Bonds made a move lower over the last couple of weeks most likely in response to the apparent inevitability of the new tax law lowering corporate tax rates. This development encouraged investors to believe that economic activity would be stronger in the future and that inflation would be higher. As a result, the yield curve’s flattening trend was broken. I’m not sure that this is a trade I would get behind at this point. The fact is, bond yields have a strong seasonal tendency to rise in December as investors expect economic conditions to improve in the coming year. In the last 9 years, only 2011 and 2014 have not seen bond yields rise in December.<1> For me to get really bearish on bonds I would need to see the 10-year note yield break above 2.65% amid yield curve steepening, and stocks would have to be performing reasonably well. This would tell me that investors were buying into a faster growth/higher inflation narrative, such that a healthy asset rotation was underway. Bottom line: resist the urge to dump your bonds until a new trend toward higher rates is more firmly established.
My feeling about the stock market is this: we are not trading on fundamentals, despite what all the 2018 Market Outlooks say. We are trading on sentiment. That sentiment has gone from mildly bullish to full-on greedy. How else to explain Bitcoin and all the other crypto currencies? If you ask enthusiasts it is about privacy and efficiency. If you give them a beer and ask them again it is about making a ton of money in a very short period. It has been my experience that get-rich-quick-trades like Bitcoin happen late in the economic cycle. Whether it is people quitting their jobs to day-trade tech stocks (1999), people buying multiple properties for a quick flip (2006), or today’s crypto mania, there is confidence that the world is full of greater fools with the means and desire to buy things at an ever-higher price. Such a cycle of emotionally driven investing never ends well. The eventual popping of the bubble creates a negative wealth effect that can spill over into other assets and possibly into the larger economy.
It is easy to suggest that stocks have moved up this year because the economy is improving, and corporate profits are going to get a boost from tax law changes. That isn’t wrong, but it isn’t the whole story. The stock market has not experienced a down month all year. That is highly unusual. That tells me that something in our collective belief system has changed. After all, stocks rose 37% in 2013 yet there were two down months. Gains topped 30% in 1997, but there were three down months.<3> Even when things were good, occasionally investors took profits. That’s how healthy markets work. The lack of even a three percent pull-back in 2017 tells me there is a certain “can’t lose” mentality at work.I fear that the end of this streak is going to result in a hard landing. Not immediately, but ultimately. As you recall, if you tried to buy the dip in 2001 or 2008, you got steamrolled. There are no good selling opportunities on the right side of a parabola.
Bottom line: I believe that it is a necessity to lighten up on stocks, and that also means to prepare yourself for the underperformance that results from lightening up early. If we are lucky, we will be selling into the long overdue minor correction that sets the stage for the next leg of the bull market and will get the opportunity to buy a lower price. Alternately, if the next leg down represents a structural shift in market sentiment we will be selling near the top of the latest parabolic stock move.
Commodities are the sector to watch. If the global economy is truly in a sustained growth cycle, the price of energy, base metals, and other commodities should benefit. If commodities don’t rally (and if interest rates cannot hold the recent rally), then economically we could be on shaky ground. Historically, technology, biotech, utilities, and staples are the classic weak economy scenario industries and they have been relatively out of favor since the tax bill became more likely than not in early December. Financial services, industrials, retail, and energy may currently be benefitting from the idea that 2018 may see a higher level of economic growth. I’m still skeptical that domestic economic growth will be higher in 2018. I expect that energy and real estate will perform well in the first quarter because they appear to be the biggest winners from tax reform. Since most technology stocks had a fairly low tax rate to begin with, they shouldn’t benefit as much from corporate taxes being lower (even with repatriation).
From our perspective, one of the better investment ideas this month has been frontier markets. From reformer Cyril Ramaphosa’s win in South Africa to the continuing turnaround story in Argentina, this is where most of the positive global surprises are coming from. My frontier markets preference is Ashmore (EFEIX/EFEAX).
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 global stock markets seem “tired” right now. It has been a very good year, with the S&P 500 up around 17% with dividends included and EAFE up just under 21%. Yet EAFE is almost 2% off its October highs and the S&P 500, while less than 1% below all-time highs, also seems to be laboring. The small cap Russell 2000 is close to 3% below its October high.<1> See Chart 1. That said, every index is well above its 50 and 200 day moving average, so the benefit of the doubt remains with the bulls. The reason I felt compelled to write about the markets today is that the biggest impetus behind the strong stock advance in 2017 has been central global bank purchases of debt and in more and more cases, stocks themselves – and that impetus may be waning.
Chart 1
We all have been told that rising profits are behind the strength in stocks this year, and to some extent that is correct. It is important to remember, however, that stocks rose from 2014 through 2016 on next to no net profit advance, so corporate profits and stock prices are not that highly coordinated in the short run. Tax reform could help stock prices, but it is increasingly less likely that we will get reform and more like we will see tax cuts, which generally means that the same size pie will be sliced differently. If, for instance, the tax burden is shifted more towards individuals and less toward corporations, then individuals will have less after-tax income to spend and therefore consumer-oriented businesses will suffer relative to those that sell to other businesses. No, the thing that has moved stock prices for the last several years is central bank activity. Buying debt to lower interest rates brings down borrowing costs, making everything from buying back shares to issuing new debt cheaper. The fact that the stock market boom has been largely debt-fueled doesn’t make it wrong, but it does suggest there is a limit at some point. Global central banks are at least talking about beginning to rein in excess credit. The Fed is starting to do that here, and the European Central Bank has indicated that they will do the same in 2018. The Bank of Japan has been extremely active in buying both its bonds and Japanese stocks this year. The Japanese Government Pension Investment Fund hit its target weighting of 25% in Japanese stocks and is now “selling into strength and buying into weakness”.<2> China stimulated their economy leading up to the recent Communist Party National Congress, but they are deleveraging now and at the same time interest rates there have recently surged to above 4%. That is not a recipe for higher stock prices.
Bottom line: The best is behind us. Further gains are possible but the central bank tailwinds are all but gone and valuations are high. Proceed with caution.
Reasons for concern:
This week’s IPO calendar lists 13 initial public offerings this week, the highest in a very long time. This doesn’t happen near market lows.
High yield debt has sold off modestly over the past two weeks. Stocks do not tend to rally for long when high yield bond spreads widen, for they are both sensitive to liquidity and economic health.
Emerging market debt has also had a rough couple of weeks. Rising interest rates due to strengthening economies eventually affects emerging market stock prices as well.
Low volatility is the best performing factor in November<3>. Utilities are the best performing industry group. Both are up. This suggests a bull market taking a breather. If they were the best performing factors/industries and both were declining, I’d be a lot more worried. Other observations:
Latin American stocks have been selling off all quarter. They may actually be oversold right now, as the correction has taken them right back to the longer term uptrend line.
After rising for much of October and November, the Japanese stock market has now declined four days in a row.<4> Momentum can be fickle.
If you are looking at alternatives, merger arbitrage is a low risk, low return option which is more palatable in a low return environment. Of the choices available, the IQ Merger Arbitrage ETF (MNA) has done quite a bit better than MERFX or ARBFX over the last one, three and five years albeit with a little more volatility.<5>
Closed-end fund discounts had been in an 18 month period of narrowing, eventually rising to less than 6%.<6> This was great for closed-end investors, especially for those that owned leveraged bond funds. Unfortunately, the trend appears to have topped out in October. Closed-end funds are not having a very good November.
Internationally, growth has crushed value as a strategy in 2017.<7> You were either in the fast growing Chinese internet stocks (Alibaba, Tencent, jd.com) and Asian technology giants (Samsung and Taiwan Semiconductor) or you weren’t. It’s nearly that simple.
Sometimes your benchmark is everything. Parnassus Endeavor (PARWX) is a large cap fund with an ESG mandate and a very good long-term track record. It has generally been considered a large cap growth fund by Morningstar. In that category, it has been in the bottom decile all year. According to Morningstar, however, the fund crossed over into the large cap blend category in 2016 and is closer to the value end of the spectrum at this point. As a large cap blend fund, its 18.3% year-to-date return puts it in the top quartile.<8>
Real estate got hit very hard in the second half of 2016 due to the problems of retail REITs (which are still down sharply), and have been fairly flat in 2017. That said, the group has made a sharp bounce over the past two weeks as the upward pressure on interest rates has moderated. I wouldn’t chase the bounce, but I think this sector would become more attractive if the overall environment remains mildly risk-off.<9>
Gold is mostly a way of playing the notion that Central banks don’t have the spine to raise rates when inflation begins to take hold because the powers-that-be don’t want to risk recession. In the absence of inflationary pressure, central bankers can talk as hawkish as they want because they don’t have to “put up”. Therefore, it is hard to see a near term catalyst for meaningfully higher gold prices.
Municipal bonds continue to outperform similar quality taxable bonds<10>. This has been true all year. <1> Source: YCharts.com
<7> Source: YCharts.com as measured by total return, year to date return of the iShares MSCI EAFE Growth ETF and iShares MSCI EAFE Value ETF.
<8> Source: YCharts.com as measured by total return, year to date return
<9> Source: YCharts.com as measured by total return of the Vanguard REIT ETF
<10> Source: YCharts.com as measured by total return, year to date return of the iShares Core US Aggregate Bond ETF and the iShares National Muni Bond ETF.
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
The stock rally continued into summer as the S&P 500 tacked on 4.48% in the third quarter.<1> That brings the year-to-date gain to just over 14%. There is an increasing sense of inevitability about the market going up, which on one hand brings more money into the market and on the other hand creates the complacency about risk that usually leads to trouble. Corporate profits were robust during the quarter, so much so that for once analysts were not rushing to lower third and fourth quarter estimates as they have done for at least the past five years. Hopes that corporate tax rates would be lowered helped small cap stocks gain 5.67% last quarter. Smaller companies typically pay much closer to the 35% statutory corporate tax rate than do large companies (which frequently benefit from special loopholes).
Foreign stock markets continue to perform well. Foreign developed markets gained 5.40% last quarter while emerging markets soared 7.89%.<2> The latter were led by the two major Chinese internet stocks, Alibaba and Tencent, each of which rose over 22% during the quarter. Gains were by no means confined to just Asia, however. Latin American stocks jumped close 15.72%.<3> Improving global growth and US dollar weakness were the main drivers. When the dollar is weak, it takes less of the local currency to pay dollar-denominated debt or to buy commodities that are priced in dollars (such as oil). That means there is more local currency in circulation.
Against the backdrop of improving world economies and strong stocks, it is no surprise that bonds gained just 0.85% last quarter.<4> Arguably, that was a fairly strong showing given the change as the markets interest rate outlook shifted from neutral with the Fed on hold to non-neutral with expectations for the Fed to raise rates. If the economy remains strong enough to justify another Federal Reserve rate hike in December, which markets currently expect, then bonds might post a loss in the fourth quarter. Emerging market debt was the best fixed income sector during the quarter.
We reduced the cash position across the board last quarter. In some cases we swapped more defensive domestic and foreign equity funds for alternatives that emphasized cyclical earnings growth over low volatility or high dividend yields. We also added a new specialty fund (Versus Real Assets) which provides access to alternative assets such as timberland, infrastructure, and crop/farm land. This should provide a return stream not tied directly to the stock or bond markets. Because we remain in the mid-to-late expansion stage of the economic cycle, we again made no meaningful asset class reallocations. As long as liquidity conditions are favorable, we don’t expect to be stock sellers.
Outlook
Predictions about the future are difficult under any circumstances. Forecasts generally involve assessing where you are currently in the economic cycle, and assuming that over the next several months you will be progressing along that curve. Yet in the current cycle, we have hardly progressed in four years. The US economy was in the mid- to late part of the cycle at the end of 2013 (so we thought), so we assumed 2014 would bring interest rate hikes and an eventual economic slowdown. Instead, we got an economic slowdown with interest rates actually falling to new lows, so essentially the economic cycle slid backwards! Since then we have clawed our way back to the same part of the cycle that we thought we were in four years ago. As such, while we believe the Fed will hike rates in December and again in 2018 in response to expected labor tightness and upward pressure on wages, we should not be surprised if that does not happen. Everything about interest rates and the markets since the great financial crisis is unlike anything we have seen before. So far this has been very benign (if not outright fantastic!) for investors. That said, it is anybody’s guess how long this benign environment can continue and what happens when it ends.
Commentary – Ten Years Ago (or Winter Is Coming)
Ten years ago this October the stock market peaked after a run of about four and a half years. It proceeded to lose more than half its value over the next seventeen months. I remember talking to investors and writing in my commentary early in 2009 that I couldn’t tell you when the bear market would end or at what price the stock market would bottom, but I was confident that those investors who could take a ten year perspective would be well rewarded. I knew that the recession we were experiencing would almost certainly be far into the rear view mirror by 2019, so if we could assume corporate earnings would eventually recover then stocks were apt to trade at much higher prices ten years out. In fact, double digit annual returns were very possible.
Eight-and-a-half years into that prediction stocks have done so well that if they did not gain another point in the next seventeen months they will have easily exceeded a 10% annualized return. Unfortunately, what I have to write and say to investors right now is more or less the opposite of what I said in early 2009: stock returns over the coming ten years are not going to be very rewarding. Almost certainly, even a six percent annualized return over the next ten years is highly unlikely.
This does not mean stocks should be sold. It just means, to steal a catch phrase, stock market winter is coming. What I mean by this is that you can think of there being long term cycles in the market where stock prices and interest rates interact. When interest rates are high, typically stocks will trade at lower valuations. The reverse is also true – low interest rates are associated with high stock valuations. During the periods where interest rates are going from high to low, there is an opportunity to earn substantially above average returns. Obviously, even counting the three significant but short bear markets, the 36 year span from the peak of interest rates in 1981 to the present has seen spectacular for investors. The Dow Jones Industrial Average has risen from 900 to just under 23,000, which with dividends included is close to a 12% annualized return! However, the time periods when interest rates go from low to high tend to be associated with below average returns. For example, the Dow first approached the 1,000 level in 1966 when inflation was around 3%. As interest rates rose to 14%, the Dow flirted with the 1000 level off and on for sixteen years and was still below 800 in August of 1982. With dividends included, stocks gained less than 6% annualized from January 1966 to August 1982.
The part that interests me the most is that year-over-year inflation actually peaked in March of 1980 at 14.8%.<6> It took the stock market more than two additional years to convince itself that the inflation era was over. Today inflation is running at less than 2% per year (though it has been increasing modestly). The Federal Reserve has begun to try to “normalize”<7> interest rates, in other words to raise them to a level at or above the rate of inflation. This would mean that savers would no longer be punished (by earning less than 0% after inflation and taxes). I would again expect it to take several months if not a year or more for investors to begin to believe that the deflation era was over (if in fact it is). If so, that could create a lot of opportunity for active investors to shift toward alternative assets.
Even if things were to occur just as I have suggested, there is no need to panic. Investors can still do okay in this environment; it just won’t offer across-the-board double-digit return opportunity. The 1966 to 1982 market was choppy, but it did not feature the sharp nominal wealth destruction that investors saw in 2000-02 or 2007-09. Only from an inflation-adjusted standpoint would the 1973-74 bear market come close. Also, even if we are entering a higher inflation time period, the amount of debt outstanding should prevent us from getting even halfway to the 1981 peak – interest costs would be too high. More than anything else, I envision an environment evolving in the next few years where there is no more room for stock Price/Earnings multiples to expand and effectively no benefit for most companies to increase operating leverage. As interest rates rise, profit margins contract. It’s a recipe for single-digit returns on average, with occasional bouts of volatility more on the order of what we saw from the summer of 2015 to early 2016.
I believe every investor in their heart of hearts knows this run of double-digit annual returns cannot continue that much longer. The economy is not growing at a rate that justifies it, and even the ever-promised corporate tax cut is a one-time change that is arguably somewhat priced in already. I am just confirming what you already know, which is that investment returns going forward are not going to be anywhere near as good as they’ve been since 2009. Investment winter is coming. Living off one’s investment returns is likely to be tougher in the years ahead. Index-oriented strategies may disappoint in that market trends are more “east-west” than north-south”. We have been thinking about what comes after the end of the “Great Deflation” for some time, so we believe we are well prepared to guide you through it.
As always, thanks for your continued trust in Trademark.
<6> US Bureau of Labor Statistics, One hundred years of price change: the Consumer Price Index and the American Inflation experience.
<7> Successfully restoring an incentive to save would theoretically lessen economic inequality because lower income savers could once again grow their money without subjecting it to the risk of the stock market. It could also hurt the stock market in that certainly some of the money that is in stocks right now would not be if savers were offered a fair return.
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.
Liquidity and the Fed Balance Sheet
Over the last several years, advisers have been subjected to article after article saying the market is expensive and therefore stocks should be sold. And yet stocks have made new high after new high. At this point advisers do not need to be reminded that stocks are expensive. What would be helpful, obviously, is some guidance on either when, or from what level, stocks will begin to meaningfully decline. As long as the Federal Reserve and other Central banks can effectively freeze the business cycle in mid-uptrend, the “when” is not going to be anytime soon. It therefore makes sense to make sure the business cycle is not advancing to the point that central banks are forced to meaningfully tighten in order to head off inflationary pressures.
Right now we are facing a situation of mild concern. The point of maximum liquidity appears to be passing. The U.S. Federal Reserve is set to begin shrinking its balance sheet in October, and it plans to raise interest rates again in December. This has started putting mild upward pressure on interest rates, since today’s very favorable bond supply-demand condition will get modestly less favorable. The more interesting dimension to this move is its impact on the stock market. We have written several times about the three scenarios the markets currently trade on (most recently on August 30th). The somewhat hawkish turn by the Fed in theory marks a shift away from Scenario 1 (lower for longer) industries like technology and factors like low volatility, large cap, and growth in favor of Scenario 2 (cyclical expansion) industries like financials and materials and factors like small cap and value. In and of itself this is fine and healthy. Hopefully, the market can spend significant time rewarding Scenario 2 stocks. At the very least, portfolios today should not have an overweight to growth relative to value, and low volatility as a factor should be de-emphasized. Emerging Markets
If global investors begin to believe that the interest rate cycle has indeed turned, emerging markets are going to feel the pain as well. Rising U.S. interest rates usually (but not always) are accompanied by a stronger dollar, which reduces global liquidity. You can see this in emerging market debt prices in September. This bears watching. The long term bull case for emerging markets is intact, but EM funds are taking in a lot of money right now just as short term conditions as deteriorating. It’s our opinion that now is not the time to be adding to EM.
PIMCO’s Raising Fees
PIMCO has announced an 11 basis point hike in fees on its Income Fund Class D (PONDX), and a 5 b.p. hike to other classes of that fund. Given that the fund has just under $96 billion in assets, and that PIMCO is cutting fees on some of its other funds, the firm is indirectly telling investors, “We have more money in this fund than we want. Please move some to our other funds.” As annoyed as I am with PIMCO’s action, I do not have a suitable substitute.
Trends Don’t Last Forever
Just keep this in the back of your mind: The fact that the world central bankers have been unsuccessful in stimulating inflation in the post-crisis environment does not mean inflation is dead. Structural issues like an aging global population and a dramatic decrease in oil prices have been headwinds to inflation in recent years. However, it is not a given that those forces will remain strong three or five years from now. This bears watching because with the amount of debt the world has outstanding even a 100 basis point move higher in interest rates could negatively affect stock and bond prices.
The market has shifted emphasis back and forth between scenario 1 and scenario 2 stocks for most of the past five years. By far the bulk of the time scenario 1 stocks outperformed, save the seven month mini-correction from June 2015 to February 2016 when investors shifted to scenario 3 (recession) – favoring high quality bonds and high dividend large cap stocks.
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.
It has been a while since we sent out an update because from an investment standpoint, not much has changed. There continues to be basically three scenarios for the market, and any individual security is a play on one, or at most two, of them:
The lower-for-longer scenario. Some call this the Obama trade. Slow economic growth and low cost of capital means that companies experiencing real sales growth can borrow cheaply. They are going to be prized, no matter how expensive, because their growth rate can be projected into the distant future with little time value of money discount. Most technology fits this description, as does certain media, industrial services, and consumer stocks. Large cap growth is the best fit sector.
The cyclical expansion scenario. Some call this the Trump trade. The idea is that economic stimulation via tax cuts and de-regulation will lead to a tradition cyclical growth phase, which will benefit companies more leveraged to the capital goods economy. Think transportation, industrial production, financial services, materials, mining, and energy. Small cap and value stocks may be the way to play this.
The recession scenario. The economy fails due to excess debt and not enough demand. High quality bonds may be the best way to play this, although utilities, consumer staples, and certain high dividend telecom and energy stocks might also work out. Very large cap dividend stocks tend to lose the least in down markets.
Since the first quarter of 2016 money has shifted back and forth between scenarios 1 and 2. In other words, money didn’t leave the stock market, it was simply redeployed. Hillary Clinton was a scenario 1 candidate, so when she lost scenario 2 stocks surged. Since March the air has completely leaked out of the scenario 2 trade on the failure so far of the Trump administration to deliver on their promises. Interest rates are back down to the levels that existed before the election and small cap stocks have almost no gain in 2017. Yet markets are not pricing in Scenario 3. Slow growth, high dividend stocks are still not attracting a bid.
Until something changes, money is likely to continue to flow to large cap growth stocks. Capitalization has been the best predictor of return this quarter. Look for very large cap stocks funds (yes, the American Funds Group should do well in this environment). I am also using the iShares Morningstar Large Cap ETF (JKD), which has a ridiculously high average market cap of $126 billion.
Other Thoughts
In other matters, I’ve been watching gold lately and I am not impressed. Year to date, the dollar has dropped 11.1% and 14.6% versus the euro and Mexican peso, respectively. And gold can only gain 13%? It’s up just 5% this quarter in a dollar free-fall? See Chart 1. Many strategists such as Ray Dalio have been recommending gold recently due to economic and political dysfunction. Maybe that will work out, but our experience is that when your thesis plays out but your investments hardly move, you need to get out of that trade.
Chart 1
I would like to pass along one of the best articles I have ever read. Charles Gave did a brilliant job of explaining why low interest rates are not just no panacea for an economy, but over time a killer of entrepreneurship. Low interest rates were what we needed to escape a frightening contraction that gripped markets in 2008, but extending them past 2010 has brought on a set of circumstances that are de-stabilizing both to the economic and political world. I believe you will find it interesting. At the very least, you will understand why scenario 1 has been so successful in this “recovery”. You can access the article by clicking here.
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
U.S. stocks rose for the seventh consecutive quarter. The S&P 500 stock index added another 3.09%, bringing its year-to-date gain up to 9.34%. Mid and small cap stocks lagged large caps again this past quarter, rising just 1.97% and 1.71% respectively.<1> Investors have preferred the relative stability of larger companies this year over the growth potential of smaller firms as prospects for infrastructure spending and tax reform have lessened considerably. Technology has been the strongest industry so far this year, while energy has been the weakest.
Foreign stocks performed very well in the second quarter as growth accelerated (especially in Europe) at the same time that the dollar fell against most major currencies. This enabled dollar-based investors to gain another 7%+ in European stocks and another 8%+ in Asia (ex-Japan) stocks.<2> The only part of the world that disappointed over the last three months was Latin America (1.74%), where Brazil was again enveloped in a corruption scandal. Emerging markets as a whole still gained 6.12%, led by Chinese internet stocks.
Bonds almost had a fantastic quarter, but remarks by the head of the European Central Bank on June 27 stopped the rally in its tracks. Yields on the 10 year U.S. Treasury Note fell from 2.39% to 2.12% in the first 86 days of the quarter, producing a price gain of over three percent. After Mario Draghi’s remarks warning the bond market that the ECB was going to taper its bond buying, yields surged to 2.30%. This cut the return for the full quarter to 1.45%.<3> Global, municipal, and high yield corporate debt gained modestly more than that, but short term bonds and inflation-protected bonds did quite a bit worse. Investors do not seem to be afraid of inflation right now, but they are really dismissive about credit risk.
We have written before about how the market has been drifting up each quarter not so much on signs of economic strength but on the continued decrease in fear. The less volatility the market expects from stocks (or any other asset class), the more of it investors are willing to hold. Behavioral finance calls this phenomenon Recency Bias. As volatility continued to decline, investors were willing to increase their U.S. stock holdings modestly last quarter. The real change was in Europe and emerging markets where the volatility decline was much more dramatic, leading to large inflows into those areas.
Activity
When the big picture (as far as the stocks and bonds markets are concerned) does not change, we do not do very much. Our activities tend to be limited to monitoring performance and replacing underachieving funds with alternatives that are more in step with current trends. This past quarter, that usually involved replacing funds with a defensive bias (such as Low Volatility ETFs) with alternatives that are better able to take advantage of a rising market. At the margin we increased international stock exposure by one to three percent, nothing major. Europe looks a lot better than it did three months ago economically and politically, but Latin America has been moving in the other direction.
Outlook
As long as the economy grows at a 1% to 2.5% annual rate, the stock market is in its comfort zone. In that type of economic environment stock prices tend to move higher no matter how expensive they are to start with, because it’s assumed corporate profits will also grow. If growth slows to less than 1%, the market worries about profits such that only companies thought to be recession resistant –consumer staples, utilities, and select internet companies – will hold up. On the other hand, if the economy grows faster than 2.5% the market tends to worry that the Federal Reserve will reign in liquidity to prevent inflation from breaking out. Financial services, energy, transportation, and materials stocks can still do fairly well with GDP above 2.5%, but most other industries do not. We are carefully watching bond yields and central bank policy statements for signs that we might be moving out of the market’s comfort zone. We know this will happen at some point, but it just doesn’t seem like that time is close at hand.
Commentary – Goldilocks and The Pigs
Market rallies tend to last as long as credit remains cheap and easily available. This allows companies to borrow at rates they can easily repay. Speculators tend to make, or increase, bullish bets because their expected rates of return are far above the cost of borrowing. By expanding its balance sheet to unprecedented levels, the US Federal Reserve has done an excellent job of providing the economy with enough cheap credit to fuel an economic expansion that has lasted over eight years. By keeping the economy in a modest 1.0% to 2.5% annualized growth channel, the Fed has helped the U.S. stock market post gains not justified by corporate earnings. As a result the market has re-entered valuation territory last seen in the late 1990s. Apparently, our collective confidence that the Fed can continue to keep us in this “Goldilocks” environment remains intact. We now run the risk that investors are over-confident in the Fed at the same time the Fed may be looking to reduce their impact on markets.
As most of us know, the U.S. Federal Reserve took radical steps in 2009 to bring the country out of a deep recession. The most significant step they took was to expand the national balance sheet by buying much of the debt they issued. This had the effect of lowering interest rates, since they reduced bond supply while demand was unaffected. Many expected that this would produce inflation, so gold soared between 2009 and 2011. Other world central banks (save Japan) chose to fight recession by cutting spending. By 2012, the results were clear – the American economy was recovering without any significant upturn in inflation, while austerity brought the Europeans to the brink of economic ruin. As the American experiment was acknowledged to be a success, the European Central Bank began to follow our lead, and gold plunged. To this day our economy has continued on its low growth, low inflation path, while other developed economies appear to be in the earlier stages of their economic turnarounds.
Unfortunately, one of the side effects of the Fed’s success is that investors now have a high degree of confidence that they need not fear inflation or recession. Greed is replacing fear. Speculative activity is again at high levels. And once again the financial services industry is creating complicated and risky speculative vehicles such as inverse volatility ETFs.<4> This doesn’t necessarily mean the market is headed for a correction but it suggests, if history is any indication, that we are probably in the later innings of this particular game.
The increase in speculative activity has not gone unnoticed. Central bankers here and in Europe have recently cited the desire to “normalize” interest rates. They do not explicitly say that they are trying to curb speculation, but in the absence of inflation that is the most logical explanation. Reigning in overly generous liquidity conditions may well be prudent, but it is not financial markets friendly.<5> It involves reducing credit available to banks (and by extension investors), and that means lower bond and stock prices.
The Federal Reserve and eventually other central banks have the task of gradually normalizing their impact on financial markets and economic activity. This means that at some future point central banks will once again allow markets to determine where interest rates ought to be. They want the path to normalization to be as smooth as possible so as not to create a market panic (remember, both bonds and stock prices are elevated due to their actions). This is going to be a delicate task, so expect the management of market expectations to involve them seeming hawkish one week and dovish the next. If you are beginning to feel like investors are being “herded” more or less like livestock, you are catching on. In other words, “farm pigs” have eaten considerably better over the last few years than the wild boars that have fought the Fed. However when credit conditions finally begin to tighten, the farm is going to be a lot less pleasant place to be.
One of the most important things to understand about modern economic systems is that stability tends to lead to instability, and vice versa.<6> Too much stability for too long and we get complacent. This breeds overconfidence that leads to speculation and eventually financial excesses. All of this builds until we finally reach a breaking point (known to economists as a Minsky moment). The Goldilocks conditions that allowed stocks and bonds to perform so well are ever-so-gradually being reversed by central bankers, who know the markets have become dependent on their generosity. They would strongly prefer not to trigger a crash, but market greed might make that impossible. The economy is currently in no danger of breaking out of its comfort zone, but a stock market that goes up every week might create destabilizing conditions anyway. This environment provides high reward potential but it’s built on an increasingly risky foundation. There is an old market saying, “Pigs get fat; hogs get slaughtered”.
<1> Source: S&P Dow Jones Dashboard: U.S. Mid and small cap stocks as measured by the S&P 600 and S&P 400, respectively.
<2> MSCI Europe Index net return in US dollars; MSCI Asia ex-Japan net return in US dollars. MSCI is also the source for Latin American and emerging market returns in the next two sentences.
<3> Barclays US Aggregate Bond Index in US dollars, per Morningstar
<4> In essence, a derivative vehicle that allows one to bet against volatility. It (XIV) is up over 95% this year as this is written.
<5> At least in the short term. If it helps us avoid a speculative crash, it will have been very friendly in the long term.
<6> This insight, the Financial Instability Hypothesis, is credited to Hyman Minsky who published a paper on it in 1992.
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
Technology stocks have done very well this year but have run into some resistance.
After flirting with Energy and Financial Services, the market has settled on Health Care/Biotechnology as the new leadership group.
The Federal Reserve seems to want to reign in excess liquidity even as recent economic measures have been on the weak side.
A reduction in liquidity after a strong run up is the kind of thing that often leads to 5-8% corrections.
There is an outside chance the next correction could be trigger a financial “accident” through computer driven sell programs.The Next Correction
I’m starting to sense that the next broad stock market correction is near. If I am right, it will be in the 5-8% range. My reasoning is as follows: technology stocks have led the market over the last few years. Tech stocks benefit from low interest rates in that since they are expected to grow earnings at greater than market average rates, the present value of those future earnings is worth more. In fact, the market views some of the best known tech stocks like Amazon, Apple, Facebook, Alphabet (Google), and Microsoft almost as utilities in that they have a well-defined niche which helps them generate a high and growing stream of cash that may help to dampen the effects of a recession. Yet it would appear that investors have pushed their prices up against the limits of their comfort zone. Perhaps it was Amazon and Alphabet both reaching $1000 per share, but in any case investors seem to be saying lately that if the market is to move higher, other sector will have to supply the lift. Financial Services and Energy tried and failed. Financial stocks can’t rally with interest rates low and the yield curve flattening. Energy stocks can’t rally with production rising more than demand. Last week, however, health care and biotech stocks really surged. They share with technology a growth bias and a relative insensitivity to overall economic growth. See Chart 1.
Source: YCharts
The bottom line is that while health care may lead the market in the near term, stock prices overall might have to pull back a bit to entice more broad-based buying. Investors did not take the Federal Reserve at its word after the last rate hike when they gave details on how they planned to gradually stop supporting the bond market with repurchases. I believe that is a mistake. I am not concerned about a 5-8% correction because statistically that kind of thing happens at least once a year. My worry is that a run of the mill sell-off might be exacerbated by computer-based sell programs designed to automatically protect portfolios from rising volatility.
So while I don’t see an economic justification for a double-digit decline in stocks in the near term, volatility-based automated trading systems are a reason that we may have one anyway. I would re-iterate that this would be a black swan; a normal 5-8% pullback is far more likely. Investors have been lulled into a false sense of security by almost record low volatility, while the Federal Reserve seems determined to begin draining the market of excess liquidity. A tighter Fed is definitely NOT priced in, so at some point that could cause some turbulence. A little extra caution may be in order.
——-
Some of you might be familiar with the concept of “risk parity”. This strategy aims to offset one type of volatility with another. For example, for stocks the biggest risk is equity or economic risk, in other words, that the growth of the economy and therefor corporate profits will disappoint. For investment grade bonds the biggest risk is interest rate risk, or the risk that bond prices will decline as interest rates rise. Under most circumstances, a slowing economy leads to lower interest rates. Therefore, what hurts stock prices might actually support bond prices. The reverse is also true.
Risk parity holds that if we believe bonds are half as volatile as stocks and that long term government bonds move in the opposite direction as stocks, then a 2/3 long government, 1/3 stock portfolio might minimize volatility yet still offer an attractive return. The problem comes in if stocks begin to decline and bonds do not exhibit the negative correlation we expected. In that scenario, our bond gains would not offset enough of the loss from stocks. As stocks fall and their volatility relative to bonds rises, risk parity funds would have to sell stocks in order to find a ratio where bond gains and stock losses were back in proportion. Since, much of that selling is computer automated, you can easily see how selling could beget more selling, much as happened with “portfolio insurance” back in October 1987.
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
Oftentimes I write updates after conferences in order to process and make sense of the information I have just taken in. This is my attempt to make sense of SIC 2017, John Mauldin’s annual get-together.
The first thing I took from the conference blog was that unlike all of the last several years, there was no referring to the United States as the “cleanest dirty shirt” or “best house in a bad neighborhood”, or any other euphemism for the idea that although things weren’t going that well in the U.S., everyplace else was worse. Several speakers brought forth the notion that in turning insular (cancelling trade deals, banning immigrants, etc.) America was ceding the future to China. China, through its initiative to conduct more trade across the Eurasian land mass through its “One Belt One Road” construction projects, is replacing the United States as the global economic engine (meaning the most important nation to have trade relations with).
The second important idea many presenters shared was a sense of being in the “fat years” so to speak. That means central banks are going to support the current economic recovery with expansive monetary policy and in some cases outright asset purchases until it works no more. Therefore, expect to go a very long time until the next global recession (we have been sacrificing magnitude for length in our economic cycles since the 1980s). But oh God, many presenters stressed, the next true global recession will be bad, because there will be nothing left for central banks to fight it with. Furthermore, we will have to confront what will become obviously unserviceable sovereign debt and pension obligations at that point. “Demographics is destiny”, Mark Yusko said (and many agreed), meaning we can see the wall that we are going to crash into but it is too late to do anything about it. Before this cycle ends, however, Pippa Malmgren believes we may see a “melt-up” in stock prices. Perhaps we are seeing that now.
International Markets
I had some concern that with the French election widely predicted to go to Macron in the days leading up to May 7th, the rise in European stock prices might be a “buy-the-rumor-sell-the-news” kind of thing. However, that has not proven to be the case. European stocks have continued to be strong performers, especially for dollar-based investors as the Euro has surged against the dollar. As a result, we are changing our domestic to international ratio in portfolios from 2.5 to 1 to 2 to 1. That means a 60-40 portfolio would move from 43% U.S./17% foreign to 40/20. It doesn’t make me feel great that in essence we are moving in the same direction as everybody else, but it is a situation where valuation, momentum, top-down fundamental analysis, and technical indicators all agree. There may be a need to consolidate recent gains (a correction of 2-5% could occur at any time given the approximately 15% gain this year), but it appears that the trend that favored the U.S. basically since the global credit crisis ended has finally begun to reverse.
Asian stocks have also been strong and I would not want to suggest Asia should be underweighted. There are near-term concerns with China as efforts to curb money supply (in order to rein in speculation) could give the stock market a bumpy ride. That said, China, India, and several other Asian nations are in a position to improve the quality of life for large swaths of their population, and in the West that has always coincided with strong financial performance. Latin America, on the other hand, should be underweighted. Though truly hopeful things are happening in Argentina, investable funds and ETFs are dominated by Brazil. That just isn’t going to go well in the near term.
Growth vs. Value
Growth as an investment style has dramatically outperformed value so far in 2017. See Chart 1. The predicted economic surge has not materialized, so investors have returned to stocks with predictable, non-cyclical growth. With declining economic growth expectations, interest rates have fallen. Two major implications from that: 1) financial services companies will earn less from lending, both in volume of loans and interest on those loans, so financial stocks may continue to under-perform, and 2) a dollar earned in the future is worth more, so we can pay higher P/E multiples for revenue growth-focused companies like Amazon. Another thing hurting the value side is the terrible performance of the energy sector year-to-date. Despite the OPEC agreement to maintain production limits for another nine months, it would appear that the world has all the oil and gas it expects to need.
Chart 1
Source: YCharts.com
Interest Rates
Perhaps the most difficult thing to do as a market strategist is forecast interest rates. 2017 predictions were near unanimous in calling for higher rates. The only questions were how much and would the yield curve flatten or steepen. It is unclear why interest rates have fallen this year as economic growth is still solidly positive and the Federal Reserve is still on pace to raise rates this year. A very flat yield curve at very low interest rate levels would in theory be a worrisome sign from an economic standpoint. It suggests that while economic growth may be mediocre, that is about the best we can do. I thought short term rates would rise to reflect what we expected from the Fed over the next several months, and longer term rates would edge upward but not nearly as much. I cannot intellectually reconcile plunging long bond yields and soaring stock prices simultaneously. Stock prices are theoretically tied to corporate profits, which are positively correlated to economic activity. Falling bond yields (rising bond prices) are usually associated with a decline in inflation expectations brought about by lower economic activity. The only explanation that would make sense is that there just aren’t enough stocks and bonds in the world to meet investment demand. Is this really true? Have global central banks created so much credit in the banking system that the prices of all financial instruments are being forced higher? If so, how and when does this end? (In another words, how do they extricate themselves from this situation without creating a massive implosion of financial asset prices)?
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.
I just returned from the Morningstar conference in Chicago. I always find it interesting to compare each conference I attend to past conferences in order to determine what issues become more and less important over time. The active-passive debate generated a lot of discussion. Morningstar derives an important part of its income from rating mutual funds and would therefore likely be hurt by the demise of active funds, yet it threw out only modest support to the active fund industry (specifically Dodge & Cox and PRIMECAP Odyssey). Ironically, greater support for active funds came from Blackrock, the owner of iShares, CEO Larry Fink. Also, while it is no secret that growth as a strategy has run laps around value since the last recession, growth managers seemed to take index performance criticism more personally. Value managers across the board acknowledged their struggles in this market but felt certain that their time would come.
There were two other areas that were prominent at the conference this time that were hardly even issues in the past, behavioral finance and sustainable investing. When I began my investment career, Modern Portfolio Theory ruled the land. Nobody dared say out loud that investors weren’t rational. If two investors ever came to opposite conclusions, it had to be that their time horizons or investment mandates were different. Or one had information that the other didn’t. Today the industry seems to fully embrace the notion that investors (even professionals) have biases, and emphasis is now on how to recognize and use them.
Sustainable (or ESG) investing has flourished recently as it has emerged as a more palatable way of avoiding “bad” companies. The goal of ESG investing is to invest in companies whose practices rank high in environmental, social and governance performance standards. The environmental screen helps avoid companies (such as those in the coal industry) whose assets might become stranded as more climate-friendly power generation grows in usage. Social seeks to avoid companies whose policies might generate unfavorable publicity and/or lawsuits, such as discriminatory hiring or anti-consumer practices (among other things). Governance issues sought to expose the fact that in companies where employee relations were poor, minority shareholders were ignored, or executive compensation was excessive the stock tended to underperform. Morningstar paid only the mildest attention to what it called “socially conscious” investing in the past, but is fully on board with sustainable investing today.
Nobody at the conference disagreed with the notion that stocks and bonds are both fully valued (if not expensive), but very few thought that the current environment (2% growth give-or-take and an inflation rate of under 2%) posed any threat to the bull market’s continuance. The biggest risk factors cited were rising U.S. rates and a strong dollar. Mildly disappointing GDP or retail sales are not going to kill the bull market.
Investing ideas:
Last winter in the wake of the market reacting to what it though President Trump would do, interest rates rose sharply. The 10-year Treasury bond briefly exceeded 2.6%. Speculative trading positions were very short the 10-year as many projected 3% yields by June. Fast forward to today and traders have closed those positions at a loss. Trading sentiment among speculators is now that interest rates will go lower. I think that sets us up for a test of 2.50% at the very least. Now may be a good time to trim duration.
Another area I believe investors will prioritize is dividend growth. For a long time, investors preferred companies with excess free cash flow to buy back stock as opposed to paying big dividends because dividends are taxable. Today there is a growing sense that stocks are so expensive that share buybacks in most cases don’t make sense. For this reason, companies are increasingly opting to declare one-time special dividends (most recently Costco), and investors are rewarding that choice.
This is the part of the market cycle where it is the most difficult to hold value stocks. One value manager said that he understands that he is “asking people to own names that they will probably hate”. Some people are better off acknowledging that they don’t have the stomach to be value investors and not investing that way in the first place, he said. That avoids “bad exit under-performance”.
Dollar-based emerging market investors have been the biggest beneficiary of the fact that the dollar has been unexpectedly weak this year. A strong dollar forces countries that borrow in dollars to use up more local currency to pay bondholders, negatively impacting liquidity. This is something EM investors have to watch carefully. For the moment, however, the dollar decline is a positive for EM, and off-the-cuff tweets only make this situation better. The risk factor here is a comprehensive tax reform package that would incentivize companies to repatriate overseas capital. I personally believe value managers need an economic growth expectation of less than 0.5% or greater than 3% to regain favor versus growth. A slowdown to less than 0.5% signals recession and would likely compress growth P/E multiples. An acceleration to 3% or more signals the kind of strong expansion that encourages capital spending and makes cyclical stocks the biggest winners. I believe neither is in the cards in 2017.
Environment, Social, and Governance
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 gained a little over 6% last quarter while bonds rose 0.82%.<1> Stocks continued the momentum from late 2016 as corporate profit expectations remained high, while bonds benefitted from the idea that the economy would not grow at an inflationary pace. There is a bit of a contradiction here – corporate profits probably cannot meet expectations without the economy growing fast enough to force interest rates higher – but for the quarter at least, investors got to have their cake and eat it too. They also were treated to a rebound in foreign markets. Currency traders sent the dollar lower last quarter as fears of a soaring dollar through protectionist trade policies faded. Emerging markets, which lost the most post-election, gained the most last quarter.
Technology and health care became market leaders once again as investors observed that the economy under Trump wouldn’t be much different than the economy under Obama – steady but slow. Sectors where expectations were higher, such as energy and financial services, had a disappointing quarter. Real estate struggled because tough times in the retailing industry are leading to soaring shopping mall vacancies. Utility stocks were a beneficiary of flight-to-safety buying when economically sensitive stocks faltered.
As mentioned, foreign stocks performed well versus U.S. stocks last quarter for the most part. It was no more than a reversal to some extent of the “Trump Trade” that investors put on last November when they sold foreign stocks and bought U.S. small and midcap stocks. Emerging markets gained 11.45% while developed foreign markets gained 7.25%.<2> See Chart 1.
Chart 1
Source: Ycharts.com
Bonds earned a little bit more than their coupon payments last quarter as interest rates declined. It paid off for bond investors to take extra risk, either in the form of high yield bonds (credit default risk) or foreign bonds (currency and sovereign risk). Investment grade U.S. bonds returned 0.82%, while high yield debt rose 2.70% and emerging market debt gained 3.28%.<3>
The 30,000 foot view of the markets over the last 12 months is that various narratives have, at different times, pushed particular parts of the market higher or lower depending on whether that sector benefits from a stronger dollar or a weaker one or whether it benefits from a weaker economy or a stronger one. In the end, none of the narratives have had staying power. Stocks continue to meander upward because more money is coming in than there are reasonably-priced alternative places for it to go. I believe that a decent percentage of it is from formerly bearish investors finally throwing in the towel.
Activity
The market has started to realize that a lot less is going to happen legislatively in the first half of 2017 than first thought. As a result bonds, gold, foreign stocks, and “defensive” U.S. stocks are more attractive. On the other hand, that realization has made inflation protected bonds (TIPs), the U.S. dollar, and economically sensitive U.S. stocks somewhat less favorable. I’m not sure it is all that wise to do a lot with one’s portfolio now if the expected changes to taxes and regulations are only going to be delayed by a quarter or two. As a result, we have been more focused on “intra-category” performance than making size or style shifts.
Outlook
Humans are incredibly adept at pattern recognition. It is how our ancestors survived when we were not at the top of the food chain. So when we observe the market rising despite relatively slow economic growth, we rightly conclude that economic growth does not drive stock prices. For the same reason, we can rule out corporate profits – they have been relatively stagnant for close to three years in a rising market. Therefore, the key driver to stock prices must have been low interest rates. When interest rates are low enough that it is profitable to borrow money to buy stocks, stocks are probably going to go up. Lack of economic growth or profit growth did not stop the S&P 500 at 2000 or 2200 so why would it stop the S&P now as it approaches 2400?
Similarly, we observed that every time something unexpected happened in the world over the last several months and the market opened sharply lower, someone (or more likely some computer program) bought stocks and the market actually finished higher. It seems as though we are becoming conditioned to the idea that the correct response to a market sell-off is to buy and as such fewer people fear a protracted downturn.
It is widely believed that market over-valuation is not a sufficient catalyst to cause a market downturn. However, while markets may stay above or below fair value for very long stretches of time, ultimately value wins out. If liquidity remains ample (and I don’t see it changing in the near term) and volatility remains low then stocks will probably grind higher even though just about every non-interest rate- related valuation metric tells us the stock market is considerably over-valued. There just aren’t enough reasonably safe, reasonably liquid (meaning easy to sell) investment alternatives out there.
Commentary – Indexing versus Active Management
I honestly hope the Outlook section you just read made you a little nervous. I hope you were thinking something along the lines of “how does this end?”, or “it can’t be this easy”. More and more market participants are gaining stock exposure via capitalization weighted index mutual funds and ETFs which are investments whose purpose is to closely match the performance of an underlying index. Why? Because it has been working and they believe it will continue to work. For the first time in my thirty plus year investment career, the investment advisor community has basically given up on beating the market. “If you can’t beat the market, join it” many say. If there is one thing I’ve learned, however, it is that no investment idea works when it is embraced by everyone.
There are two primary reasons why indexing has worked especially well over the past ten years (1) it is an inexpensive way to invest in capitalization weighted benchmarks that have disproportionately benefited from the low interest rate environment and (2) superior performance among active funds has not persisted.
Indexing is based on the belief that taking the cost of trading into account, it is difficult (if not impossible) to outperform the market over time. All investors together by definition are the market, thus for any given period some do better than the market as a whole and some do worse. Even the better performers see their advantage eroded when the costs involved in buying and selling are taken into consideration.
Active management is based on the belief that investment management is a skill that is difficult to master and as such, superior returns are available to those who do. The argument centers on the idea that the most skillful can add value through security selection and are therefore worth paying for their superior knowledge and process. The “skill” argument was taken for granted until roughly ten years ago because it was so easy to cite the returns of Warren Buffett, Peter Lynch, Bill Miller or several others. Today, however, nobody’s recent record looks all that spectacular. The Fairholme and Sequoia funds, once revered in the fund industry, have suffered mightily. As a result of the lack of high profile success among active managers lately, indexing through exchange traded funds (ETFs) has captured the lion’s share of new investment dollars.
While I understand why this has happened, I am becoming increasingly nervous. Trademark has used capitalization weighted ETFs for years as a core portion of our portfolios. However, with all the new money piling in, I begin to wonder whether or not those investors understand the risks they are taking. As long as you make the assumption that the stock market is reasonably valued such that one can expect to earn a very high single-digit annual return by buying and holding a market based ETF, it is hard to argue with indexing as a strategy. If you also assume that the past ten years are better indicators of the future than the previous twenty five in terms of the inability of one year’s best performers to sustain their edge, then once again indexing is the way to go. On the other hand, if you see the market as being so overvalued that mid-single digit annual returns are a best case scenario going forward, then simply matching the market’s return doesn’t seem so appealing.
I will say again that high valuation is not a sufficient catalyst by itself to cause stock prices to fall. That said, however, valuation is the best long-term guide to future stock price performance. As I have argued many times in past commentaries, high valuation tends to lead to low subsequent long term performance and low valuations lead to high future performance. It is true that when you buy at levels that are expensive relative to history, you are not necessarily punished by an immediate loss of principal. Often in fact the market goes on to make new highs over the next several months or even years.<4> On a fifteen year basis or longer, however, valuation is hard to beat as a predictor. If you bought the S&P 500 in late 1999, only in the last three years or so would you have a gain in inflation-adjusted terms.
I also want to emphasize that active managers may not have merited the acclaim (or paychecks) the best of them received in the 1990s, but they aren’t idiots either. The more that stocks are purchased due to their inclusion in a capitalization-based index as opposed on their individual merits, the more scope there is for a manager to outperform by doing deep analysis. However, it may take longer for their discovery to be rewarded. In addition, it is much more difficult to add value when you are one smart person competing against a hundred or a thousand other smart people trying to determine what Apple is going to earn next year than it would be if indexing reduced your competition to fifteen or twenty (maybe only two or three if you were researching Donaldson or Fastenal). The skill of stock picking is bound to matter a lot more if the market as a whole is performing poorly (as it was in the 1970s and early 1980s) such that the extra value that someone who can read a balance sheet and income statement can provide is valued once again.
To sum it all up, it’s important to state that this commentary is not to argue against indexing per se. We use indexing extensively, especially in smaller portfolios. The point is to observe that historically anytime a sector, investing style, or strategy becomes almost universally applauded it tends to end badly. Its merits are well-known while its drawbacks are minimized or ignored altogether – until the event occurs in which they become obvious to everyone. We are in the ninth year of an upturn that began in March, 2009. It stands to reason that a strategy that has kept investors fully invested with minimal investment costs would be popular. And as I suggest at the end of the Outlook section, I’m not looking for this bull market to end imminently<5>. What I am saying is that at some point in the not too distant future this bull market will end, and success at that point will probably require a different approach than the one that has been so successful over the past eight years. Trademark Financial Management stands ready with both the historical knowledge and the intellectual flexibility to modify our approach to the indexing versus passive management debate to take advantage of different market environments.
We thank you, as always, for your confidence in us.
Mark A. Carlton, CFA®
<1> Stocks as measured by the S&P 500 Index and bonds as measured by the Barclays US Aggregate Bond Index. Source: YChart.com
<2> Emerging markets as measured by the MSCI Emerging Market Index and Developed Markets as measured by the MSCI Europe, Asia, Far East Index. Both indices include dividends and are stated in U.S. dollar terms. Source: YChart.com
<3> High yield bonds as measured by the Barclays High Yield Corporate Index and Emerging Market Debt by the Barclays EM Aggregate Index. Source: Morningstar Adviser Workstation
<4> Alan Greenspan made his famous “irrational exuberance” comment in December 1996, more than three years before the market peaked.
<5> Typically the market makes a top over several months, and there is no evidence as yet that the topping process has begun.
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.
