SUMMARY

The second quarter of 2019 is in the books, as they say, and it was another good one for both stocks and bonds.  US equities once again outperformed both non-US developed and emerging markets equities. The key to market gains was Federal Reserve Chairman Jay Powell’s capitulation on interest rates.  Ordinarily, the Federal Reserve does not cut interest rates during a period of strong market performance for fear of stoking investment speculation.  Nowadays, however, restraint is an old-fashioned notion.  Investors have understandably reacted to the idea that credit would become both easier to obtain and less expensive in the same way a child would if you told them that there would be two Halloweens this year.  Yay! More candy!  See Exhibit 1 for a market summary.<1> Concerns about trade wars, Iran, North Korea, etc.  have all taken a back seat, at least for now.

Exhibit 1: Second Quarter Market Returns

According to JPMorgan, financial, materials, and technology were the three best industries gaining 8.0%, 6.3%, and 6.1% respectively.<2>  Only one sector declined last quarter, health care (-2.8%).  The yield on the 5-year Treasury note declined by 47 basis points (bps), ending at 1.76%. The yield on the 10-year Treasury note fell by 41 bps to 2.00%. The 30-year Treasury bond yield decreased by 29 bps to finish at 2.52%.<3>

Interest rates plunged during the quarter as investors began to anticipate interest rate cuts.  It is somewhat paradoxical to argue that the economy is strong yet continued economic growth requires ever lower interest rates, but here we are.  Every category of bonds rose, with riskier ones tending to gain the most.  Emerging market debt has done the best this year since lower interest rates reduce the relative attractiveness of the US dollar, causing its exchange rate to decline.

International markets rose last quarter for the most part.  Economically speaking, there was a fairly sharp deterioration in the Euro area with Germany contracting the most.  In the emerging world, the economies Taiwan and South Korea fared the worst.  It is no coincidence that these three countries depend on exports – which were strongly affected by the ongoing trade conflict between the U.S. and China.  That said, European stock markets mostly performed quite well due to massive interest rate declines (in many cases to less than 0%).  Russia and Argentina had two of the best performing stock markets in the first half of 2019.

ACTIVITY

Given the decline in interest rates and resulting impact on markets, the only “wrong” asset to have last quarter was cash.  We reduced the cash position in many portfolios by adding marginally to both stocks and bonds.  In bonds, interest rate sensitivity was a positive, so we tried to lengthen duration by adding longer term treasury bond exposure.  On the stock side, we increased our weighting to funds that emphasized certain sub-sectors that were thriving – insurance within the financial services sector, payments processing (think Visa, Paypal, and Mastercard) within the consumer discretionary sector, and data infrastructure within the real estate sector (think cell towers).  Oh, and owning funds that over-weighted Microsoft and underweighted Alphabet (Google) also helped.

OUTLOOK The average person might still be a little skeptical about this year’s stock rally, but active investors aren’t.  A lot of money has been committed to the markets over the last several weeks as Fed Chairman Powell’s decision to reduce short term interest rates is seen as a done deal.  How can a professional not be “all-in” knowing a rate cut at the July 31st meeting is all but assured?  As such, there is a very real risk that investors will “sell the news” once the cut is announced.  Three decades in this business has trained me to be cautious when I know everybody is on the same side of the trade.  While there might be a pick-up in volatility in the short run, I don’t see a significant correction as long as interest rate cuts are on the table.  In fact, I wouldn’t rule out a 1999-style upside blow-off as investors contemplate the possibility of several rate cuts before the 2020 election.  This is not a contradiction; I’m just describing two very different but highly plausible scenarios.

On one hand, despite the U.S. stock market’s having gained roughly 20% so far this year, investors are not especially exuberant.  If they go all-in on the idea that we will have very low interest rates and unusually high profit margins for years to come because the Federal Reserve is all powerful (when it comes to using monetary policy to fight off recession) then we could go much higher.  On the other hand, most areas of the US stock market are already expensive based upon historical levels of interest rates and cash flow.  If the economy slumps and the Fed is unable to revive it with its monetary tactics (and as a result the “all-powerful Fed” narrative crumbles) the downside could be considerable.

HOW THE INVESTMENT WORLD HAS CHANGED

When I began the Chartered Financial Analyst program in 1993, the financial industry was firmly convinced that the stock markets were efficient.  In other words, if a stock sold for $50 per share, you could be sure it was worth $50 per share, because if it sold for $47, investors would rush to buy it and if it sold for $53, they would rush to sell it.  Another name for this process of determining a stock’s intrinsic value is price discovery.  The only way to outperform the market was to discover something about the company or its industry that was not common knowledge and therefore not priced in.  As a result, large investment firms sought preferential access to company management, while less well-connected analysts either pored over financial reports looking for a clue everybody else missed or made visits to a company’s suppliers and customers.

By the end of the decade, however, investor behavior had radically changed.  Internet mania was in full swing.  Conventional analysis could not explain why investors should pay three-digit prices for companies that were losing money, yet that is precisely what they did.  Almost nobody was still selling overpriced companies short – to do so was financially suicidal.<4>  After all, while there was no value-based justification as to why PMC Sierra (PMCS) was trading at $140, you couldn’t be sure it wouldn’t go to $160 or even $200.  Price was a completely separate thing from intrinsic value.  As such, it might be reasonable to buy PMCS if it broke above $150 (thereby confirming that momentum was intact) but you certainly wouldn’t buy it at $90 (because that price would only be reached if something disastrous happened to the stock or the market as a whole, in which case the stock could go a lot lower).  And that is exactly what happened, not just to PMCS but also to Palm and Sun Microsystems and Lucent and ADC Telecom and so many more.

Famed investor Warren Buffett likes to say that when stocks drop he rejoices like other people do when peanut butter or dish soap prices drop, because he can buy more and save money.  And that makes intuitive sense; everybody should want to buy low and sell high, right?  Not anymore.  It has become a buy high, sell higher world.  A low price suggests there is something wrong with the company; perhaps it can’t compete in today’s digital world.  A high price means just the opposite.  Companies can see their stock appreciate, even to comically high levels, if they can control both the float (number of shares available to be traded) and the narrative (the commonly held idea about how a company will perform in the future, largely as a function of how it is positioned to benefit/suffer from the way the world is changing).

When a company’s narrative matters way more than what its financial statements say, there is tremendous room for error.   Though it isn’t a company, let’s think about Bitcoin.  The bitcoin narrative is that it is the currency of the future.  It rose exponentially because nobody could really tell you what it was worth, but everybody knew that in the future we’d probably all be using it.  Who was to say it wasn’t worth $15,000 per coin? Or $50,000 for that matter?  Yet when the narrative broke (as fears grew that world governments were going to outlaw it) and it started falling in earnest, there was no natural level that would support it.  Would it stop at $7,000? $4,000?  $100?   Who knew?  As Ben Hunt wrote in Epsilon Theory, “the only determinant of price for a non-cash flowing thing is Narrative”.<5>

By contrast, a bond gives you a series of payments and then at maturity you typically get your principal back.  You can use basic math to put a value on that income stream.   Similarly, companies generate a stream of revenue through sales.  If this revenue exceeds the cost of generating it (including taxes and depreciation), you can put a value on the excess cash flow (we call it earnings or net profits) whether they are used to pay a dividend or buy back stock or simply retained on the balance sheet.

Investment assets are generally valued on the basis of the present value of all expected future cash flows.   Cash flow should, theoretically, temper one’s ability to attach a ridiculous valuation to a stock because you can always use math to determine what future cash flow expectations are embedded in the stock.  This is something you cannot do with a Picasso or a 1955 Mickey Mantle baseball card because they are non-cash flow producing assets.  Occasionally, however, investors make outlandish projections about the future growth of a company because they fall in love with the narrative.<6>

The valuation today of Beyond Meat, for example, suggests investors expect a very high growth rate, persistently generous margins, and very little competition.  Yet the essence of capitalism is that if a new company takes the market by storm it attracts competitors which fight it for market share and depress profit margins.  The fundamentals cannot in any way justify a price which as of 7/12/19 is 100 times sales, but a small float and an extremely enthusiastic narrative have pushed it up over 6-fold since the May 2019 IPO. Beyond Meat, along with Tesla and Uber and most of the cannabis companies and many other nonprofitable companies now public, constitute an increasing share of today’s stock market.  Yet they trade at valuations that may have very little support if market sentiment – the broad market narrative – should turn negative.

Don’t get me wrong, our world is changing rapidly and those firms that can innovate or position themselves to benefit from the innovation of others may well have a very bright future.  But words like “disruption” are being thrown around like “clicks” was twenty years ago (especially in the private equity sphere).  We are again, I fear, over-projecting the rate at which the world will change.  In doing so, we expect profits from new disruptive companies to arrive sooner and be larger than they probably will be.

Investors believe that low interest rates are their friend because they enable securities to trade at higher prices – because the present value of future cash flows is higher when interest rates are low.  The problem is that low interest rates destroy market discipline.  PMC Sierra and Bitcoin could not thrive in a high interest rate environment because investing in non-interest-producing assets gets tougher as rates rise.<7>  Low interest rates are enabling private companies to get financing without going public, and when they do go public it is under terms (often without voting rights and at aggressive valuations) that are designed for speculators, not investors.

I began my financial career when the structure of the market (floor traders, high liquidity, proprietary trading desks, low investment turnover, etc.) encouraged price discovery, which favored stable prices.  Today’s market structure (high turnover, algorithmic trading, low institutional liquidity, etc.) has evolved to favor momentum trading, which is inherently MORE risky even though it is usually LESS volatile on a day-to-day basis.  Rising stocks keep rising and falling stocks keep falling.  Intrinsic value is meaningless. When a stock goes up steadily for a long period of time, we tend to see it today as less risky than a stock that has been choppy and/or gone mostly sideways because we have learned to focus on an asset’s price trajectory – not on its value at the current price.  In doing so, we risk dramatically overpaying when the investment climate changes.

We are doing our best to be sensitive to the current (bullish) narrative while also being aware of how quickly investor attitudes can change.  Momentum can suddenly reverse.  We believe we’ve done a good job lately of participating in the low interest rate/disruptive technology led bull market.  That said, knowing the risks as we do, we will get defensive from time to time as the factors that are driving the rally appear to weaken.  It’s a balancing act, and we are never going to get it perfectly right, but we believe it is a more client-friendly alternative to the steep periodic losses that the buy-and-hold approach offers.

Endnotes <1> Source: Dimensional Fund Advisors. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index ), Emerging Markets (MSCI Emerging Markets Index ), Global Real Estate (S&P Global REIT Index ), US Bond Market (Bloomberg Barclays US Aggregate Bond Index), and Global Bond Market ex US (Bloomberg Barclays Global Aggregate ex-USD Bond Index ). S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2019, all rights reserved. Bloomberg Barclays data provided by Bloomberg.

<2> 3Q19 JPM Guide to the Market

<3> Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index ), Emerging Markets (MSCI Emerging Markets Index ), Global Real Estate (S&P Global REIT Index ), US Bond Market (Bloomberg Barclays US Aggregate Bond Index), and Global Bond ex US Market (FTSE WGBI ex USA 1−30 Years ). S&P data copyright 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2019, all rights reserved. Bloomberg Barclays data provided by Bloomberg. FTSE fixed income © 2018 FTSE Fixed Income LLC, all rights reserved.  Source: Dimensional Fund Advisers

<4> A short sale happens when an investor borrows shares from another market participant and sells the shares prior to hopefully buying them at a lower price at some point in the future. At its core, it’s a bet the stock will decrease in value.

<5> Epsilon Theory – The Spanish Prisoner, 07/05/2019

<6> Thirty years ago, stocks that ran way ahead of intrinsic value would have been sold short.  Today, new companies often offer to the public a small fraction of the stock issued, with insiders holding onto the majority of the stock.  This makes shorting very difficult, because being “squeezed” (or forced to buy back the stock at a higher price) is a significant danger when the “float” is small.

<7> If interest rates are 2%, for example, I forego very little income investing in something that pays 0%.  I just have to believe it will appreciate more than 2% annually.  If I believe it will appreciate 10% annually, and my borrowing cost is 3% over short term rates (2%+3% = 5%), I would be justified in leveraging my exposure to that asset.  If, however, interest rates are at 6%, the equation is very different.  I have a much more significant income penalty to make a non-yielding investment.  Leverage is so expensive (9%) that the investment is hardly worth the risk.

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 rebounded sharply in the first quarter as investors reacted favorably to the Federal Reserve’s change of heart on interest rates.  When Fed chairman Jerome Powell said back in early January that the rate hiking cycle was over and that the Fed’s balance sheet was not going to contract any further, the market abruptly stopped pricing in recession for 2019 and instead started discounting a profit recovery later in the year.  Over the years we have discussed the importance of liquidity – greater liquidity tends to be better for risk assets; this is yet another example of how a positive change in market liquidity can lead to a strong rally.

Arithmetically, last quarter’s 13.65%<1> S&P gain does not completely erase the previous quarter’s -13.52% loss<2>, but it sure feels a lot better.  The small cap Russell 2000 gained 14.58% last quarter but is still down -8.56% over the previous two quarters combined.  See Exhibit 1. That said, I don’t think anybody really hoped we could erase those steep fourth quarter losses in just three months.  Markets are sometimes said to take the escalator up and the elevator down, so when stocks rise almost fast as they previously fell, that tends to be a good sign.  In my experience, at least.

Exhibit 1

S&P 500 and Russell 2000, 9/30/2018 – 3/31/2019

Source: YCharts

It is also encouraging that international markets largely kept pace with the U.S. market’s advance.  In fact, in local currencies many foreign markets performed better.  There really wasn’t any poorly performing major foreign market last quarter, despite evidence that global growth was slowing.  According to Barrons<3>, world equity funds were up 11.64% (in dollar terms) last quarter.  China led the way, while India and Latin America were among the bottom performers.  Despite the fiasco that is Brexit, European stocks rose 10.38%.

It was also a good quarter for bonds.  Falling inflation and a more friendly Fed created a favorable environment for every area of the bond market.  High yield bonds performed the best with a gain of over seven percent<4>, but even short-term treasuries, the least volatile bond category, gained 1%<5>.  That is an unusually good return for one quarter, considering bonds have averaged 2.74% per year over the last five years<6>.

Activity

We didn’t over-react to stock market weakness during the fourth quarter of 2018, and as such were not in the position of being forced to buy back into the market at higher prices during the first quarter (not that we didn’t add a little here and there).  There were a few moves to be made at the beginning of the year in foreign stocks (which we had trimmed late in 2018).  We also increased our exposure to international bonds more recently once the U.S. Fed signaled an end to the interest rate tightening cycle.  That takes the pressure off foreign central banks, making it easier for them to cut rates in response to the weakness in their economies without worrying about currency depreciation (and capital flight).

Outlook

Going forward, we are looking for a catalyst to break out to highs above those we saw in September and January of 2018 (approximately 2935 on the S&P 500).  Investors are hoping that a comprehensive trade deal between the U.S. and China will be that catalyst, but the market may well view the trade deal to be a “buy-the-rumor, sell-the-news” event absent meaningful and enforceable intellectual property guarantees.  Good luck on that!  In the meantime, I believe the U.S. stock market will eventually challenge the old highs on lack of bad news more than anything else.  Stocks are still expensive on a price to sales and price to cash flow basis, but decent investor demand combined with corporate stock buybacks continues to provide a tailwind.  The concern I have is that the November through April time period is traditionally more favorable for stocks than the May through October period, so a failure to make new highs by Memorial Day (should that occur) may cause market psychology to deteriorate.  That said, if Fed policy remains easy, market liquidity is plentiful, and signs of imminent recession are scarce, we will probably not get defensive in any major way.

Commentary – It IS Different This Time Editor’s Note: This commentary takes inspiration from Ben Hunt’s April 17th issue of Epsilon Theory, titled “This is Water”

Quite a while ago I wrote a Commentary entitled It’s Not Different This Time.  My thesis was that although technology stocks were behaving as if we had entered a new era in which profitability did not matter, eventually companies that don’t generate net profits don’t survive.  The idea of the title came for one of my mentors, who very early in my career told me to be extremely careful every time I heard the words ‘It’s different this time”, because it’s never different this time.  His point was that we are in a perpetual market cycle of recovery-optimism-euphoria-anxiety-panic-capitulation-recovery.  The details change from cycle to cycle but those human emotions don’t.  Insofar as the discussion relates to investor behavior, he was absolutely right, of course.  That said, there is another way to look at market cycles of the past and to conclude that it is, in fact, quite different this time.

Ben Hunt’s article, which everyone should read, makes the point that capitalism works because of its dynamism.  A company or an industry thrives because underlying conditions turn favorable or because it creates those conditions.   Those industries or companies are therefore able to generate higher profit margins.  New companies then enter that space to try to capture a share of the higher profits.  Also, employees of the higher earning company want to be paid more as a result of the higher profits they are helping to generate.  Eventually these and other factors combine to push margins back down.  Reversion to the mean also works in the opposite direction.  Poor financial results in an industry drive firms out of business and wages down, such that surviving firms have an improved competitive landscape.  Hunt goes on to state that if economic dynamism is lost due to “financialization”, or the ability to generate higher profitability without having to sell more products or services, it isn’t really capitalism any more.  He cites dramatically reduced corporate tax rates and super low interest rates as factors that have allowed corporate management to say to employees essentially “you are not the reason for our excess profits, so we are not sharing them with you.  We are reserving them for shareholders and for ourselves, as we have been smart enough to leverage these low interest rates and buy the right politicians”.

So here we are.  In an environment of low inflation, low productivity, and low growth.  Where running large deficits does not lead to spiraling inflation.  Where the Federal Reserve can essentially keep the business cycle out of recession almost indefinitely by expanding credit.  And where a few investors have said to me lately (more or less), “if this is all true, why not turn the “risk knob” up to 11”?

Fair question.  I guess the best explanation is that my investing career began in 1986.  I remember October 19, 1987, when stock dropped -22.3% IN ONE DAY.  I learned a strategy (in that case it was called portfolio insurance) that involves selling when the market drops a certain percent may work for a small group of people, but if EVERYBODY adopts the very same strategy it will not work for ANYBODY.  I learned on August 2nd, 1990 when Iraq invaded Kuwait that you can focus on a myriad of geopolitical hot spots and still fail to forecast the one that blows up in your face.  I remember in 1998 how the smartest financial minds in academia made more than four billion dollars disappear in the Long Term Capital Management fiasco.  From that I learned that just because you create a model that says a certain event should occur no more frequently than once in 10,000 years doesn’t mean that it won’t happen (or that your model is correct).  From the late 1990s tech wreck I learned that if the markets reward revenues instead of profits, eventually people will sell dollar bills for 99 cents.  From the financial crisis of the 2000s I learned that just because a particular aggregate price had never declined before (in this case housing) doesn’t mean it never could.  We all also learned from Chuck Prince of Citigroup that Wall Street firms will do things they know are stupid as long as everybody else is doing them.

The point of all this is to say that every time the market has indulged in behavior that suggests it believes it has found the key to perpetual prosperity there has eventually been a train wreck.  We just had a -19% stock market correction because the Federal Reserve raised the federal funds rate to 2.5%!  Forty years ago it took double digit interest rates to cause this big of a decline.  In 1987 an increase to 7.25% on September 22 helped precipitate the crash.  In 2000 rates peaked at 6.5% in May.  In 2007 interest rates only needed get to 5.25% to burst the housing bubble<7>.  It appears that interest rates have to keep falling or we cannot sustain the bull market.  Obviously, there is a wall out there that we will eventually hit since there is a lower limit to interest rates (such that easing won’t work anymore).  Japan found that level, and Europe seems to have as well.

What I hope you take from all of this is that we recognize that the dominant paradigm has shifted.  The 3-5 year business cycle of thirty years ago is a thing of the past.  The belief that a bull market must end because a certain amount of time has passed has proven unfounded.  Today investors and the Fed no longer fear inflation, corporate America no longer fears debt and in fact believes leverage and low taxes solve everything.    All that said, human nature has not changed.  Losses lead to prudent behavior which lead to gains which lead to increasingly reckless behavior which eventually lead to spectacular busts.  We are committed to investing in a globally diversified portfolio of stocks and bonds which we believe will help cushion portfolios during a major downturn. When you have short business cycles as we did in the 1980s and 1990s the rewards for avoiding the busts arrive regularly.  When cycles stretch for a decade or more as they do now, those rewards are much less apparent.  Having experienced what I have over thirty plus years, I have a certain respect for risk because I know how quickly large gains can turn to losses.  What global central banks have been doing is a great experiment.  There is no historical precedent for this much corporate and government debt.  I hope this works out well for all of us but I have my doubts<8>.  And because of that, I’m going to err on the side of caution.

<1> S&P 500 and Russell 2000 performance are per Morningstar Workstation

<2> You would still have a -1.72% loss

<3> Barrons Quarterly Issue, 4/8/19

<4> BBgBarc US Corporate High Yield, per Morningstar

<5> BBgBarc 1-3 Yr US Treasury, per Morningstar

<6> BBgBarc Aggregate Bond, per Morningstar

<7> Kimberly Amadeo, Fed Funds Rate History with Its Highs, Lows, and Chart, thebalance.com 03/21/2019

<8> Because the unavoidable byproduct of financialization is economic inequality, and this is leading to political instability across the developed world.

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.

Annual ADV Notification

As a registered investment adviser, we provide certain important information to you on an annual basis, which is included in this Annual Notice. Our most recent disclosure statement as set forth on Form ADV Part 2 and 2b is now available.  There have been no material changes since the February 28, 2018 Form ADV Part 2 brochure. If you need a copy at any time throughout our relationship, please call us toll free at 952-358-3395 or 866-944-0039 or send an email to john@trademarkfinancial.us.  A copy is also available at our website, www.trademarkfinancial.us.  Additional information regarding our firm is also available at www.adviserinfo.sec.gov. You should always contact the financial advisor listed on this quarterly statement immediately if there are any changes in your financial situation, investment objectives, email address, or if you wish to add or modify any reasonable restrictions to the management of your account. As always, should you have any questions or require any additional information regarding this Annual Notice, please do not hesitate to contact us.

Summary

Stocks had a rough quarter worldwide.  In fact, 2018’s poor performance has raised the question as to whether or not the post-financial crisis bull market was over.  Stocks declined during the summer of 2011 and again from late summer 2015 through mid-winter 2016, but both times they rallied sharply after the low was put in.  This reinforced the strategy of “buying the dip”.  2018 saw a correction in the first quarter followed again by “dip” buying which pushed the major market averages once again into record territory by the end of the third quarter.  Immediately thereafter, a second sell-off began.  The fourth quarter decline was deeper from top to bottom (-19.8%)<1> than the previous ones and the breadth (the percentage of stocks making 52-week lows) was greater as well.  In other words, almost no stock was spared (especially not the large consumer technology stocks that made the most money for investors on the way up).  The fact that the ten percent first quarter decline was followed up so soon with an even larger decline is not a good sign, but it is not conclusive.  It does warrant additional defensiveness, we believe.

The S&P 500’s -13.52% decline in the fourth quarter is the worst quarterly performance since the fourth quarter of 2008, and day-to-day volatility in December rivalled that of 2008.<2>  Small company stocks fell an astonishing -20.02%.<3>  Ten of the eleven industrial sectors declined, with only utilities able to claw out a small gain (1.4%).<4>  Energy plunged -25.1%,technology lost -17.5% and industrials fell -17.3%.<5>  For the full year, the S&P 500 index fell -4.38% and the small cap Russell 2000 was down -11.01%.<6>

International stocks actually provided a bit of a diversification benefit in the fourth quarter.  Developed international market stocks fell -12.54%, but emerging markets lost only -7.47%.<7>  Over the full year, however, the declines were -13.79% and -14.58%, respectively.<8>  The question of whether the U.S. stock market could continue to do well when foreign markets were doing so poorly was ultimately answered in a negative fashion.  That said, the fact that emerging markets only lost about half of what U.S. stocks did in the fourth quarter might mean that EM has become so cheap that the downside from here is rather limited.

High quality bonds such as treasury and agency-backed mortgages were the beneficiaries of the weakness in stocks.  The Barclays Aggregate bond index rose 1.64% last quarter to end the year up 0.01%.  Both high grade corporate bonds and lower grade “junk” bonds lost money in the fourth quarter and over the full year.  The best place to have been last year in bonds was the safest – short term Treasuries (1.89%).  Short term municipal bonds also performed relatively well (1.76%).  International bonds lost over -5.17% in 2018 on the strength of the U.S. dollar.<9> Activity

Volatility increased dramatically during the fourth quarter, which kept us quite busy.  There were plenty of things to do in terms of making portfolios more conservative, including raising cash, replacing or reducing funds that aim to outperform the market on the upside (but often lose more in down markets), reducing or eliminating exposure to lower quality corporate bonds, and increasing exposure to low volatility and/or dividend-oriented equities.  We also took advantage of the sharp sell-off in international stocks in 2018 to do tax loss harvesting.  Taxable investors probably noticed substantial changes in December.

Outlook

I wrote last quarter that there were potential catalysts in both directions.  The downside catalysts won out.  The Trump Administration did not strike a deal with China (although it pretended to do so after the Argentina summit).  As a matter of fact, Vice President Mike Pence’s October speech was more of a “double down” on the trade war than an olive branch of any type.  The government shutdown seems likely to drag on, which will reduce first quarter 2019 GDP.  On the other hand, lower interest rates (the 10-year note, which a lot of consumer loans are tied to, is down to -2.72%) and lower gasoline prices are helping the consumer.

Given the above, it is difficult to foresee a strong first quarter performance from the economy.  The three hopes for investors are that 1) the double-digit market decline last quarter is already more than reflected in current market prices allowing for a rebound, 2) that the relatively minor economic slowdown market pundits are calling for in 2019 doesn’t turn into a full-fledged recession, and 3) that the government eventually re-opens and lawmakers again provide policy certainty, which would allow businesses to make their investing and hiring plans for the rest of the year more confidently.

Commentary – Mr. Market

For every asset there is a tug of war between people who want to buy and people who want to sell.  Prices are set, effectively, by those who change their mind and trade accordingly.<10>  Buyers and sellers (“market forces”) are usually slightly out of balance requiring the marginal buyer to pay a little more or the marginal seller to accept a little less than they’d like. The side that capitulates and accepts the market price depends on conviction, which can be fragile and fleeting. It can be influenced by economic data, a rumor, company specific information or oftentimes just the gut feeling of the market participant.

At the beginning of 2018, a growing global economy and corporate tax reform combined to raise the outlook for corporate profits.  The demand for stocks was high relative to the supply (shares that people were willing to sell), so excess demand allowed sellers to demand increasingly higher prices.  One of the interesting characteristics of investments (be they stocks, art, or bitcoins) is that a sharp rise in prices tends to increase demand as investors project even higher prices.<11> The converse is also true, as stocks decrease in value investors project that trend into the future. Behavioral finance calls this recency bias.<12> Exhibit 1 shows the US Investor Sentiment Index (the percentage of investors who are bearish or expecting lower prices) plotted against an ETF tracking the S&P 500. You can see that as the ETF decreases in value, the percentage of bearish investors spikes. It’s a visual representation of recency bias.

Exhibit 1

Source: YCharts.com

Famous investor Warren Buffett quotes his mentor, Benjamin Graham, as saying that “Mr. Market” is like a manic-depressive business partner: “Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.  For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and we can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.”  Buffett concludes: “Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.” <13>

CNBC, Fox Business News, Bloomberg, and a host of others authoritatively opine daily on what is driving the Mr. Market’s mood.  The explanations always seems to makes sense, but they are seldom of any real value to investors.  If you think about it, the news has been largely the same over the last five months – the trade conflict with China, a fairly strong but modestly slowing domestic economy, the toxic political climate, among a host of other things and yet we saw stocks soar in late summer, plunge throughout the autumn and then turn sharply upward again after Christmas.  It is sentiment, the tug of war between fear and greed, that moves Mr. Market.

We have been navigating the markets for more than three decades, helping investors to keep their calm no matter how Mr. Market feels.  We know that money is a very emotional issue for many people, which makes what we do – helping to dampen Mr. Market’s mood swings by applying both valuation and sentiment analysis – so important when markets appear to be irrational.  Drawdowns (paper losses) are inevitable.  As an investor you must be prepared, both intellectually and emotionally, for sentiment to occasionally turn negative and your portfolio to decline.  Being able to make clearheaded decisions in difficult times is what separates successful from unsuccessful investors.  Trademark tries to turn adversity to your advantage by investing in globally diversified portfolios of stocks and bonds that we hope dampen Mr. Market’s mood swings and allow you to remain invested.  We thank you for allowing us to help guide you through these difficult periods.

-Mark A. Carlton, CFA

Endnotes

<1> From the market high in the S&P 500 on September 20th to the low on December 24th.

<2> Blackrock Returns Comparison, December 2018

<3> As measured by the Russell 2000 Stock Index

<4> Sector performance courtesy of S&P Dow Jones

<5> As measured by Dow Jones US Sector Indices, Blackrock Returns Comparison, December 2018

<6> Source: Blackrock Returns Comparison, December 2018

<7> As measured by MSCI EAFE and MSCI EM, Blackrock Returns Comparison, December 2018

<8> As measured by MSCI EAFE and MSCI EM, Blackrock Returns Comparison, December 2018

<9> All bond category performance data is provided by Blackrock Returns Comparison, December 2018.

<10> The person who owns Tesla and believes it is worth $500 per share doesn’t move the market any more than the person who thinks it’s worth $100 and doesn’t own it.

<11> This tends not to be true for objects of consumption, such as steak or peanut butter, where rising prices invite substitution.  Investments are not fungible in that way.  If you want to participate in a stock rally but think prices are too high, you don’t go out and buy bonds.  If you like Apple products and want to profit from their increased use, you don’t go out and buy Home Depot or Nike stock.

<12> Recency bias is the tendency to think that what’s been happening lately will keep happening. One of a group of Behavioral Financial Biases that can cloud investors’ judgment. Recency Bias can cause investors to stay in stocks or other instruments because they have been performing well, despite warning signs like historical or relative high valuation. On the other hand, this bias can also keep investors from buying when stock prices are low, as in early 2009, because for months stocks had been falling and under Recency Bias one would expect that to continue. Source: YCharts.com

<13> Berkshire Hathaway Annual Letter to Shareholders, 1987.

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