocks.  Fortunately, this October has gotten off to a good start.  Increasingly, the market volatility that one associates with October actually occurs in September, so once we get to the start of earnings season in mid-October, we are usually “out of the woods” so to speak.  We can’t predict exactly when the market will get over its September funk in any given year, so we tend to avoid seasonal trading.  That said, we were not at all surprised when stocks made new all-time highs on October 21st.

We believe that earnings season will continue to provide a boost to most stocks as corporate profit margins remain at or near record levels.  The next period of caution will arrive right before the Federal Reserve meeting on November 2-3.  The Fed is expected to announce a modest tapering in bond purchases, which would remove some of the very ample liquidity from the market.  An announcement of a greater than expected tapering would almost certainly adversely affect both stocks and bonds, but Chairman Powell seems keen not to roil the markets the way he did in late 2018.

Commentary – It’s What You Know For Sure That Just Ain’t So

Mark Twain had a number of wonderful and witty sayings.  “Kindness is a language which the deaf can hear and the blind can see”, and “God created war so that Americans would learn geography” are two of my favorites.  His quote, “It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so” is probably the one with most relevance to investors.  Twain seems to have understood overconfidence bias some 80 years before Daniel Kahneman and Amos Tversky won a Nobel Prize for analyzing people’s behavioral biases.   In the thirty-five years since I started in the financial services industry (yes, in 1986) nothing has cost people more money than the attempt to sidestep market declines because they just knew that the market was about to go down.

I am not saying that timing the market is impossible because that is obviously not true – those who try are occasionally successful.  Great market calls are so rare though that we tend to remember the names of the very few who made them.   Jesse Livermore, Elaine Garzarelli, and Michael Burry come to mind.  I am instead saying that market timing is a low probability exercise.  Selecting both a favorable time to exit and then an auspicious time to re-enter the market is very difficult.  Despite more than a century of attempts, nobody has found an indicator robust enough not to give false signals timely enough to warn you before the market is already down more than 10%.  Professionals talk about “batting average” because they know NOBODY gets every trade right.  Non-professionals often believe that there are those who get all the big moves right, because the advertisements on the internet tell them so.

One of the worst mistakes non-professionals make is believing that the fate of markets lies with who is in the White House.  The fact of the matter is that stock performance depends primarily on corporate profits (both current and expected), the future rate of inflation (because inflation reduces the value of a dollar earned in the future), and the amount of liquidity provided by the Federal Reserve that companies, investors, and speculators may use to leverage up their return.  For example, Apple Inc. generates billions of dollars in free cash flow every quarter.  It does not need to borrow money in the bond market to fund its operations, but it does so anyway in order to buy back some of its shares.  This increases the reported earnings per share because Apple’s growth rate is higher than it’s cost of borrowing.  If the Fed holds borrowing costs low enough, even very mediocre companies with much lower returns on capital can take advantage of this form of arbitrage.   That is what we are seeing today.  It’s gone on since the Great Financial Crisis, and it has largely contributed to the twelve-year bull market that began in March 2009.  Presidents do not control how much liquidity is in the economy, at least not directly, therefore they tend to get too much credit or blame for stock market movements.  Companies focus on serving their customers and growing their businesses, regardless of who is in the White House. No particular policy of the Biden administration, the Trump administration, or the Obama administration before that was the catalyst responsible for the bull market.

There is an old saying on Wall Street – “the trend is your friend until the bend at the end”.  This is a clever way of saying that all trends, including this one, will eventually end, but the smart money respects it and doesn’t constantly try to “front run” the ending.  Bull markets do not end because prices get too high, rather they die because the fuel that propelled them to the high prices has been exhausted.  Leverage is wonderful on the way up but disastrous on the way down.  Knowing this forces us to carefully watch liquidity conditions, inflation, and corporate profit margins to get a hint at when we might shift to a more defensive posture.  Not because we think we can avoid the next market crash, but that we may be less exposed when one does come.

Mark Twain also wrote: “October: This is one of the peculiarly dangerous months to speculate in stocks.  The others are July, January, September, April, November, May, March, June, December, August, and February”.  Humor aside, every day we think hard about what might go wrong and how this bull market may end.  Stocks are by almost every measure quite expensive, inflation appears to be on the rise, and at some point the Federal Reserve will not be able to be this accommodative.  That said, the bull market has overcome many challenges over the past several years and has therefore earned the benefit of the doubt.  That is we try very hard not to let our concerns cause us to give up a meaningful amount of return potential.

One thing I’ve learned is that all large market declines start out as little market declines, but the vast majority of little market declines do not turn into crashes.  Crashes happen when the initial problem is not handled right.  You can’t predict policy errors or market panic in advance.

S&P 500 performance from Standard & Poor’s via Morningstar

Sector performance information via JPMorgan

Foreign stock performance from MSCI International (Morgan Stanley), via Morningstar

S&P 500 return, again courtesy of Standard and Poor’s.

Disclosure

Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year.   It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.  Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio.  No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them.  Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.

Summary

Stocks maintained their strong advance in 2021 by adding another 8.55% last quarter.  Technology, Energy, and Real Estate led the way.  Economically, that makes little sense – technology, as a long-dated asset, should benefit from disinflation while energy (a cyclical) should respond to economic strength and higher inflation.  The Telecom and Utility sectors are usually viewed as defensive because people generally don’t use less electricity or phone service during a recession.  Here too performance varied widely; telecoms rose 10.72% last quarter while utilities lost 0.41%.  Rather than flowing in one particular direction in response to a coherent Federal Reserve policy, money in the market is sloshing around haphazardly.  Attributing any given day’s results to a particular concern, such as COVID or China or inflation, is giving traders way too much credit.

Source: JPM Guide to the Markets 3Q 2021. The Fed’s balance sheet expansion lifts stocks after the Great Financial Crisis and again after the COVID Crisis

The Federal Reserve continues to pump money into the financial system by buying bonds.  This is depressing yields, forcing income-seeking investors to opt for riskier securities if they do not want to settle for historically low yields.  All of the Fed’s buying doesn’t do bond investors much good in the long run.  A decade of central bank bond buying has all but ensured that inflation levels will exceed the yields of high quality bonds.  Today, the bond market yields less than 2%.  Given that inflation is currently around twice that, bond investors receive about a -2% annual return in purchasing power terms.  Even without factoring in inflation, the U.S. Aggregate Bond Index has delivered a -1.60% loss through the first half of 2021.  Some bond investors have migrated to riskier high yield “junk” bonds which have returned 3.62% so far this year, while others have embraced dividend paying stocks.  One hopes they remember that in the last real bear market (2007-09) quality bond losses tended to be well under -10% (in fact long treasuries actual rose), while high yield bonds and dividend paying stocks each lost more than a third of their value.  The market has an expression for taking large risks to obtain modest returns – picking up pennies in front of a steamroller.  That pretty much sums it up.

Switching to foreign markets, foreign stocks were again rather subdued compared to the U.S.  Developed foreign markets gained 5.69% and emerging markets rose 6.08%, according to S&P Dow Jones.  Both indices are up less than 10% year to date.  Japan has been notably weak, while Canada has strung together two straight quarters of 10% plus gains on the strength of soaring lumber and energy prices.  China’s crackdown on its technology leaders has been a drag on Asian and emerging market indices because these stocks are some of the largest components.

Gold has had a rough half year so far as the dollar has been strong, but commodities in general have been having one of their best years in a decade.  Energy and agricultural commodities have led the way.  With inflation posting some of its strongest numbers in years, this area has become more interesting to us.  We are looking at ways to hedge inflation that don’t involve gold or inflation-indexed bonds.

Activity

There was not as much trading activity this quarter, as the narrative driving both the bond and stock markets remained largely unchanged.  We review portfolios on an ongoing basis to see if there are any funds or ETFs that are underperforming such that we could replace them with better performing alternatives and not expose the portfolio to greater concentration risk.  At the margin we have reduced the weighting in cash and bonds and increased the percentage allocated to stocks, but we are conscious that we (and the market as a whole) have been forced to pay ever higher prices for the hope of future returns.  Steamroller indeed.

There has been a very sharp correction in the more aggressive sectors of the market – cryptocurrencies and cutting-edge industries like electric vehicles, genomics, financial technologies, and cloud-based consumer technologies.  We don’t have much exposure to these areas, but to the extent that we do, we are riding it out.  One must expect a much higher level of volatility if one hopes for significantly greater return.  Again, money moves in and out of these stocks so fast that a tactical approach (timing) just doesn’t work.

Outlook

From time to time, there will be “corrections”.  Volatility is a part of investing, such that if you aren’t comfortable with the occasional 5%-10% decline, perhaps you are more of a saver than an investor.  That said, once a decade or so the stock market undergoes a more significant decline (30% or more) usually tied to either a sharp fall in economic output or a sharp rise in costs (inflation).  Ex-post, market corrections associated with either of those causes may be correlated with an inverted yield curve or an abnormal advance-decline ratio. On the other hand, the “crashes” of March 2020 and October 1987 fall into the category of event-driven sell-offs, where one does not get much of an early warning.

Investing can be broken down into macro (asset allocation) and micro (individual security selection).  Much of the macro part of investing is trying to identify those times in which the risk of a more significant decline is elevated.  When those conditions are present, investors should re-assess their asset allocation.  Most of the time that risks are elevated the market will undergo a modest correction but then the upward trend will promptly re-establish itself.  In these cases, taking no action will have been the better strategy.  The longer the market goes without a major decline, however, the more valuation and sentiment can get way out of whack and the odds of a major market event rise.  Theoretically, the sharp plunge sixteen months ago should have put us in a place where we would not have to worry about excess speculation for several years.  As we all know, however, speculation has come back with a vengeance.  Stock prices have about doubled off their March 23rd low.

The stock market doesn’t peak because valuations reach 20 times earnings or 18 times sales or 5 times book value or any other accounting metric.  Instead, markets peak when investors begin to worry that they won’t be able to find other investors to sell to at higher prices.  Therefore, it is important to be able to sense when the market (or a segment of it) is approaching its saturation point.  As I stated above, we appear to have reached that point earlier this year with Bitcoin and other cryptocurrencies and with companies that fit the “disruptive technologies” description.  Hopefully that is all the correction we will get for now, but I find it difficult to believe that we are going to get off that easy.  That said, we have not yet positioned our portfolios for a more serious decline.  Risk on, but watching closely.

Commentary

When I started in the financial services industry in 1986, the Federal Reserve was in the process of bringing interest rates down from the mid-teens.  It had been necessary to hike rates to 16% or so back in 1981 in order to crush inflation.  By 1986 rates had fallen to around 10% as inflation retreated into single digits.  The Fed never seemed to be able to go two straight meetings without changing the discount rate, because fears of returning inflation seemed to conflict with fears of economic slowdown.  This tug of war served active investors very well – if you could correctly anticipate the Fed’s next move in time to position yourself accordingly, you could expect to make a greater-than-market-return profit.  The dynamism of interest rates and the business cycle drove investment decision.

Today everything is different.  The Federal Reserve is basically stuck on zero percent.  There is no business cycle to speak of, because the Fed is trying (through its open market activities) to maintain a perpetual state of early-to-mid cycle.  This encourages a more passive approach to investing.  If you imagine a bathtub where the Fed is filling the tub while investors thrash around like a three year-old, active investing is essentially betting on which areas of the tub will see higher or lower water levels, while passive investing is betting on the overall water level.  Since the 2007-09 financial crisis, a succession of Fed governors have made the latter virtually a slam dunk.

In this environment, very few major companies ever go bankrupt relative to 30 or 40 years ago because interest rates are much lower and most companies of any size have access to credit.   Of course, their stock and bond prices have risen to reflect their much lower degree of economic risk.  The problem is, if the Fed ever stops pumping money into the economy through the purchase of government and corporate debt, interest rates are likely to rise.  This means credit won’t be as easy to obtain and more companies will fail and therefore risk premiums will have to rise.  In other words, stock and high yield bond prices will fall.  If you recall, the Fed tried to end this process back in October 2018 and the 4th quarter of that year was rather ugly for investors.

Why, you might ask, would the Fed ever stop pumping liquidity into the market if doing so would cause a market decline?  One reason is that not everybody in an economy is an investor.   Some only have the means to be a saver.  Because the Fed is keeping interest rates artificially low, savers get less interest than they should.  In essence, savers are subsidizing investors.  This helps increase wealth inequality across classes, and history suggests that rising wealth inequality ultimately does not end well.  At some point (probably during the next recession), the idea of stimulating the economy through Fed purchases is likely to become politically unpopular (the bottom 50% of the income spectrum owns such a tiny percentage of the stock market that it’s almost impossible to perceive on a line graph).

Things have changed a lot over the past 40 years.  The way one reads the market and the tactics one uses to maximize return for a given level of risk have certainly changed.  As a result, our methods have evolved to the use of more passive vehicles like ETFs and now, rather than anticipate the Fed’s next move, we start from the default position that the Fed is not going to change its tactics unless it absolutely must.  That day will come, but it is not going to be tomorrow and it is probably not going to be for quite a while.  When it comes, advisors and investors will face a new environment and new tactics will have to de devised.  It is our mission to guide you through that as smoothly as we can.

Meaning that almost all potential buyers are already in.

Incidentally, I am not worried about the stock market effects of a resurgence of COVID. I do not foresee the country shutting down like it did last year. America has collectively decided that it is going to stay open and deal with the consequences.

 Per S&P Dow Jones Indices

1.97% as of Today per YCharts (Vanguard Total Market Bond ETF)

It’s even worse if you own CD’s that yield 1% or less

S&P Canada Broad Market Index Total Return in US dollars, per Morningstar Workstation

Disclosure

Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year.   It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.  Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio.  No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them.  Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.