The U.S. stock market posted another strong quarter, rising 7.20%. Once again, however, U.S. stocks were pretty much the “only game in town”. International markets were about flat on balance, with developed markets up 1.51% and emerging markets down -2.16%. Bonds were almost unchanged as the S&P U.S. Aggregate Bond Index rose 0.07%. The question on every investment professional’s mind lately is “How long can this performance divergence last”? At some point, many professionals believe, either foreign stocks have to rally or U.S. stocks need to decline because the performance and valuation gaps are almost historically wide. That said, the trend has been to overweight U.S. stocks and hope the point of transition is both gradual and resolved by foreign stocks rising.
If one was inclined to look for cracks in the armor of the current U.S. stock rally, it would probably be that small and mid-size stocks performed poorly in September. Midcap stocks declined -1.10% to finish the quarter up 3.48% and small cap stocks were off -3.17% in September to close the quarter with a 4.38% gain. By way of comparison, the S&P 500 was up 0.57% in September and 7.20% for the quarter. See Item 1. This suggests rising interest rates and tight labor markets might be beginning to have an effect, because one would expect smaller companies to have higher borrowing costs on average than larger ones, and less ability to “offshore” their labor.
Item 1
Source: YCharts
International stocks continue to be hurt by the strong dollar, especially in those countries with high dollar-denominated debt and/or higher oil prices due to the Iran sanctions (remember that globally oil is priced in dollars, so a 20% increase in oil prices plus a 10% stronger dollar means oil costs 32% more in local currencies). In addition, the Chinese-American trade war is clearly hurting the Chinese market while both Brexit and the new Italian government are two separate issues currently weighing down European stocks. Short of the U.S. capitulating on its tough trade stance, it is hard to see what would trigger a bull market in foreign stocks even though they appear to be cheap in comparison.
Bonds performed well earlier in the summer but that all ended in September (-0.48%) as it became clear that interest rate pressures were building. Less interest rate sensitive segments of the bond market, such as floating rate loans and high yield debt, managed to gain over one percent on the quarter. High quality municipal and treasury bonds each gave up less than one percent.
Activity
There wasn’t that much to do in July and August as the dominant bullish trend from the second quarter carried over. Bonds were quiet and the dollar actually declined, allowing stocks to continue their upward march. In September, as we approached the day (the 26th) when we expected the Federal Reserve to raise interest rates, markets got nervous. Seeing that this was playing out more in small company stocks, we took some profits in small cap ETFs in many accounts. We also reduced interest rate sensitivity on the bond side by trimming the PIMCO and Baird exposure in favor of short-term bond ETFs. Overall, we began to think more defensively.
Outlook
Since the end of the quarter a few strong economic reports on October 3rd and 5th helped push long term interest rates to their highest levels since 2011, and stocks subsequently buckled under the pressure. So far, U.S. stocks have given back a little more than foreign stocks this quarter, but nothing has emerging unscathed (save gold, which has trimmed its year-to-date loss from -8% at the start of October to less than -6%). At this point, potential catalysts exist for both a run at 3000 on the S&P 500 (again, involving a significant reduction in trade friction with China leading to a stronger renminbi and lower oil prices) and, alternatively, a continuation of the current sell-off (an escalation of the trade conflict leading to more dollar strength and less global economic activity). If I had to guess I would say that a deal eventually gets made that both sides can declare victory on, and markets rally (led by emerging markets). Call me cautiously optimistic.
Commentary – In Defense of Foreign Investing
What is the right amount of a portfolio to invest overseas? A purely neutral policy would put about 45% of one’s equity portfolio overseas because that approximates the foreign slice of global stock market capitalization. Item 2 from JP Morgan shows the global market breakdown by capitalization. But wait, why should we be neutral? Foreign stocks offer currency risk. Their economies are, generally speaking, not as robust. In some cases their accounting systems are not as transparent. Their overall profitability trails ours. It would seem therefore that the international weighting should be quite a bit lower than 45%, but how much lower? This is probably the biggest challenge in portfolio management right now. The implications are significant.
Item 2
Source: JP Morgan 4Q18 Guide to the Market
According to Morningstar, US stocks have a 10-year average annualized return of 11.97% through September 30th. This would be the return on the equity portion of your portfolio if it had no international stock exposure. If you diversified your equity exposure by capitalization (as global stock indices do), your annualized return would fall to about 9%. If you held a two-thirds domestic, one-third foreign exposure (as the average investment advisor does according to TD Ameritrade), your return would be a little better (about 9.8%). Tactically underweighting foreign stocks to just one-fourth of total equity exposure improved the return to 10.32%.
Is all this to argue that foreign stocks are a drag on returns and therefore should be excluded from portfolios? Certainly not. My investment career has included two periods in which foreign stocks dramatically outperformed U.S. stocks. The first was from 1985 through 1990, and the second from 2003 through 2007. Broadly speaking, one would have done better in foreign stocks from 1985 through 1994 and 2000 through 2009, so the periods of strong U.S. outperformance were 1995 through 1999 and 2010 through the present. The current period is very long by historical standards, which is why so many market pundits predicted that the strong performance of foreign stocks in 2017 marked the beginning of a new era. It is exceedingly difficult to successfully predict a major secular change – and it obviously didn’t happen in this case either. That said, if history is our guide it will happen at some point. If one waits until the rally is obvious, they will likely miss out on a significant amount of gains.
Item 3 illustrates why many professionals have been expecting foreign stocks to outperform. Historically there has been a fairly high correlation between foreign and domestic stocks, and the performance gap has never been particularly wide. Until now. As the chart shows, the U.S. has historically traded at a price to earnings premium to foreign markets of 1.6 times on average. That premium is 3.9 times today. Maybe you can argue our economic stability and military strength warrant a greater premium than 1.6x, but 3.9x seems rather extreme. It is the kind of thing you would expect to see if there was significant global turmoil.
Item 3
Source: JP Morgan 4Q18 Guide to the Market
On a global basis, non-U.S. stocks are 45% of total stock market capitalization. Tactically, Trademark has been under-weight foreign stocks by that measure. Depending on your risk tolerance, an average portfolio we manage is roughly 24% invested in non-U.S. companies today. As such, our portfolios clearly reflect the turmoil many foreign countries are experiencing. Yet we feel it is a mistake to write them off completely even though they have been a drag on performance this year. Overall foreign markets are significantly cheaper than ours and the growth rate of foreign economies is higher. Our policies (tariffs, taxation) have contributed to their difficulties in many cases, but it is foolish to believe that they can’t or won’t adapt. As investors, we should hope that they do, because the U.S. stock market is not likely to duplicate its 11.97% ten-year average over the next ten years.
Thanks for your continued trust in our management,
Mark A. Carlton, CFA®
As measured by the S&P 500, Source: S&P Dow Jones Index Dashboard, September 28, 2018
As measured by the S&P Developed Ex-U.S. BMI and S&P Emerging BMI. Source: S&P Dow Jones Index Dashboard, September 28, 2018
S&P Global Index Dashboard,9/28/18 is the source for both quarterly and year-to-date U.S. stock and bond returns.
As measured by the S&P U.S. Aggregate Bond Index. Source: S&P Dow Jones Index Dashboard, September 28, 2018
The value of the market as determined by aggregate stock share prices multiplied by stock shares outstanding.
Approximately 55% US, 34% developed foreign and 11% emerging markets (per JPMorgan and MSCI).
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
The Fed and Interest Rates
Interest rates are probably going up by 25 basis points later today. The market and I believe it’s a done deal. The interesting part will be the Fed comments regarding future policy action. Any sign that the expected December hike has become less certain or that next year’s rate hikes are “wait-and-see” are likely to be taken as market friendly, especially for the international stock markets. There is already a sense that the performance gap between U.S. and non-U.S. equities had reached historic proportions, and this helped fuel the international stock rally last week. The rally in international stocks will probably continue only insofar as the dollar correction lasts. A hawkish Fed on Wednesday means higher rates, a stronger dollar, and more international stock pain.
Diversification
It’s has been a difficult environment for asset managers who are philosophically committed to diversification. With domestic stocks ahead around 10% (all figures YTD through September 16th), any money allocated to foreign stocks (-4%), domestic bonds (-1.5%) or foreign bonds (-3%) is negatively impacting your returns relative to the U.S. domestic market which is most people’s market performance reference point. For example, a 60/40 portfolio invested 40/20/30/10 (domestic stock, foreign stock, domestic bonds, foreign bonds, respectfully) has returned 2.45% before fees. If you were a skilled tactician and over-weighted U.S. stocks while underweighting foreign stocks and bonds (50/15/30/5), you could have improved your return to 3.80% pre-fee. The point is, no diversified 60/40 investor should have any reasonable expectation of having earned even half of the S&P’s 10% return.
Some might respond to this by saying that they don’t care about diversification – “just give me the best return, I don’t care where it comes from”. The problem with this statement is that it assumes one can know where the best returns are going to come from. In retrospect, it has paid off handsomely to have investment in U.S. stocks over the past 9 years. Nothing else is even comparable. That said, it is in no way guaranteed that U.S. stocks will remain the best performers over the next 9 years (or even the next nine weeks). Below is an asset class return graph from J.P. Morgan. Each color corresponds to a different asset class. The white boxes represent a balanced portfolio. I include the chart to illustrate that year-to-year performance volatility of individual asset classes is high. Trying to pick the ‘winning’ asset class one year may lead to large underperformance the next year.
Source: JP Morgan 3Q18 Guide to the Market
It has been pointed out several times over the past few years (by myself and others) that valuations for most U.S. stocks are stretched; at some point that rubber band is going to snap. The reason advisors should care about this is that it isn’t the three or four percent that you have in emerging market debt that is going to destroy a client’s portfolio. That asset class is already off more than 10%; if it loses another 15% from here, that is only another 0.6% in a diversified portfolio. If, on the other hand, U.S. stocks finally come back to earth – say 25%, your 50% exposure is going to cause a -12.5% wealth reduction.
China and Tariffs
China would like to make a deal with the U.S. and is prepared to make modest concessions. The Trump administration wants major concessions, so that it can announce that the Chinese “caved”. The U.S. stock market has been betting on the former scenario. I do not believe that the latter scenario, that a deal isn’t reached and things escalate, is reflected in current market prices. Semiconductor chip stocks might be the exception to that last statement. They are off 7% since the first tariffs were implemented back in June.
The Long Bond
Watch the 3.22% yield level on the 30-year bond. That level provided support during past bond sell-offs. If it doesn’t hold, the yield on the 30 year could quickly move to 3.5%. more importantly, it could more decisively confirm that the great bond bull market ended in 2016 and the era of reflation is underway. This could also eventually light a fire under gold.
Corporate Debt
I am reading about a lot of concern regarding corporate debt levels. Issuing debt (to buy back equity) has been a very attractive way to boost earnings and stock prices over the past seven years because interest rates have been low. Rising interest rates will make that harder to service. Think about it this way: If a company had a $5 billion market cap three years ago with $2 billion in debt, it had an enterprise value of $7 billion and a leverage ratio of 40% ($2 billion/$5 billion). Let’s say the company aggressively borrowed to buy back its stock and was rewarded with a big P/E multiple increase. It now has a market cap of $10 billion with $6 billion in debt. The leverage ratio is now 60%, but we don’t care because we believe the company is a skillful manager of its balance sheet. Eventually, the economic cycle peaks and the stock price begins to fall. As the stock price falls, the leverage ratio increases, which makes the company look riskier. Soon we have a $7.5 billion company with an 80% leverage ratio ($6 billion/$7.5 billion). The company would like to pay down some of that debt because credit conditions are tougher now , but it isn’t exactly flush at this point, so all it can do is lobby the Fed to lower rates to help it out. The lesson is that high interest rates serve a purpose. When rates are high, companies are very careful about taking on debt. In an environment of permanently low rates, debt is taken on and rolled over, but never retired. Eventually it chokes the company (and by extension, the economy itself).
Tactical Speaking
Value is performing better than growth this month but I’m not ready to shift my portfolio just yet. I would scale back my overweight to momentum growth (if I had one)
International equity is cheaper that domestic equity and had a good week but I’m not changing my portfolio yet. Small cap developed international stocks and emerging market stocks are oh-so-cheap, but that is probably a 2019 story.
Large caps are outperforming small caps. I absolutely would reduce or eliminate small cap over-weights. From a Fed and a political standpoint, uncertainty is high. That favors bigger and more defensive stocks. The “small-is-better-shielded-from-trade-concerns” argument is played out.
The bull continues. Investors have responded to any and all bad news over the last six months not by exiting the stock market but by redeploying assets within the stock market. As long as that continues, side with the bulls.
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
Economy
Famous hedge fund investor Stanley Druckenmiller is known for his assertion that it is liquidity that moves markets, not earnings. If that is the case, the current debacle in Turkey should be watched carefully. Turkish President Erdogan’s efforts to control rising inflation have blown up in his face. The Turkish lira has declined sharply over the past two weeks. Whenever you see major losses like this, you should ask yourself “who else is exposed?” Obviously Turkish consumers are hurt by a plunging currency because that will lead to soaring inflation on anything that needs to be imported. Turkish businesses that borrowed in dollars (most of them) are going to have a hard time. German and Italian banks, which are the biggest lenders to Turkey, are also understandably having a very difficult time. The currencies of other emerging market and frontier market countries continue to be hurt because in a crisis, investors tend to prefer the U.S. dollar and the Japanese yen. Even other developed markets have been losing ground over the past few weeks. Despite stabilizing over the past three trading days, we are not out of the woods yet. All eyes are on the Federal Reserve which has repeatedly signaled its intention to raise rates in September. This may very well spark a renewed run in the dollar and out of more vulnerable markets.
So far, the U.S. has by-and-large avoided the contagion that has engulfed most of the rest of the investment world. I cannot predict how long investors will continue to shift assets to the U.S.; I can only say that in the short term it makes sense from a tactical standpoint as both technical and fundamental trends are supportive. Valuations are not, of course, but valuation has never been a good timing tool. You may want to own emerging markets because they are currently priced to return much more than domestic stocks over the longer term, but you have to deal with the fact that every day other advisors and investors are throwing in the towel, depressing your share price. How much pain (underperformance) are you willing to withstand?
I would always rather buy an inexpensive asset with momentum than an expensive asset with momentum, so if I can offer any good news from a valuation/regression-to-the-mean standpoint, it is that growth, with its heavy tilt toward technology, has cooled off a bit lately. Investors have been willing to look at more cyclically driven shares this month, including industrials, transportation, and retailing. On the more defensive side, pharma and real estate are doing better. I feel much better about investing today (at less than 1% below January’s all-time high) knowing there are other pockets of strength outside big tech. I believe the S&P 500 will break the January high this week, for what it’s worth. There is still so much liquidity out there, and it continues to look for a place in U.S. stock and bond markets. That said, I expect a pullback in September because it is a traditionally weak month and there will probably be jitters around the Fed and the midterm elections.
Jeffrey Gundlach of Doubleline recently articulated that there is too much money shorting long-term treasury bonds. I agree. Whenever there is a big speculative imbalance, something has to give. The short speculators in gold were recently proven right, but I agree with Jeffrey that the logic in the case of long bonds is flawed. The Fed can raise short term rates to a point where the yield curve inverts because inflation is still largely contained and because an inversion isn’t as predictive as it was in the days before massive central bank intervention. If you are a bank in Germany or Italy right now and you are concerned about your balance sheet, the 3% you can earn on a 30-year T-Bond is AAA-rated, yields much than 30-year European sovereign debt, and is likely to appreciate (at least near term) versus the euro. I believe demand is going to keep long rates under control unless our economy slows dramatically (and I don’t see that happening in 2018).
Mutual Funds
This is a good time to remember that when you invest with the American Funds family, your equity funds typically have more international exposure than their peers. Growth Fund of America has 13.3% in foreign stocks, almost exactly double that of large cap growth competitor T. Rowe Price Blue Chip Growth. Not a judgement on either fund, just a heads up for those that might be interested in their total foreign exposure.
The strength in the economy has really helped high yield municipal bonds outperform higher grade munis. The latter offers more inflation risk and less credit risk, but credit has been surprisingly strong this year so investors have been generally rewarded for taking that risk. I believe that will continue.
Mairs and Power, a St. Paul Minnesota based investment management firm focusing on companies in the upper Midwest, got stomped by their peers over the last several years due to their overweight in industrial firms (which are more prevalent in this part of the country). The Growth fund (MPGFX) is putting up some category topping numbers this quarter.
Lastly, you may consider hedging some international exposure by using IHDG (Wisdom Tree Hedged Quality Dividend Growth ETF) in place of a non-hedged international ETF (VEA or SPDW) or a blue chip foreign fund like Europacific Growth.
Source: Morningstar Adviser Workstation
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy
Summary
Stocks rebounded last quarter – at least here in the U.S. Trade war fears drove up the value of the dollar on the idea that tariffs would lower America’s trade deficit, which would mean fewer (and therefore more valuable) dollars in the world for commercial purposes. The U.S. economy depends a lot less on importing goods than most countries, so it can better afford less inter-national trade in favor of more intra-national trade. That said, most institutional strategists believe that a full-on trade war will not happen; this is a big reason why the Russell 3000 gained 3.89% last quarter. As a firm responsible for protecting investors’ principal, however, the trade conflict makes us nervous. History is full of disasters that just didn’t seem all that bad at first.
As mentioned, U.S. stocks enjoyed a nice rebound from the first quarter’s modest loss. The first half of 2018 saw a gain of 2.95%. If you are an old school Dow Jones Industrials fan, stocks rose just 1.09% and are down -1.05% for the first half of 2018. On the other hand, if you set your course by the technology heavy NASDAQ index, stocks rose 6.61% during the second quarter and 9.37% through June 30th. Obviously, what you owned made an unusually large difference last quarter, a fact I will elaborate on in the Commentary section. Small cap U.S. stocks were a beneficiary (the S&P 600 is up 9.39% through last quarter), to a large extent, of the trade war fears in that they are less likely to be major exporters than larger companies.
The performance of foreign equities in dollar terms was pretty awful. Emerging markets (-7.96%) were hit the hardest by trade concerns. The issue is that certain countries borrowed substantially in dollar terms, which allowed them to pay less in interest costs because the buyers of those bonds then carry dollar risk, not lira or peso or rupee risk (just to name a few). The risk is that if the dollar rises sharply (as it has recently) the issuing country has to exchange a lot more of its currency for (the same amount of) dollars in order to pay the bondholders. This was felt most acutely in Brazil, Argentina, and Turkey, but everybody else suffered as well. While Latin America was the biggest loser at -20.86%; there were no winners in dollar terms.
Bonds came oh-so-close to breaking even last quarter, losing just -0.16%. This brought their year-to-date performance to -1.62%. It was just a tough quarter for conservative investments as bonds, utility stocks, real estate, and dividend-oriented equities all declined. Floating rate debt managed to eke out a modest gain last quarter, as did short term bonds. Interest rates have now climbed to where the yield on short term debt is now high enough to overcome the negative effects on principal. The best performing sector of the bond market was high yield municipal debt, which rose over one percent. Emerging market debt lost a staggering -5.4%.
In some accounts we keep a very small amount in gold and/or commodities as an inflation hedge. This detracted modestly from performance over the course of the quarter.
Activity
With the dollar suddenly strong, job one was making sure we were not overly exposed to emerging market stocks or bonds. Because of their favorable long-term potential and diversification benefits, we did not eliminate those positions. Nobody rings a bell when a sector hits bottom, and in fact often the rebound from sharp sell-offs can be quite strong. Our second priority was making sure we had enough exposure to the higher growth areas of the market, such as small cap stocks and momentum growth stocks. In an environment where the combined performance of every sector except information technology was essentially zero (see Item 1), you absolutely had to own some tech. The third priority was making sure the duration of the bond portfolio was low enough such that what you might lose to rising interest rates was more than compensated for by yield. This was true of both taxable bonds and municipals (where it still pays to take a little extra credit risk).
Item 1
Source: Seeking Alpha Outlook
My crystal ball is even hazier right now than usual. The two biggest issues for the stock market at present are interest rates and trade policy. The fact that after surging in the first quarter interest rates were little changed last quarter helped investors feel more at ease. Investors are concerned about the trade war, but they seem to be operating under the idea that it is a mixed blessing for the U.S. while a devastating blow to foreign countries. Pundits talk about winners (companies and industries that do not export) and losers (companies that export) while assuming every foreign company is a trade war loser, because the performance difference between U.S. and non-US stocks was 4.63% last quarter! That thinking fails to understand that in local currencies foreign markets rose 3.47% last quarter. The bottom line for me is that I can’t see the current strength of the U.S. continuing beyond another quarter or two. As our currency appreciates, our exports are becoming too expensive to foreign buyers. Eventually this will translate to lower sales and profits for our exporting companies.
That said, stocks have gotten a bit of a reprieve from interest rates as the trade war has intensified, because investors assume it will slow down the global economy. There are those that now think the Federal Reserve will only hike rates one or two more times this economic cycle, which, if true, would be stock friendly (as long as the global economy doesn’t slow down too much). Goldilocks, you’ll recall.
I think one of two different scenarios will play out. One is that the trade issues will be resolved and the stocks, countries, and currencies that depend on world trade will bounce back strongly. In this scenario the global slowdown will prove to have been a “breather” that sets us up for two or more years of expansion (much like the late 2015/early 2016 slowdown pushed interest rates down and fueled a two-plus-year market rally). The other, less likely scenario in my opinion, is that the stock market already reached its cyclical peak on January 26th. That view comes from the fact that U.S. stocks as a whole have not been able to make a new high since then, and neither investor optimism nor market breath is nearly as strong as it was. At some point the U.S. may go from being the only port in the storm to just another country in a bear market.
Commentary – The Tortoise and the Hare
Economic conditions change often drastically from one market cycle to the next, but human nature doesn’t change much at all. There is a certain path we as investors almost always follow as the cycle progresses. Coming out of a recession, nearly all stocks go up because every company’s earnings are expected to improve, yet investors are fearful and therefore underperform. Once investors are sure the recovery is for real, they look for companies that have relatively better growth prospects while they reduce their holdings of companies they held primarily for safety and yield. This progresses in fits and starts (because economic data is never a smoothly ascending or descending line) until the peak of the cycle. At that point, all of the market’s net advance is fueled by earnings growth-oriented companies. Defensive companies, like those in the utility or household products industries, decline in value because investors don’t prize safety anymore. Even modestly growing companies see their shares stagnate as overconfident investors focus on the biggest winners. With fewer and fewer stocks carrying the market, the burden of the expectations placed on those companies ultimately becomes too great. Over-owned at this point, they suffer the largest declines when the next recession hits and investors turn back to the safety of stocks that pay a nice dividend and are less likely to disappoint.
While it is never possible to know exactly where you are in the cycle, it is significant to note that the top ten technology and consumer technology stocks accounted for 122% of the S&P 500’s gain in the first half of 2018 (see Item 2). The cumulative performance of the other 490 stocks in the S&P 500 was less than zero. Item 2
Source: Seeking Alpha. Data as of June 28th, 2018
We might generalize the performance of growth stocks and dividend stocks as hares and tortoises respectively. When they are both at their best, it is difficult to see why anybody would bet on the tortoise. Unfortunately, hares have a nasty habit of sleeping and otherwise getting distracted while tortoises just plod on toward their goal.
At least they used to. Over the past several years the hares have built a huge lead over the tortoises. So large in fact that even though tortoises have won more races historically than the hares, nobody seems to believe the hares will ever lose again. “Things are different this time”, they argue. “Hares are more focused now, and the race course contains obstacles that hares can more easily get over, and the length of the course and the temperature, etc.” All of which may be true, but the fundamental nature of a hare is that they are not meant for long races. That which drives rapid growth is very difficult to sustain over time, whether you are a rabbit or a multi-billion-dollar corporation.
Will today’s hares (Amazon, Apple, Netflix, Facebook, etc.) have endurance? Time will tell.
So how does this apply to your portfolio? Obviously when the hares are running strong you want to have some exposure there. On the other hand, hares surrendered more than half their value in the 2008 -09 financial crisis AND during the 2000-02 technology crash. Your risk with the tortoises is not so much what you lose in a crisis but what you don’t make in the expansionary phase when hares are doing so well. A well-diversified portfolio contains both tortoises and hares, but it is human nature that while we get frustrated both with plodding turtles and sleeping hares, we tend to favor hares over tortoises because their potential speed is higher. They can make us the most money in the least amount of time.
This presents a challenge for most investors. If they want to participate in the current rally they must own the popular stocks that are almost certain to fall the most after the cycle peaks. If they want to play it safe, they are going to probably earn very little until the cycle turns. Growth stocks gained 7.28% in the first half while value stocks lost -2.22%. Furthermore, the sub sector of growth stocks that focus on momentum rose almost 8.86. The allure of growth is understandably extremely strong right now. That said, if experience teaches you anything in investing it is that great returns never come from doing things that are psychologically easy. Following the herd is comforting for long periods of time and then it becomes terrifying during those times when the herd is in full panic.
So please remember this if the temptation gets strong to sell the tortoises and load up on hares. We are at the part of the cycle where expectations for certain “hares” are very high. Diversification may not make a poor man rich, but it will also not necessarily make a rich man poor. We strive to blend assets that have strong growth potential (but are currently quite expensive) with those that are cheap and promising (but currently facing challenges) and others that are reliable (but not that exciting). We don’t always get that balance just right, but we never lose sight of why it is important to try in the first place.
Thanks for your continued trust in our management,
Mark A. Carlton, CFA®
That said, adopting from the outset the notion that trade deals have a winner and a loser and we intend to win makes it very difficult to negotiate, because by definition you are demanding that the other side(s) agree to lose.
Russell 3000 stock index, the broadest measure of U.S. stock return.
Performance figures for all stock market averages are per Morningstar.
Source: S&P Dow Jones Index Dashboard: US, June 29, 2019
Source: MSCI Emerging Market Index per Morningstar
Source: Barclay’s US Aggregate Bond Index
Emerging Markets Hard currency debt, per Lipper (Barrons, 7/9/2018)
Counting Amazon and Netflix as tech stocks, not consumer discretionary stocks. Per SG Cross Asset Research.
Not for aggressive investors who will buy the “hares” and endure the inevitable periodic bouts of high volatility, nor for the very conservative investors for whom an all-tortoise portfolio will provide modest income and “sleepability”.
Source: S&P Dow Jones Index Dashboard: US, June 29, 2019. As measured by the S&P 500 Growth and S&P 500 Value indices.
Source: S&P Dow Jones Index Dashboard: US, June 29, 2019. As measured by S&P 500 Momentum index.
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.
Emerging Markets
I am nervous about emerging markets. EM can handle a gradual strengthening of the US dollar to a point, but not the sudden surge that we have seen lately. For an EM issuer, owning debt in dollar terms means that as the dollar appreciates, the amount of local currency needed to service that debt rises. This leaves less currency in the local economy, so sudden significant dollar appreciation is like a sudden recession. This plays out first in vulnerable economies and/or those countries whose debt profile favors dollar-denominated debt over local currency debt. Turkey and Argentina have been hammered recently and Brazil is struggling as well. This could ultimately spread throughout EM debt and equity markets, so the situation bears careful watching. I still believe that investing in both asset classes is a prudent long-term asset allocation decision, but you always have to be aware that currency instability can occur at any time so periodic sell-offs like this are a WHEN, not an IF. Those that are more tactical in nature will sell at times like this and they will buy into rallies, just as they did last year. It’s the nature of the beast.
In the emerging market debt space, I believe that Doubleline Low Duration (DELNX) and Ashmore EM Short Duration (ESFAX) are worthy of consideration. Both funds, by nature of their short durations, have outperformed longer duration alternatives, which is to say they have lost less. If you want to make a tactical call on currency rates, you should consider a to shift to a hedged foreign bond (non-EM) like PIMCO (PFOAX) or the Vanguard or iShares ETFs (BNDX, IAGG).
On the EM equity side, less volatile funds may be a good way to access the asset class right now. On the mutual fund side, I believe American New World (NWFFX) has performed relatively well. iShares Currency Hedged EM (HEEM) is the defensive play on the ETF side. A word of caution that frontier market funds like Ashmore Emerging Market Frontier Fund (EFEAX), , are especially vulnerable right now.
Commodities
Commodities tend to perform well in an environment where economic growth is increasing, such as we have now. Interestingly enough, gold does not. Gold isn’t really an industrial metal, so unlike copper or aluminum, demand doesn’t meaningfully pick up as GDP rises. Furthermore, the expectation that the Federal Reserve will hike several more times this cycle means that real (inflation-adjusted) interest rates will continue to rise. If you can earn a positive after-tax return in a safe security like a Treasury note, why do you need gold? It is my belief that the time to own gold is when the economy begins to roll over such that the Fed can’t raise rates any further even though the inflation measures are still rising. In other words, when real rates are falling or negative.
A couple of commodities funds that you may want to research further are PIMCO Commodities Plus Strategy (PCLAX) and Doubleline Strategic Commodity (DLCMX). The former is more aggressive and as such has better performance in 2018. If you’re interested in a more eclectic offering the LoCorr Long/Short Commodity fund (LCSAX) is one to look at. It’s a managed futures fund with the ability to go in either direction. The managers tend to avoid financial futures (stocks or interest rates) which have really tripped up a lot of managed futures funds in recent years.
I also believe it’s a good time to be cautious in the energy sector despite the nice run-up over the last two months. The oil futures curve is in backwardation implying the market expects oil to fall steadily through the rest of this year and 2019.
Interest Rates
Interest rates have been rising recently due to economic strength and the Fed unwinding its balance sheet. The 10-year note hit 3.10% on May 16th, the highest level since July 2011 (yes, higher than at any point during the 2013 “taper tantrum”)<1>. There is an element of “boiling frog risk” here, in that nobody knows exactly how high is too high for stocks to shrug off. At the close of the market on May 16th, however, the 5-year T-note had a yield of 2.94% while the S&P 500’s yield is 1.94%<2>. As people begin to realize that they can earn 3% yield in Treasury notes, I tend to believe that will begin to weigh on equities. Not calling a top, just saying be careful. Since 2009 we’ve been in an environment where there has been no return for savers. Today there finally is although the yield remains modest. It will be interesting to see if reluctant investors become savers again the next time stocks sell-off.
Election Related Seasonality
Seasonally, the six months leading up to mid-term elections tends to be one of the worst times to invest in the four-year presidential cycle. Perhaps this is because the party in office tends not to do well and that creates policy uncertainty. In any event, I just wanted to pass that along.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Summary
The stock market’s long quarterly winning streak ended in the first quarter, but the loss was less than one percent. Probably more significant than the market’s loss in the quarter was the return of volatility – something we hardly saw at all in 2017. Since the market peak on January 26th the market has made more than two dozen daily moves of more than one percent. The question for investors is whether this new more volatile period will be resolved favorably with markets ultimately going on to new highs, or whether this signifies the beginning of the end of the bull market.
The actual loss for the S&P 500 was small, -0.76%. What was so distressing about the quarter was the fact that stocks were at one point up more than 7.5%. There was almost a “melt-up” in stocks in January after the corporate tax cut was enacted, as analysts scrambled to raise earnings guidance for 2018 and afterward. Stocks shrugged off rising interest rates until the 10 year note flirted with 3% after the January jobs report; at that point, however, they began to care a great deal! After bottoming on February 9th stocks began to recover. They had erased about two-thirds of their 10% post-January 26 decline when the President announced trade tariffs. This prompted threats, retaliation and ultimately a second journey into negative territory, which is where we finished the quarter. Such volatility is historically normal.
Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 33 years out of the 39 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.
Exhibit 1
Foreign stocks largely followed the same trajectory as U.S. stocks last quarter. Developed markets closed with a loss of -1.53%, while emerging market stocks posted a 1.42% gain. The best region last quarter was Latin America with an 8% gain, followed closely by “frontier markets” – those countries with markets too small to be included in the emerging market index. Canada and Australia brought up the rear with losses of 7.3% and 5.7% respectively. Exhibit 2 highlights last quarters broad market returns. Exhibit 2
Bonds reacted to the prospect of greater economic growth and higher fiscal deficits in the future the way you would expect – they sold off sharply. The decline was as much as -2.5% by the end of January, but as the trade war increased the chance of a global economic slowdown, bonds rallied somewhat in March. The bond index ended with a total return of -1.46%. The only broad fixed income category to post a gain was floating rate debt. High yield bonds lost a bit more than the benchmark, with longer term government and corporate bonds coming in last.
Activity
In the wake of the sharp increase in volatility, we examined the risk in each portfolio. We had been letting profits run throughout 2017 and into 2018 because interest rate conditions were benign and stock price momentum was so strong. In late January the former changed and soon after the latter did. In response to rising interest rates we reduced duration in the bond part of portfolio by selling longer duration funds and replacing them with shorter maturity bond funds (especially those with floating coupons). On the stock side we substituted cyclically sensitive stock funds for those that emphasize dividends. As the declines spread from bonds to stocks, we began trimming stock exposure back to a neutral weighting. In this environment, short term debt is becoming more attractive since it fluctuates very little and its yield is very close to that of U.S. stocks.
Outlook
2017 was an incredible year for investors. Both U.S. and foreign markets gained more than 20%, and at no point did we experience a drawdown of 3%. At some point, we all knew that period of near market perfection had to end. We feel that global economies are not growing fast enough to support 20% annual profit growth, and with global central banks finally reigning in credit supply, liquidity won’t support those kinds of stock price gains either. That phase of the market cycle is most likely over. From here, we can hope for further earnings-driven market gains, but price-earnings multiples (the price that investors will pay for a dollar of earnings) appears richly valued and may even have peaked. The danger is that they will shrink from here. Such an environment warrants a more cautious stance. Also, as recently as December 2016 the yield on Treasury Bills was around 0.25%. Today, after five interest rate hikes, it is closer to 1.50%. Since the yield on the S&P 500 is less than 2%, choosing to be a saver (as opposed to an investor) is once again a viable option.
In short, the combination of higher interest rates, a less friendly liquidity environment, and better competition from fixed rate investments creates a more neutral environment for stocks versus the strong tailwinds we’ve had in recent years. Add in trade friction and political uncertainty and arguably stocks could be poised for decline. We are monitoring the situation carefully. Technical indicators are still positive – at the margin, investors would rather buy dips than sell into strength. At long at that remains the case we are probably not going to under-weight stocks.
Commentary – Why We Didn’t Turn Bearish and What It Would Take
Sometimes the market goes down and investors wonder why we don’t just sell everything and go to cash until things blow over. This is a good question, so I want to go over it again.
There are times every year when market conditions seem to warrant a decisively more conservative stance. Typical arguments for doing so may be based on excessive market valuation, a political event, an economic change or even the threat of military conflict. Frequently it will be an outright decline in stock prices. In my thirty-plus year career in the investment field I would guess there have been close to a hundred times I’ve thought about getting significantly more defensive. That said, only in about six-to-eight of those instances would that have turned out to be a good decision. The truth of the matter is that the U.S. stock market has an upward bias. Betting against it has generally not been very rewarding. If one is going to attempt to outperform the stock market by selling high and buying back lower, therefore, one must carefully pick their spots. The odds are strongly against successfully doing so, and there is no one that can claim they have demonstrated this skill repeatedly.
What do I mean by an upward bias? Exhibit 3 illustrates that between 1926 and 2017 annual market returns were positive 75% of the time. Exhibit 3
Stock prices are in the long run closely tied to corporate profits and corporate profits tend to rise over time. Additionally, the government likes to see stock prices rise and therefore has an incentive to take steps to both increase the likelihood of price gains and more pointedly, to arrest any significant stock price decline. Along those lines, it has been strongly believed over the past ten years that Fed Chairmen Bernanke and then Yellen would intervene to support stocks if necessary. Another structural positive for stocks is the amount of savings relative to the supply of stocks. Low interest rates have provided an incentive for companies to borrow money to buy back their stock in order to raise per share income. This creates the bullish dynamic of too much money (demand) chasing too few shares (supply), which Economics 101 tells us leads to higher prices. Finally, betting against stocks (short selling) is more complicated because shares must be borrowed prior to sale and that can be expensive.
If all of this has you feeling that stocks are a pretty good bet most of the time, you are reading this right. Since stocks have so much going for them, there would need to be several negatives in place to warrant underweighting them in portfolios. Here are some the factors that might cause us to reduce our stock weightings:
Valuation. We would have to believe that stocks were so overvalued such that a value-restoring market plunge was far more likely to occur before earnings could rise enough to justify current prices;
Technical weakness – in other words, falling prices. More than just falling prices, in fact, but the confirmation that investors were becoming disenchanted with stocks via a drastic change in investor sentiment. This would involve stock prices making a series of lower highs and lower lows.
Liquidity impairment – whether through a surge in interest rates, a recession, or a major corporate bankruptcy, this is a condition where asset holders worry about being able to sell what they own at current prices and banks worry about the value of that which they hold as collateral.
Rising interest rates – because of the negative effects they have on corporate profits and price-earnings ratios. Rising interest rates negatively impact the profitability of most companies plus they make financing a leveraged portfolio more expensive.
Serious economic weakness – a mild slowdown might easily be offset by falling interest rates, but typically rates can’t fall fast or far enough to offset the damage of a serious recession because profits my fall below the level needed to service existing debt. Also, banks may not be willing to provide capital to other entities if they are worried about their own solvency.
Global conflict – most conflicts can be and are resolved without economic damage because each side understands what it stands to lose. On rare occasions a conflict between major powers occurs because one side can no longer accept the status quo and the other side is unwilling to accommodate the other.
The biggest problem with opportunistic selling is that there is seldom any kind of signal in terms of when to buy back. Valuation is a very relative thing; nobody rings a bell when a recession ends or liquidity conditions ease. Experienced managers may get a “feel” but that is hardly something you can quantify nor is it a recipe for a repeatable investment process.
As far as today is concerned, the most negative aspect to the broad market is that it’s generally considered overvalued but it’s been overvalued every month since late 2012 (with the possible exception of January and February 2016). The market is not technically as strong as it was three months ago but most measures are still positive. Interest rates are rising on a six- and twelve-month basis, but they are actually flat to lower over the past one and three months. The other concerns are just not there, though we can’t rule out that the current trade spat becoming a full-on trade war.
To sum up, stocks have an upward bias over the intermediate and long term, so to warrant under-weighting stocks in portfolios, there needs to be very compelling reasons to do so. Fortunately, that just doesn’t happen very often. Over time, we have adapted our processes to create a higher bar in terms of what needs to happen for us to turn defensive. We believe that has helped us to capture more of the market’s upside in the recent past, and will continue to do so going forward.
Thanks for your continued trust in our management,
Jill Mislinski, dShort, Advisor Perspectives April 13, 2018.
S&P 500 Index total return per Morningstar
In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
MSCI EAFE Index (developed markets) and MSCI EM Index (emerging markets) per Morningstar
S&P Dow Jones Indices
Source: YCharts.com
BBgBarc US Aggregate Bond per Morningstar
S&P Dow Jones U.S. Index Dashboard, March 29, 2018
Performance per Morningstar; volatility data per JPMorgan Guide to the Markets, 1st Quarter 2018.
Source: Dimensional Fund Advisors, Market Declines and Volatility
According to Trading Economics, the annual increase has averaged over 7.4% between 1950 and 2017.
It is not clear yet what Chairman Powell would do; that might be behind some of the more recent volatility
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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.
A Correction?
The longer we remain below the January 26th high in the S&P 500, the more significant those highs become.<1> The term “correction” applies to a market decline that follows a market high. The implication is that the market’s longer term uptrend is intact, but it is just undergoing a period of consolidation. The longer the market goes without making a new high, the more that implication becomes questionable. If the “correction” has been fairly shallow and steady, so much the better in terms of the likelihood of breaking out to new highs. On the other hand, if the correction consists of a sharp fall, a rally that fails to reach the old highs, and another decline back to the lows of the initial decline, that is not as good. A correction that turns into a prolonged pattern of lower highs and lower lows is ominous. So far this correction has not seen lower lows, so the bulls still have the benefit of the doubt.
Continuing that thread further, growth stocks made new all-time highs on March 9th while value stocks continue to significantly underperform year to date.<2> See Chart 1 below. Furthermore, growth stocks did not have a closing low in late March or April that was below the February 8th closing low, whereas value stocks have had three. I must conclude that the much awaited (hoped for?) shift to value has not occurred. I have been tempted by the correction in “FAANG” stocks to change my models more toward value, but the supporting evidence is just not there. Dividend-oriented stocks tend to lose less on poor market days, but if a real shift had occurred, non-high yielding value stocks (financials, for example) would outperform on rally days.
Chart 1, Source: YCharts.comSmall Company Stocks
I do not think that small company stocks are particularly cheap, nor would I have interest in them from a cyclical standpoint (I believe we are late in the economic cycle and small caps do not typically perform well in recessions). That said, ever since the President brought trade sanctions to the top of his priority list, small caps have significantly out-performed large caps.<3> See Chart 2. The reason is simple – small caps are much less likely to earn a significant portion of their income from exporting, so they are less vulnerable to retaliatory measures. It is hard to foresee this issue going away anytime soon, so at this point I think it would be a real mistake to be underweight small company stocks.
Chart 2, Source: YCharts.com If one is going to increase small company exposure, what would one sell and what would one buy, you might ask. I am no fan of increasing my overall stock weighting, so the proceeds have to come from stocks. I believe the argument can be made to reduce large cap US. stock exposure by 3% and reduce international stocks exposure by 2% (1% each developed and emerging; trade wars hurt everybody). I would increase U.S. small cap exposure by 2-3% and I would put the remainder in floating rate debt and/or cash. Floating rate gives me a better yield/return, but cash gives me optionality in the case of a sharp sell-off.
Short Term Debt
Short term debt instruments have seen a nice rise in yields lately. This is because the Federal Reserve has been raising interest rates and because LIBOR has been rising for a variety of non-alarming reasons. The two-year treasury note now yields more than the S&P 500. See Chart 3 below. Increasingly investors are asking themselves if the high volatility, modest return expectation they have for stocks is better than the safe yield they can get from government bonds or CDs. A high percentage of the gains U.S. stocks have experienced over the last several years has been from multiple expansion (as opposed to earnings growth), because investors felt there was no alternative. That attitude is fading.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
The stock market recovered most of its losses from the sharp, interest-rate related sell-off in early February. That said, the bounce appears to have stalled without having made new highs on a broad market basis (the NASDAQ did make an all-time high on March 13th). This is in spite of the fact that interest rates peaked in the third week of February. They have been falling lately as this month’s inflation numbers have not confirmed the stronger numbers from last month. See Figures 1 and 2 below. I am going to address how we currently feel about both that bond and stock markets in the near term, and what we are doing in portfolios.
Figure 1
Source: S&P 500, YCharts.com
Figure 2
Source: US 10 Year Treasury Note Yield, YCharts.com Bonds
Reacted violently to strong economic reports all through the month of January and into the third week of February;
Broke through their 2017 high points across the maturity spectrum;
Threatened in the case of 10 and 30-year bonds to technically signal a conclusive breakout (ending the 30+ year bond bull market), but ultimately backed-off;
Rallied on oversold conditions in the last week of February, gave up that rally, and are trying again to rally on some economic weakness (retail sales) and the possibility of a global economic slowdown tied to trade wars. Given the terrible performance of bonds since the beginning of the year, the recent rally has been underwhelming to say the least. The 10-year note has to break back below 2.80% to signal that the near-term outlook is even neutral. A break back below the 2017 high yield of 2.64% would confirm the “goldilocks” market environment had returned and would probably be bullish for financial assets. High yield bonds have not performed well lately, which may not be a good sign for economic health overall. The same can be said for the rising LIBOR rate.
Stocks
Plunged to their 200-day moving average on February 9th;
Rallied hard late that day and for the next week;
Have been grinding their way sideways to higher over the last four weeks but remain well below their January 26th
Volume and breadth during the rally period have not been as impressive as they were prior to January 26th, and VIX has remained north of 15 (higher than it was at ANY point in 2017).<1> Two thoughts. One, almost all long term technical indicators are bullish. There have been no major failures or breakdowns so far. Bull markets generally experience consolidation periods, and, given the strong performance of stocks in 2017 we were way overdue for one. Odds are, that is what we are going through now. On the other hand, the stock market typically never goes straight from bull to bear – there must be a peak, a decline, and a failed rally before things really get going on the downside. Because of the 10% sell-off last month, we now have the first two components (the peak and the decline) in place. If the current rally fails to lift the broad market to new highs, the technical implication would be that the February 9th intra-day low may need to be re-tested.
How We Are Positioning Now
Prior to January 26th most of the negative market news focused on the historically high current valuation. There was nothing fundamental or technical to suggest the market was at risk. To that end, the most I could muster was to say that economic and market conditions were as good as they could be and maybe therefore it made sense to take some profits before things changed. Today things have changed somewhat.
The common conditions that have killed past bull markets – rising interest rates, foolish trade policies, etc. are on the visible horizon. As such, more care is warranted now though I still believe that it would take several months of choppiness for the market to completely roll over. Typically, investors who have been very well rewarded by “buying-the-dip” don’t suddenly become rally sellers in three weeks.
That is all a prelude to say that we are increasing exposure to short term, medium quality debt at the expense of stocks and longer maturity debt. We touched on reducing interest rate exposure in our last report, so I won’t go over that again, but it’s worth a read. Modestly reducing stock exposure, both international and domestic, is a nod to the ideas that:
Valuation may not matter in the short term, but eventually it does;
Interest rates are probably at a point in the economic cycle where they are headed higher which is not a positive for corporate finances, and from here anything that would send interest rates meaningfully lower would probably also be very negative for stocks.
We may be headed toward at a trade war. Historically, trade wars have decreased overall economic growth while increasing inflation.
Central banks are beginning to “mop up” some of the excess liquidity they’ve provided to the markets for the last 6-9 years (depending on the central bank) via ultra-low interest rates and aggressive open market operations. The bottom line for stock investors is this: Over the past nine years we’ve had just about all the good news one could hope for. However, easy credit, corporate tax reform, and a collegial global trading environment are now behind us. If corporate earnings don’t dramatically accelerate, what are the other potential upside catalysts? A little caution at the margin is warranted.
<1> The source for all bullet points is Telemet Orion
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
The continuation of the negative response of bonds to the strengthening economy and more importantly, to the normalization of interest rates, began to spill over into the stock market on January 29th. Over the next two weeks, a historically normal level of volatility reasserted itself in the stock and bond markets. I’d like to discuss what happened and how we are positioning now.
What Happened
In our view, the market surge from the passage of the corporate tax cut in late December through Friday January 26th was a “melt-up”. Investors were euphoric, believing the stellar returns of 2017 would be repeated in 2018. The S&P 500 was up about 7.5% for the year at the close that Friday.<1> As is often the case, however, investor enthusiasm got out of hand. Speculation in products designed to magnify returns on the upside led to steep losses as the market ran into a wholly predictable speed bump<2>.
Stocks declined modestly on the 29th and 30th as investors began to realize that 2018 might in fact see three or four interest rate hikes.<3> When the Labor Department reported a robust employment number on February 2nd, interest rates surged well above their December 2016 highs. The stock decline gained momentum. See Figure 1 below.
Source: YCharts.com
It should be noted at this point that about a decade or so ago financial wizards created an investment product called VIX, which enabled one to hedge stock risk by owning exposure to volatility. If your stock portfolio declined for example, volatility (VIX) would theoretically rise, which would offset some or all of your losses. Some years ago, however, those wizards introduced a product that did the exact opposite of VIX – in other words the security they created increased in value if volatility (VIX) declined. Rather than a hedge, that security (VelocityShares Daily Inverse VIX, Ticker: XIV) is essentially a pure speculative bet that the stock market will continue to rise. It is hard to imagine a better environment for this product than 2017; the stock market rose every single month last year and never declined as much as three percent at any point. XIV gained 182% in 2017!<4> At some point, however, things were bound to change.
Beginning last week, as interest rates rose, and stocks began to sell off, volatility soared. Investors in various products that bet against volatility saw losses pile up and they flooded the market with sell orders to try to limit their losses. The stock market buckled under the weight of forced selling Monday, Tuesday morning, Wednesday afternoon, and again on Thursday. XIV, which closed at $136.73 on January 26th (up from just over $50 on New Year’s Day 2017), fell to $5.40 as of the close on 2/6 – a loss of over 96%!<5>
The past two weeks have wrung a lot of the speculative excess out of the stock market. The economy and corporate revenue growth are strong, and it would be exceedingly rare for an economy hitting on all eight cylinders (so to speak) to suddenly blow out six of them. There are almost always several months from the point of maximum market participation to the point where the whole market rolls over<6>.
Putting Volatility in Perspective
Volatility is a normal part of investing, and the markets certainly reminded us of that fact last week. It’s important to keep a long-term perspective and recognize that to be successful investors we need to accept volatility as a necessary part of our journey. Below is a look at the calendar year returns, intra-year gain and intra-year decline of the Russell 3000 since 1979. As you can see, large swings higher and lower are a regular part of investing.
Source: Dimensional Fund Advisers
In taking a longer-term perspective we inherently accept the fact that capitalism works. If that’s our fundamental belief, it’s easier to ride out periods of volatility. Below is the distribution of US market returns since 1926. The red blocks red represent years of negative total market return and blue blocks represent years of positive total returns. As you can see there are more blue than red blocks; since 1926 75% of the time the market has produced positive annual returns. Of course, past performance is not a guarantee of future results, but as investors we can use history as a foundation to inform our beliefs.
Source: Dimensional Fund Advisers
How We Are Positioning Now
We believe that for the time being interest rates will stabilize around current high levels. These levels are not high enough to hurt the economy broadly speaking, but they will continue to cause problems for the companies and industries most sensitive to interest rates. Utilities, real estate, and consumer staples stand out in this regard. Here’s the real trick: these industries are typically the worst to own in a rapidly expanding economy but the best to own once the economy rolls over. The recent sell-off has really improved the valuation characteristics of utilities and REITs relative to the overall market, yet they are still performing relatively poorly. High dividend and low volatility strategies tend to emphasize those themes and most of those funds are under performing. I don’t think that is going to change in the short run. Investors may want to look at strategies that emphasize quality instead. Quality probably won’t be a market leader, but it may give me some degree of downside protection without being too vulnerable if rates continue to rise
We believe the time has come to underweight bond duration relative to the Barclay’s Aggregate Bond Index. Additionally, we are cautions with regard to below investment grade credits. Over the last two weeks floating rate bonds held up well, while high yield gave up more than a percent-and-a-half.<7> While we believe high yield may have a relief rally in the short term, this is not an area you want to overweight if you expect interest rates to rise.
The bottom line for stocks is this: if interest rates remain reasonably stable in the new higher range they have established in 2018, we believe stocks may once again resume their rally. If not, and weakness spreads beyond utilities and real estate to the industrial and transportation sectors, we’ll have the first evidence the longer-term bull market may be ending. Because stocks performed so well over the previous three months, short and long term moving averages are still confirming that the primary trend is upward – even with the recent decline. For that reason, we believe that a modestly bullish bias continues to be warranted.
<2> Some background: With the economy performing well, the Federal Reserve no longer needs to take extraordinary measures to support it. They can continue to raise interest rates toward their natural level, which is a little above the rate of inflation (currently around 2.1%). We are always told the stock market can handle rising interest rates. There is always a point, however, when that is no longer true.
<3> The Fed has been telling us it expected to increase rates three or four times this year, but investors have become conditioned to the Fed losing its nerve and only hiking once or twice in a year.
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
There is really nothing negative one can say about 2017 in terms of the stock market. Returns were great almost anywhere one invested. A lot of market-friendly events occurred – Emmanuel Macron’s victory in France turned the tide against nativism and spurred a 25.32%<1> gain in Europe; China stimulated its economy ahead of the 19th Communist Party Congress, leading to a 41.18%<2> return; and the United States passed a tax reform bill that lowered corporate taxes from 35% to 21%, contributing to a 21.83%<3> gain for the S&P 500. Interest rates remained low enough to support both stock buybacks and takeovers, and perhaps most importantly allowed companies to continue to use debt markets to raise needed cash instead of diluting investors by issuing stock. All of this left most people asking by year end, “How long can this continue”?
For the most part, risk was really rewarded last quarter. Conservative investments made money – they just made a lot less. Utilities gained just 0.2% while Technology rose 9.0%, for example.<4> In an environment where stocks exhibited the least amount of volatility in modern history, investors were emboldened to take on more and more risk. That also played out internationally through emerging markets, which surged 7.44%<5> on the quarter and 37.28% for the year. Energy and telecommunications each managed to post a gain last quarter though both sectors lost money for 2017.<6>
Bonds made modest gains in the fourth quarter. The main bond index rose just 0.39%<7> to finish the year with a 3.54% gain. Riskier sectors such as emerging market debt and high yield corporate debt led the way for the full year, but it was more conservative sectors like municipal bonds and inflation protected securities that did the best in the fourth quarter. With interest rates perhaps having made a significant bottom in 2016, there is an increasing belief that the long bond bull market is over. If this is indeed the case, then bond investors need to be more opportunistic now. Using long duration bonds to bet on yield curve flattening was a good strategy until recently. Overweighting foreign bonds to benefit from a falling U.S. dollar is working right now.
Source: Dimensional Fund Advisors, Q42017 Quarterly Market ReviewActivity
Activity last quarter primarily centered around reducing the cash position in moderate and conservative portfolios. Aggressive portfolios already had lower than normal cash positions. That said, we did try to find room in larger portfolios for a new fund that invests in hard assets such as infrastructure, agricultural land, and timber. The Versus Real Asset Fund gives us access to those asset classes in a mutual fund format that we expect to have low correlation to the stock or bond markets, and have very little volatility. At some point this bull market is going to end, and we want to own some assets that cannot be dumped wholesale when greed turns to fear.
Outlook
There are echoes of the late 1990s in today’s stock market. In those days the narrative was about how technology was going to revolutionize communications and commerce (it did, but that didn’t justify paying hundreds of dollars per share for companies with negative cash flow). Today the narrative is about global central banks being run in service to global equity markets such that another -50% plunge in the stock market is unlikely. Again, while there is some truth to this in terms of central bankers trying to be conscious of their effects on markets, at some point the stock market will have a significant decline. Narratives are powerful because they contain elements that are undeniably true as they seek to explain day-to-day investor behavior. A bullish narrative, for example, inhibits selling. Investors both bought and sold stocks in the late 1990s, but what was significant was that they bought a lot more technology stocks than they sold. Today’s central bank narrative has prompted investors to sell out of individual stocks and more niche-oriented mutual funds and to buy the stock market as a whole through index funds. The problem is that no narrative can be sustained forever. Eventually economic conditions will deteriorate to the point where central banks cannot (or will not) support very higher stock prices. Thus, investors will participate in the bull market as long as it lasts, but it is also 100% certain they will participate in the subsequent decline.
As far as when that might occur, we are watching interest rates as well as market breadth and a host of other market internals. These suggest stocks are likely to go even higher, at least in the short run. We have written on numerous occasions that stocks are expensive, but valuation does not drive short term performance. For those of you that are concerned about geo-political events, they rarely drive market performance either. Markets have no good way of discounting the risk of a war with North Korea, for example, so they choose to ignore the situation unless and until it becomes critical. There is a part of me that really wants to sell and lock in these stock market gains, but I will only do this incrementally unless we get a market or interest rate-based catalyst.
Commentary – Leaning Against the Wind
In a market that seems to do nothing but rise day after day, the question for all money managers becomes how to add value. Other than through the highly risky strategy of leverage, all one can hope to do in a very strong market is to keep up with it. In an asset management program in which the maximum amount of portfolio risk is capped, we will not be able to keep up with an index on an after-fee basis because we can’t take more risk than the index. It is tempting in such circumstances to convince oneself that risks are very low. That way, one can justify a higher equity weighting and therefore come closer to index performance. In other words, if stocks exhibit very low volatility over an extended time frame, then they must not be very risky. The problem is that market volatility has over time proven to be mean reverting. Put another way, periods of low volatility ultimately give way to periods of high volatility, and vice versa. Viewing the market with a perspective of years and decades instead or days and weeks, one understands that a pronged period of abnormally low volatility does not decrease your chances of experiencing a sizable loss, in fact it increases your chances. From this it follows that a good investment strategy should involve “leaning” against the prevailing sentiment of the time.
Think about the times where market sentiment was the most extreme in either direction. In April 1999 the Dow Jones Industrial Average passed 10,000 for the first time. This wasn’t a “sell everything” moment (short of an impending asteroid collision, it is hard to think of what would be), but it was a good time to reflect on the odds of stock prices being much better or much worse two or three years hence since they had trebled over the preceding six years. Stock would still rally another 15% over the next several months, but a “lean against” strategy of taking some profits would have saved a considerable amount over the next four years. Similarly, the stock market went into a virtual free fall in October 2008 after Lehman Brothers failed. The Dow briefly went under 8,000 on October 10th, 2008 before closing at 8,451. With stocks roughly 40% below their peak just one year and one day earlier, it was hard to imagine that the downward trend could still be going two to three years hence. Leaning against the tide at that point admittedly would have been difficult. The market didn’t ultimately bottom until the following March (at 6,547), but buying at 8,451 would have looked great just two years later as the Dow rose back above 11,000 (to say nothing about how good it looks today)!
The point is, nobody knows when or where the market is going to make a meaningful top or bottom. Investor sentiment is possibly the most reliable indicator that we are approaching an extreme. Greed really seems on the rise today judging by the rapid rise of stock prices, the absence of any even modest correction since Brexit, and the surge in both cryptocurrencies and the stocks of any company claiming to have exposure to them (or to Blockchain, the technology that drives them). It seems to me that right now is a good time to step back and think about how much better things might be two or three years hence relative to how much worse they could be. The stock market is up two-and-a-half times from its October 2011 low; maybe we will eventually get a treble this time as well. That fact is that neither we nor anybody else is going to call the exact top without being extremely lucky, so we must plan on the most likely scenario which is that we don’t meaningfully reduce stock exposure until is clear that there has been a significant change in market conditions. I can promise you that we won’t be the only sellers on that day. If this bull market ends with a long period of sideways action like in the late 1960s, missing the actual “top” won’t matter much. On the other hand, the speed at which technology stocks collapsed in 2000 or financials in 2008 was breathtaking.
Economically speaking, we are an eight-cylinder engine hitting on all eight cylinders right now. I’m not saying it can’t get better, but I am saying it can’t get much better. Perhaps the current mood of investor enthusiasm for stock could become even more crazy and people might quit their day jobs to trade Bitcoin and Ethereum futures, but I think we agree that we are a lot closer to the greed end of the sentiment spectrum than the fear end. It’s time to plan for the end of this wonderful, powerful bull market. As an asset manager, Trademark is constrained both by how much and how little risk we can take. Asset managers are tacticians. When market momentum and breadth are very strong, and sentiment is trending in the right direction, as is the case today, history suggests stocks are going to do well in the near future. So, tactically, that is the way we have positioned portfolios. At Trademark we attempted to (1) alter asset class weightings (the mix of stocks/bonds/cash) in response to increased risks and (2) use mutual funds and ETFs whose strategies are less volatile than the overall market. That said, we will never move portfolios to 100% cash, no matter the circumstances. Your advisor can work with you to determine how much risk you need to take to meet your goals and how much potential principal volatility you can stomach. Now is the time to have a discussion with your adviser about how much risk is in your portfolio. We believe it is time to begin leaning against the tide by getting a little more conservative right now, but ultimately that decision should be the result of a discussion between you and your advisor.
As always, thanks for your continued trust in our management program.
-Mark A. Carlton, CFA
<1> MSCI All Country Europe net return is US dollars, per Morningstar
<2> MSCI China all share index net return in US dollars, per Morningstar
<3> Standard & Poors 500 Index total return (including dividends) per Morningstar
<4> S&P Sector Indices per JPM Guide to the Markers, 4Q2017
<5> MSCI Emerging Markets net return in US dollars per Morningstar.
<6> S&P Sector Indices per JPM Guide to the Markers, 4Q2017
<7> BBgBarc US Aggregate Bond Index per Morningstar.
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.
