Emerging Market Asset Allocation

It would be unthinkable to put together an investment portfolio today that did not include Apple, Amazon, Microsoft, and Alphabet.  Perhaps also Facebook, Tesla, and Netflix.  These companies have become very powerful through domination of at least one critical niche in the new economy, plus they are constantly pushing the frontiers of innovation.  There are also foreign companies for which the same can be said, yet more American investors and advisors do not take the same care to ensure that they have them in their portfolios.  The two most important companies in the world today just might be Taiwan Semiconductor and the Netherland’s ASML Holdings, as they each have control of a part of the most critical aspect of modern society – high end semiconductors.  Moreover, if one wanted to ensure they were exposed to the largest consumer markets in the world, how could one not own China’s Tencent and Alibaba, India’s HDFC Bank, and MercadoLibre – Latin America’s ecommerce giant?

I am looking at our portfolios now to ensure not just that we have enough emerging market exposure but also that we haven’t inadvertently missed out on any of these innovative firms.  This is where the growth in this very slowly growing global economy is coming from.  It should certainly be understood that any and all of these companies will have challenges from time to time, be they from a strengthening dollar or some kind of conflict in their home country.  The important thing is that many American investors are becoming discerning enough to know that 1) you don’t sell ALL emerging market positions because India is quarreling with Pakistan or because China is quarrelling with the U.S.; and 2) like it or not, the 4.3% of the earth’s population that the United States of America represents is not going to dominate the 21st century as it dominated the 20th, no matter what we do.  To be clear, doubling your EM weighting might not pay off over the next 12 or 24 months.  Rather, this is a strategic asset allocation decision grounded in the belief that EM economies, and their component companies, are poised for a strong decade.

Bonds and Inflation

We’ve witnessed a minor upturn in inflationary expectations in January, which is nothing unusual this time of year.  The benchmark bond index dropped -0.86% for the month (which was still better than the S&P 500’s -1.02%, it should be noted).  I am not worried about bonds because I expect a fairly disappointing economic environment for most of the year relative to what markets were pricing in late last year after the vaccines were discovered.  I’m not going to get negative on bonds until we see a bounce in the measures of the velocity of money.

Let Your Winners Run

In a recent Barron’s, James Anderson makes reference to a recent study done by Hendrik Bessembinder of Arizona State which basically states that most companies’ stocks do not outperform      T-bills.  By far the largest stock gains come from a surprisingly small number of companies that are able to compound wealth over long periods.  Anderson believes the message from this study, which looked at 62,000 companies worldwide from 1990 to 2018, to be that one should be very careful not to sell great companies too soon because they are few and far between percentagewise.

Active vs. Passive

In the active vs. passive debate, one active argument that almost never gets made is this:  Active managers rarely do truly idiotic things.  What do I mean by this?  The iShares Russell 2000 ETF (IWM) owns GameStop (GME) because it is a small cap stock and owning it is what it is supposed to do.  IWM does not apply any type of profitability filter unlike the Vanguard Small Cap ETF (VB) which does.  Last month, as GME’s price soared, so did IWM’s.  Much faster than did VB’s.  Therefore, uninformed investor money tended to flow in late January to IWM, which was forced to invest it in more and more shares of GME as its price rose.  When one invests in IWM, one may believe that they are receiving a fraction of a percent of hundreds of different small companies, because that is usually true.  If you bought it on January 25th, however, you were unwittingly taking a flier on GME, which was at that point over 8% of the portfolio, and in other sub-Reddit champions such as Macy’s and Bed, Bath & Beyond.  There are several other ETFs where this phenomenon was even more egregious, such as the Cambria Shareholder Yield ETF, which had a lot more GME to start with, so its weighting got to well over 10%.  That is being unwound in a hurry today.  The point is that you should be careful to know your passive investment products, because a “buy-anything-in-this-capitalization-range” policy can bite you if you are not careful.

Oh, and by the way, this type of speculative behavior is just never seen at or around stock market bottoms.  Just sayin’.

Disclosure

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

The Fed

Not much to say about the U.S. stock market overall.  I’ve been reading a lot of analogies lately, so here is mine:  Imagine northern California, circa 1849.  Gold has been discovered, and a lot of people are getting rich mining and especially by selling equipment to miners.  The cost of everything is up because there is plenty of money available relative to the supply of picks, pans, shovels, horses, denim, food, whiskey, etc.  You can argue that “in the real world” of New York or even St. Louis those items wouldn’t cost nearly as much, but if you were in San Francisco and wanted to mine, that was what it cost.  The point is that the Federal Reserve has opened up the credit spigot and the “gold” of easy money is inflating the stock price of the new pick and shovel companies like Nvidia, Zoom, Tesla, and others.  However, U.S. and foreign companies engaged in “real world” industries such as industrials, financials, real estate and utilities, haven’t felt nearly as much of a liquidity surge, as thus their stock prices really haven’t budged that much (and certainly aren’t at all time highs).

Now, we know easy money booms don’t last forever.  Going back to our analogy, whereas the supply of gold in California’s rivers was finite, the Fed’s ability to flood the world with liquidity seems to be limited only by the market’s concern about how much is too much.  I don’t get the sense we are close to that point, so while a correction may be overdue, it just might ultimately result in even more stimulus.

A Thought Experiment

What conditions would create the perfect scenario for long-term underperformance of a particular country? I believe the following would need to be present:

1. 1.That country would have to start out at very high absolute valuations, say over 25 times earnings.
   
2. 2.That country’s market should be dominated by a relatively overrepresented economic sector as compared to other global markets, and that sector should be even more highly priced than its domestic market as a whole – let’s say 36 times forward earnings expectations.
   
3. 3. That economic sector should be over-owned both in that country and globally as a percentage of global market capitalization.
   
4. 4. That country should trade at a premium to the rest of the world, generated in no small part by its reputation for strength and stability. However, this reputation may not reflect the current reality of this country.
   
5. 5. That country should have engaged in corporate financing practices that render the majority of its firms vulnerable to an increase in interest rates, such that it increasingly falls upon the country’s central bank to underpin its market by buying the bonds of its major corporations.
   
6. 6. This country should have the world’s reserve currency, such that it has to run a trade deficit in order for the global economy to grow. This country’s currency should begin to experience weakness as foreigners become concerned about how much of that currency may flood the world at some point given its central bank’s massive credit creation.
   
7. 7. The country should be experiencing deteriorating trade relations with much of the world, including the world’s second most powerful economy. That other country should be growing at a rate that would allow it to contemplate using its own currency to conduct global trade, or at the very least no longer doing business in the currency of its rival.
   As I see it, the U.S. checks all seven of the boxes.  The U.S. is 4% of earth’s population and 55% of its market capitalization.  It is hard for me to imagine our relative advantage being greater ten or twenty years from now.  At some point, we are all going to own a much higher percentage of foreign securities, probably because of U.S. underperformance.
   
   

Stop Listening
I can think of no worse way to waste one’s time than to listen to investment companies discuss the upcoming election. Please keep two things in mind: (1) Investment companies have a terrible record determining the winner and, more importantly, (2) they are abysmal at forecasting the implications, even if they are correct about who wins

Furthermore, experience shows that even if one knew that Trump was going to be re-elected, one would still have no idea what he would actually do.  Do yourself a favor and stop listening. Remember, capital has historically found a way to flow toward productive capacity regardless of election outcomes.

The Bond Market

Source: YCharts as measured by the Bloomberg Barclay’s US Aggregate Bond Index

Disclosure

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

Summary

Stock prices rebounded sharply last quarter as investors began to anticipate an economic recovery.  Whether the recovery actually comes to pass as soon as the market hopes is another thing entirely, but it is important to remember that the stock market is a discounting mechanism.  In other words, it represents the collective expectation of participants.  A great deal of money moved out of the market back in March as market participants expected, and therefore priced in, a high degree of pandemic related economic uncertainty. Markets really, really, hate uncertainty. As investors regained clarity, and re-adjusted their expectations, they began to re-invest cash in May. Those inflows have provided a cushion for the market on most down days and extra fuel on good days.

Both foreign stocks and domestic bonds rose during the quarter as well.  Domestic bonds benefitted from direct Federal Reserve buying of corporate and government debt, while international stocks were aided by central bank activity in China, Japan, the European Union, and in the United Kingdom.  Under normal circumstances, higher quality bonds might well have declined in price as the economy began to recover.  Because of the Fed, the strong performance of stocks was continually supported by record low bond yields.  As long as this environment persists, financial assets have the wind at their back.

The S&P 500 rose 20.5% last quarter, trimming its loss on the year to -3.1%. While it may seem obvious that technology was the top performing sector during the second quarter, tech was actually third behind energy and consumer discretionary (the latter sector now encompasses Amazon and Home Depot). Energy stocks lost so much in the first quarter that even with a 32% bounce last quarter they are still down almost -35% year to date.  Technology only lost -12% in the first quarter, so its 30.5% surge last quarter pushed it to a gain of nearly 15% for the year through June 30th.  Utilities (up 2.7% for the quarter) and consumer staples (8.5% for the quarter) were the only two sectors that didn’t gain 10% or more.  Smaller stocks enjoyed a larger bounce than large caps last quarter with the Russell 2000 gaining 25.4%.  To keep this in perspective, that gain only reduced the 2020 loss to -13% from roughly -30% in the first quarter.

International markets climbed back 14.9% last quarter but are still down -11.3% year to date.  There was a lot of variance between regions.  China is up 3.5% in 2020 having risen 15.3% last quarter.  That is by far the best foreign market performance this year.  European stocks gained almost the same amount last quarter (15.4%), but that still left it down -13.2% due to their much deeper first quarter decline.  Latin America soared 19.1% last quarter but that barely registered against the -45.6% first quarter debacle.  Japan led the way during the quarter (19.8%) but is still off -6.2% over the six-month period.

The Barclay’s Aggregate Bond Index rose 2.9% last quarter, but that tells you very little about the average bond because the index is longer in duration (more sensitive to interest rate movements) and higher in quality that most actual bonds outstanding.  Most intermediate and long-term bond funds performed much better than that, as liquidity returned to the sector.  Barclay’s 1-5 year corporate bond index swung from a -2.2% first quarter loss to a 3.3% year-to-date gain on the strength of a 5.6% second quarter rally.  Low quality “junk” bonds rose 9.5% during the quarter, which brought them back to -3.1% on the year.  On the other hand, safe short-term Treasuries only gained 0.3% last quarter, but are ahead 3.0% for the full six months.

Activity

We began the second quarter with much higher than normal cash levels because of our concern about the economy, and while we are still somewhat overweight cash, we have been active in terms of finding sectors where we believe there is opportunity.  We have added positions in convertible bond funds for our conservative investors and in health care for our more aggressive ones.  For some we have ventured into sub-sectors like genomics and data centers.  We are also interested in the clean energy sector, but it is currently dominated by Tesla, which is comically expensive at 787 earnings.  A price like that presents too much business execution risk.  We shifted some of our international stock exposure from developed markets to emerging markets during the quarter as the latter have faster growth rates and, with the exception of Brazil, seem to be handling the Covid crisis fairly well.  Looking forward, we are thinking about increasing exposure to Europe as their policy responses to the crisis seem to be working better than ours, and their political situation is, for the first time in longer than I can remember, more stable than ours.

Outlook

It is really difficult to forecast future market movements under any circumstances, but today it seems especially foolhardy.  If the virus has a stronger than expected second wave in the fall, for example, stocks would be vulnerable because that scenario is not reflected in current prices.  If there is uncertainty following the U.S. election, as there was in 2000, that would almost certainly have a negative impact (as it did then).  If the current “it’s only a matter of time until we have a vaccine and things can go back to normal” narrative is replaced by something more pessimistic, the market will trade lower.  The upside for the S&P 500, which as of July 27th is at 3228, relies on continued positive developments on the virus front, more normalization of the economy, and no constitutional crisis in November.  If the S&P 500 was trading at 2800, simply the absence of bad news might well be enough to push stocks higher, but that is not where we are.  In fact, the NASDAQ might be in bubble territory. As such, we are looking closely at our international exposure.

American stocks trade at a substantial premium because of our much greater weighting in non-cyclical growth industries (information technology and biotechnology) and our long record of political and economic stability.  The former I believe will not change anytime soon, though there are some very impressive foreign technology companies like Alibaba (China), ASML (the Netherlands), MercadoLibre (Argentina), and Shopify (Canada).  The latter is overstated, perhaps vastly.  Financial professionals are not talking about Brexit or the Italian elections these days; the biggest political wildcard is America.

Commentary – Risk Budgeting

The last six months are about the best illustration I can imagine against trying to time the market.  Even if you were so prescient as to have gone to cash at the end of February the mental anguish associated with buying back into the market would have been substantial.  What would have been your buy signal?  The number of new coronavirus cases? New unemployment claims?  Stock market moving averages? None of those indicators have proved to be useful trading tools thus making re-entering the market incredibly difficult.

At Trademark Financial Management, we maintain a gradualist approach to managing market exposure because market timing is so difficult.  We don’t believe that we can consistently add value moving all-in and all-out of the market.  We marginally trim positions when we feel conditions are deteriorating and we add to positions when we feel they are improving.  Sometimes we add value this way and sometimes we don’t.  Our goal in the effort is to try to reduce losses, but invariably there will be some reduction in the upside that follows, because we won’t get back in at the very bottom.

That said, we believe we can add value by re-deploying the marginal amount of cash raised into areas of new market strength.  After a sell-off, the characteristics of the new advance are often different than the previous advance. Recently, we have observed that the coronavirus has significantly accelerated the adoption of specific technologies.  Americans are now using services like Zoom and Grubhub because they are convenient, but it is fair to say that most of us weren’t clamoring for the chance to meet remotely or have our groceries delivered before the crisis hit.  Furthermore, our response to the virus is accelerating other trends like the demise of the retail store and the increased use of electronic payment.

We look for funds that are capitalizing on those trends and add them into portfolios according to “risk budgets”. Typically, a client with a greater risk tolerance will have a higher risk budget and we’re more likely to add a thematic investment. Risk budgeting also involves tradeoffs between competing investment characteristics. For example, expensive assets may take up a greater share of the risk budget.

The technology sector is up about 17% for the year and 52% since the March 23rd low.  This means it has considerable risk should investors abruptly sour on it.  Maintaining an overweight to technology, therefore, requires us to under-weight areas that are cheap but lagging.  If momentum begins to improve in a cheap sector, such as developed market stocks, we would have to draw from technology in order to increase our weighting there, or else we would exceed our risk budget.

I think the biggest takeaway from the market this year is that nobody really knows where prices are headed.  We spoke with many people about the stock market in March and to a person they thought stocks were headed much lower.  Some were right for a short period of time but, of course, none were ultimately correct. Part of our job is to help investors avoid making emotional investment decisions.  Everybody has heard that the key to investing is to “buy low and sell high”, but they just can’t do it by themselves.  A good advisor helps their clients by tempering their emotions and keeping them focused on the long-term investment plan.

This has been a difficult year for many investors because stocks have not behaved as we would have expected given the severe shock to the economy.  This leaves us grasping at what is a fair level for the market.  I have an idea where that is, but I don’t necessarily expect the stock market to find that level and stay there.  The Federal Reserve has added an unprecedented amount of liquidity to the financial system, which means that most of the time, stocks are going to trade above fair value.  It is important, therefore, to understand the added risk that comes along with an intentionally inflated market.  Using a gradualist trading approach helps us avoid getting swept up in the euphoria that accompanies a strong market, yet it keeps us from dialing back too much when things look dire.  Risk budgeting is a discipline in which we recognize that if we are to take additional risk in an area that appears attractive, it has to be offset by having lower exposure someplace else.  Over the three decades that we have been investing for our clients, they have really helped us keep our mistakes small.  In investing, that is everything.

As always, thank for your continued trust in our management,

Endnotes U.S. stock average figures are rounded to the nearest 0.1%.  They are taken from Standard & Poors through Morningstar Workstation, or in the case of sectors, directly from S&P’s quarterly summary.

International stocks performance is taken from Morgan Stanley Capital International (MSCI) again via Morningstar Workstation.

Bond performance is taken from Barclay’s Capital via Morningstar Workstation.

Source: YCharts.com as of 7/28/20

Mark Carlton, CFA®

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.

Investors are herd creatures.  We can’t help it; 100,000 years of programming is hard to unlearn.  That said, what enabled our ancestors to survive on the African plains and later in medieval societies was the ability to quickly figure out which way the “wind” was blowing (as Bob Dylan put it) and get in step.  The problem with this during periods of instability is that the herd doesn’t really know where it is going, so changes of direction can occur rapidly.  The “herd” drove stock prices almost 30% lower between March 4th and March 23rd because the downside to the economy seemed limitless.  A sustained upside move followed as the Federal Reserve and Treasury Department took steps to say, in essence “we won’t let it get any worse”.

The S&P 500 hit 2948 late last Wednesday afternoon, a level first reached during the second week of October 2019.  The thought that stocks should trade on April 29, 2020 at the same level as October 11, 2019 seems absolutely ridiculous!  Forward earnings estimates today are dramatically lower than they were six months ago.  Yet here we are, all because the narrative the herd was following had changed from “the world is falling apart” to “there are incredible bargains to be had”.

Realistically, there aren’t many bargains to be had.  Take the energy sector for example.  The dramatic plunge in oil futures in late April led many to believe that oil stocks were dirt cheap.  A closer look argues otherwise.  Chevron stock closed at $110.74 on the February 19th, the day the S&P peaked.  It lost a little over half its value ($54.22) at the March 23rd low, but trades at $93.41 as this is written. This is much closer to its high than its low, despite the huge hit to prices and consumption.  Maybe there is still value in small caps (which plunged over 40% between February 19th and March 23rd and have only retraced about half of that loss) but certainly not in the S&P 500.  Sharp reversals in both directions are a known characteristic of bear markets.  The idea that you have one sharp down move and then recovery and new highs is a bull market notion.  We have to be open to the likelihood of several drawdowns before the market as a whole is healthy enough to make new highs.

Revisiting the notion of disruption that I wrote about back on February 21st, disruption is only going to happen faster now because business models that didn’t, or couldn’t, adapt are even more vulnerable in the new reality society is facing.  Companies like JC Penney will probably fail faster than they would have prior to the pandemic and so will many of the malls that they operated in.  The market is struggling with how to value those industries that made sense in a world where employees needed to work in close proximity either with their customers or with other employees.  Can airlines make money if the middle seat is no longer booked?  Will ticket prices need to be 50% higher?  Will people fly as much if they are?

At the time of my February report I likened the faith in the disruption narrative and the Federal Reserve to the faith in the dot.com future the market showed in 1999.  Back in 1999 I believed that investors were overpaying for Amazon relative to Sears because the latter was profitable, and the former was decidedly not. Obviously, not a great decision on a 20-year basis but Sears did outperform Amazon until about May 2007.  The point I was making was that those companies that are positioned well for the future are definitely the ones you want to own for the long term, but if bought at a time when the herd is falling over themselves with greed they can be poor short term investments.

Over the weekend, Berkshire Hathaway “hosted” its annual meeting.  Though shareholders could not be present this time, CEO Warren Buffett made a speech and answered questions electronically.  One of the most surprising elements of his remarks was that Berkshire had not done any major buying during the Covid-19 sell-off, and he didn’t plan to do anything in the near future.  In fact, he was a net seller having drastically cut Berkshire’s airline exposure.   Given Buffett’s comments 12 years ago in the wake of the Financial Crisis, the apparent conclusion has to be that stocks aren’t anywhere near the bargains today that they were back in 2008.  If you believe Buffett still has the wisdom he possessed during his incredible 50+ year investing run, one really has to question the stock market’s rally at this point.  If stock prices decline 15% but intrinsic values fall 20%, for example, the market hasn’t become “cheaper”.

It is a statistical truth that small caps outperformed large caps in April.  That was a bounce-back from deeply oversold conditions in late March and has shown no follow-through in May.  Value stocks had a nice run in the last two weeks of the month, but the story is the same here.  Technical trends very strongly favor growth over value and large over small today.  They are a little more ambiguous when looking at domestic versus international in the short run (we believe that longer term measures still favor overweighting domestic stocks).

One last item of note; on their conference call this morning, renowned strategy firm Bank Credit Analyst expressed a preference for inflation protected bonds on the idea that product shortages due to supply bottlenecks plus gradually rebounding energy prices would keep inflation levels well above treasury bond yields.

In retrospect, investors preferring profitless Amazon to profitable Sears were right, of course.  The move from companies with a heavy “brick-and-mortar” footprint to those that could leverage digital technology had already begun by the late 1990s.  They had a very deep “hiccup” between 2000 and 2003 as the recession made things very difficult for companies that didn’t have positive cash flow.  Companies like Amazon had positive cash flow even though net earnings were negative.  Interest rates were low enough that they were able to survive, and then, obviously, to thrive.  This is something to keep in mind as one contemplates whether or not there will be a reversion to the mean that elevates “value” stocks at the expense of growth stocks.  Digitization and low interest rates have completely changed the business and investing world.  I cannot see a scenario where investors once again prefer high fixed cost companies like airlines, automakers, and steel producers over low fixed cost knowledge industries like software design and genomics.

End Notes Source: YCharts.com

Source: YCharts.com, S&P 600

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.

Exactly one month ago (February 19, 2020), the S&P 500 made a high just above 3393 before closing at 3384.  We didn’t know it at the time, but that was the market top.  All of the major market averages were above their moving averages.  Sentiment was strong, though we were aware that China was going through a crisis with a nasty virus that seemed to be centered in and around Wuhan.  Remembering the SARS and the Ebola virus concerns and how they ultimately had very limited market impact, investors were not prepared to discount the potential risks.  After two mild down days, stocks began to sell-off more earnestly on Monday the 24th.   110 points, or -3% were shaved from the S&P 500.  That was one of the more volatile days in the month, and a harbinger of things to (though we didn’t know it at the time).  By market close on Thursday the 28th, the S&P 500 had moved below both of its uptrend lines.  Stocks plunged at the open on Friday the 28th, but recovered much of their losses by market close.  The first week in March saw stock prices rise for the first three days overall, and while the market fell Thursday and Friday, Friday’s close was higher than the previous Friday’s close.  This seemed to suggest that the market might be building a base of support in the 2900 range.  If only!

Over the weekend of March 7th-8th we began to see really scary information coming out of Italy and Iran.  The medical establishments in those countries were overwhelmed.  There was no way that we were going to keep the virus from meaningfully impacting the United States.  Stocks plunged to their June 2019 support levels around 2745, which put a floor under the market for three days.  When on Wednesday night the entire sports world shut down after an NBA basketball player tested positive for the virus, stocks gave way spectacularly the next day.  Friday the 13th saw a strong rally back to the 2700 level based on a late day speech from the President suggesting he was finally taking the crisis seriously.

This past week has witnessed a procession of plunges and rallies making lower highs and lower lows as the market fully discounts the impact of shutting down major sectors of the economy for weeks or months.  The market’s drop of more than 25% in 16 trading days was unprecedented in history – the previous record was 27 days in 1929.  We extended the record to 30% in 18 days this week.

From my perspective, stocks have moved from well above fair value through fair value to below fair value.  Admittedly, since we really have no idea what corporate earnings are going to be either this quarter or at least the next two quarters, estimating fair value is quite difficult.  That said, NYU Stern Professor Aswath Damodaran created a useful chart<1> as to what the S&P 500 would be worth given various levels of earnings loss in 2020 and recovery in future years.  It implies that S&P 500 fair value was about 3030 on February 19th.  According to Damodaran, if earnings drop by 20% this year and 75% of that is recovered by 2025, today’s fair value falls to about 2870.  If you are more pessimistic and see earnings falling 30% and only half ultimately being recovered, 2550 is fair.  Anything in the range of 2500 to 2700 on the S&P 500 makes sense to me at this point, and it is 2450 as I write this.  Not dirt cheap but certainly worth a look if one has a time horizon of three years or more.

Obviously, we are still going to have some bad days.  The infection and death numbers are going to keep going up.  Unemployment is going to rise sharply in the near term.  That said, it appears that the multiple plunges in the stock market over the past four weeks have discounted a great deal of the economic damage we currently expect.  Cruise industry stocks are down 80% or more.  Hotels chains are down 50-60% or more.  Airlines have lost 2/3 of their value or worse.  The most affected areas of the economy literally cannot drop as much in the future under any scenario as they have already fallen.  It is very difficult to imagine that we are not much closer to the bottom than the top.

Volatility has not been confined to the stock market.  The bond market has been as wild as I have ever seen it, including 2008.  As volatile as 2008 was, basically one can say the high quality bonds rose and low quality bonds declined, based on the projections of default risk.  This crisis started out that way as well.  Long term bond yields declined, and prices rose fairly steadily until March 9th.  Then high quality bonds began to fall and fall hard despite the extremely weak prospects for inflation.  It appears that as the market for stocks and weaker quality bonds fell, higher quality bonds were sold in order to meet margin calls or provide liquidity.  The price of exchange traded funds (ETFs) have started to diverge meaningfully from the net asset value of the underlying bonds due to illiquidity.  We believe that it will be a matter of several days for volatility to subside in the bond market such that AAA-rated bonds will better reflect inflation projections.  All of this does remind us that during a crisis we cannot always count on diversification to save us, because correlations across asset classes tends to converge.  It is fair to predict that future portfolios may have to own fewer bonds as we search for other non-correlated asset classes.

For our part, we made our first across-the-board transactions in late February as stocks broke through their moving averages.  In March we have opportunistically trimmed small cap, mid-cap, and value stock positions in the U.S., cut foreign stock exposure by about 3% (from an average of amount 16% to 13%.), and also cut back on BBB (the lowest rung of investment grade) bond exposure.  Average cash in our portfolios has gone from 3%-6% (depending on risk tolerance) to 6%-18%.  We are at price levels where it probably makes sense to start nibbling at bargains, but we would like to see more time go by such that we have increased confidence that those investors still inclined to panic sell will have completed their transactions. It has always been our investment philosophy to “lean-in” to markets where conditions are favorable and to lean away when conditions weaken.  That’s where we are now.  We are mindful of the fact that the possible announcement of an effective treatment for the virus could spark a massive rally at any time, so the notion of completely selling out of the market makes no sense to us because we could never re-establish positions fast enough.

Thank you, once again, for your trust in us.  We are gratified for this and we work very hard to continue to earn it.

<1> Aswath Damodaran, A Viral Market Meltdown Part II: Clues in the Debris, Seeking Alpha, March 13, 2020.

Disclosure

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

THE NEW GOLD RUSH

Welcome to the new gold rush.  There is a feeling in the investment world that we are in an Age of Disruption that is going to change the way we do everything.  From a stock investor standpoint, therefore, companies are either disruptor or disruptees.  If you are among the former, you are going to own the future and therefore, the narrative goes, no stock price is theoretically too high.  If you are among the latter, the amount of money you’re making (or more likely losing) today doesn’t matter. The market seems to believe that in the future you won’t exist so why bother estimating your last few years of cash flow when the disruptors are just SO MUCH more interesting.  This certainly feels reminiscent of 1999 to me. What makes today different however, is that the market believes the Fed has learned its lesson this time.  We know that the Fed popped the dot.com bubble in March 2000 after it began removing the excess liquidity it had flooded the economy with leading up to Y2K.  The current market narrative absolutely believes that the Powell Fed is not going to make that mistake; it will inject reserves in a crisis and it will never take them back out.

Seriously, though, there is a mindset right now that sees stocks as being almost invulnerable due to low interest rates, spectacularly friendly central banks, and the continuing decline in the supply of stock shares.  In other words, the internals are so positive that it will take an external shock to cause a bear market.  The Wuhan coronavirus was thought to present that kind of threat, but the market now seems to believe otherwise.  Back in late 2018 the U.S.-China trade war similarly spooked investors.  Today, it is hard to see that market pullback as anything other than a buying opportunity because for the past ten years, it’s been exactly that.  Taken even more broadly, it seems the market believes that every external threat is a buying opportunity – because, in recent history, that’s what it’s been.

(And even as I wrote last paragraph I was thinking: “This is when bull markets end.  When everybody is convinced that it can’t be stopped.”)

MINNEAPOLIS CFA SOCIETY DINNER NOTES

I had the good fortune of being at the CFA Society annual dinner last Thursday night.  The keynote speaker was Rick Rieder, head of Fixed Income at Blackrock and consultant to the Federal Reserve Bank of New York.  The following are some of his insights I think you might find useful:

1. 
   1. Interest rates are going to stay low for a very, very long time due to demographics (aging global populations), the excess of demand for bonds over supply of bonds, technological innovation (nobody can raise prices without inviting disruption), and the inherent stability of a service economy versus a manufacturing economy.
   
2. 
   2. Financial conditions are too easy. The Fed will not lower rates in 2020.
   
3. 
   3. Bonds are a terrible place to put money if one is seeking risk adjusted return. Bonds yield vary little and do not provide nearly enough compensation for the risks they present.  They aren’t even good as “ballast” against a stock market decline (again, because rates are so low).  One would be much better off using out-of-the-money options or being long volatility, both of which are underpriced, versus using overvalued bonds to hedge against a pullback in stocks.
   
4. 
   4. Today the consensus view is arrived at much quicker than in the past; in days, not weeks or months, so we all get “correctly” positioned in a very short time. A meaningful change to the accepted current wisdom could be very dangerous, for the sheer volume of money that would attempt to move out of very crowded trades.
   
5. 
   5.Illiquidity is priced way too high. In the past investors were paid a premium to lock up money.  Today there is so much demand for returns that don’t have to be marked-to-market daily that private markets are probably MORE expensive than public ones.
   
6. 
   6. Price-earnings ratios are not a good measure of stock valuation. A better way is to measure free cash flow adjusted for financing costs (which today are very low).  Looked at this way, stocks are not expensive.  They are a much better bet than bonds.
   
7. 
   7.The valuations of innovative companies are going to keep rising relative to the valuation of those that don’t or can’t. There is no business cycle in the conventional sense anymore, so waiting for the late cycle move in inflation that boosts late cyclicals and other value stocks at the expense of growth and interest rate sensitive stocks is not going to pay off anytime soon.
   
   

A FEW MORE THOUGHTS

The next morning (Friday the 14th) I listened to an interesting conference call with Bill Eigen of JPMorgan (their head of Opportunistic Fixed income).  He said almost the exact same things as Rick Rieder did the night before.  Many Bond pros really don’t like bonds right now.  They prefer stocks from a risk-reward standpoint.  As Eigen pointed out, bonds are basically math.  You know exactly what you are going to get.  Under most scenarios at this point, the expected future total return you’ll earn is too low to compensate for the risks you are taking.

The energy sector may be worth a look right now.  Energy stocks have underperformed for years, and most sit at, or near, decade lows.  The catalyst to a move higher may be the realization that fracked wells have a much shorter lifespan than regular wells.  Energy producers are fracking in the easy and obvious places now, and those wells are being quickly depleted. Meanwhile, those companies are reinvesting the proceeds into more new production.  At some point supply could fall below demand again as energy companies realize that maximizing production capacity may not the best way to build shareholder value.

Another interesting industry is utilities.  Fund managers love to talk about how they don’t own any utilities since they are highly regulated slow growing companies trading close to record high valuations.  And yet they keep going up in price.  Why?  The low cost of leverage and the popularity of low volatility investing.  Also, as our society moves toward an increasingly wired society, it uses more power, as would the widespread acceptance of electric vehicles.

Through last Friday, gold bullion ETFs (IAU, GLD, etc.) were up approximately 3.8% for the year.  Oddly enough, gold mining ETFs and funds were down -1% to -4%.  It is hard not to think that bullion is just a better instability hedge than mining stocks (which to some extent are going to reflect liquidity conditions in the economy).   That said, be careful of the tax consequences of owning bullion ETFs in taxable accounts. They may make a better investment for tax deferred accounts.

-Mark Carlton, CFA

Per Telemet Orion

Per Telemet Orion as measured by GOAU, GDX, SGGDX, and OPSGX

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

2019 closed on a high note for stocks as interest rate cuts fueled a speculative boom which has continued into 2020.  Against a backdrop of accommodative central banks all over the globe and a somewhat more cordial relationship between the world’s two foremost economic powers, investors everywhere became more aggressive.  With dividends reinvested, the S&P 500 soared 31.49% on the year.  9.07% came in the fourth quarter alone. <1>  Returns around the globe were almost as strong; international developed markets were up 22.49% while emerging markets were up 18.42%.<2>

The outstanding returns in 2019 were somewhat surprising given the fact that corporate profits fell during the year.  It’s important to recognize that our market gains are increasingly dependent on corporate leverage and government reserves.  I’m not predicting the stock market rally’s imminent end, but debt expansion like this can’t go on forever.

That said, we are enjoying some very good times right now.  Once again, the technology sector led the way.  Tech soared another 14.4% during the fourth quarter to bring its full year advance to 50.3%.  Communications Services (9.0% and 32.7%) and Financial Services (10.5% and 32.1%) also outperformed last year.  Energy stocks only rose 11.8% last year (a good chunk of that was in the fourth quarter).  Real estate and utilities rose 29.0% and 26.3% respective last year, but utilities only rose 0.8% in the fourth quarter and real estate actually lost -0.5%.  It became apparent that investors were shifting from conservative stocks to more aggressive ones.  This is typical late cycle behavior. <3>

Individual markets around the globe were also impressive.   Europe was one of the better areas with a gain of 23.5%, and that improves to 25.9% if you exclude the U.K.  China gained 23.7%.  Among emerging markets, gains were much more varied.  Russia soared 52.7%, but India only grew 7.6%.  Interestingly, German stocks are negative on a two-year basis (starting from the beginning of 2018).  China and India were about flat.  Japan and the U.K. were up single digits, while France and Brazil posted double digit gains.  The latter’s two-year gain of 26.6% topped even the U.S. (25.7%).<4>

Bonds enjoyed a strong 2019 although almost none of their return came in the fourth quarter.  The anemic 0.18% return last quarter pushed the full year gain to 8.72%.  Bonds were largely a story of interest rate exposure (duration).  Two-year treasuries gained just 3.31% while the 30-year bond climbed 16.43%.  Corporate bonds performed well across the spectrum, while mortgages, asset-backed securities and floating rate debt lagged.  The lesson on the bond side was not to bet on inflation; almost everything we expected in terms of economic growth and inflation in late 2018 did not come to pass last year.  The dollar fell during the fourth quarter but rose for the full year. <5> Activity

As market conditions improved and investors seemed to fully grasp that we were in “melt-up” mode, we felt it was appropriate to take cash levels down.  They’re as low as we have had them in at least twenty years.  We increased stock exposure nearly across the board.  In more aggressive portfolios we took positions in sub-sectors such as semi-conductors.  With others we opted for stock factor ETFs that emphasized strong balance sheets or business model resilience.  We pared back exposure to the low volatility factor ETFs because in a strong market volatility is your friend.

We also increased our weighting in emerging market bonds and stocks as the dollar began to decline late in the year.   A falling dollar is a tailwind for emerging markets.

Outlook

As I stated in the first paragraph, U.S. stock prices rose over thirty percent last year without any gain in aggregate corporate profits.  In 2018, on the other hand, corporate profits posted strong gains while stocks declined almost -6%<6>.  In recent years, central bank policy has become so easy that the performance of the underlying companies in the financial indices is now less important than the interest rates by which those profits are discounted.  That is an extraordinary fact when taken in the broad swath of financial history, and I have two comments about it.  One, this has been going on for several years, and will likely continue in the short-to-intermediate term.  Fighting the Federal Reserve is generally not a smart move.   Two, the decoupling of stock prices from corporate profits is ultimately dangerous.  How can one feel confident that the price they are paying for stocks is backed by something more tangible than the spirit of the times and the willingness of central bankers to continually expand the national balance sheet?

Commentary

The first chart comes courtesy of Jill Mislinski of dshort.com.  It is a graph of the S&P Stock Composite Index for the last 150 years plotted against a long term trendline.  Current levels are at record highs above trend.  This should give one pause.  That said, it may be misleading to compare valuations of today’s asset-lite service economy to its asset heavy manufacturing history.  Perhaps valuation should be much higher now.  I would also point out that in 1997 stocks exceeded their early century highs and would go on to rally strongly for two more years.  While it is hard to take anyone seriously who would argue that stocks are cheap, the current rally doesn’t have to stop just because we have exceeded previous valuation peaks.

Chart 1

Source: A Perspective on Secular Bull and Bear Markets, Advisor Perspectives, 1/2/20

U.S. Stocks performed very well in 2013, decently in 2014 and 2016, and very well again in 2017 and 2019.  Strong stock returns do not in and of themselves suggest that sentiment has shifted so strongly bullish that a correction is imminent.  In the wake of the first three of these rallies we did not see a big spike in investor bullishness.  However, investors did get greedy in January 2018, which led to a “VIX crash” and a 10% pull-back.  When everybody is bullish, the saying goes, there is nobody left to buy.  While I don’t think greed is as pervasive today as it was in 1999, I believe it is at least as strong as in was in early 2018.  So does Chaikin Analytics (see Chart 2).  A year ago, when fear was peaking, it proved to be an excellent time to invest.

Chart 2

Source: Chaikin Analytics, CNN.com Fear & Greed Index, 1/14/2020

With Alphabet’s (Google) Friday close, we have now three stocks with market capitalizations above $1 trillion for the first time ever.  Apple is at $1.397 trillion and Microsoft is $1.275T – each now represent greater than 4% of the S&P 500 Index.  Congratulations to all of them.  That said, when any stock has gone above 4% of the S&P 500 over the last thirty years their future performance has not been that good.  This chart from the Leuthold Group makes the point that it is tough to sustain profit growth when you get above a certain size.  Just some food for thought now that both Apple and Microsoft are in this category and Alphabet and Amazon are not far away.

Chart 3

Source: Jayonthemarkets.com/2019/12, The Leuthold Group

The final chart I have is of stock market performance in presidential election years and non-election years.  In general, as you can see, stocks prefer non-election years.  Election years also tend to see market gains, just smaller ones.  There tends to be a sell-off in the spring as investors start focusing on the election in earnest and then another one in the month or two leading up to election day where uncertainty is at its highest.  Once that uncertainty is removed, the stock market almost always performs well.  There are, of course, no guarantees.  Both 2000 and 2008 were election years.  This just shows that there are patterns that would be expected to prevail IF (and this is a big IF), they aren’t overwhelmed by larger issues.

Chart 4

Source: Strategas, Fidelity Investments, 11/4/2019

Our portfolios are currently on the aggressive end of the appropriate ranges, consistent with our client’s various risk tolerances.  Yet knowing that most others are positioned similarly makes us nervous.  If you think we should be taking more risk right now, ask yourself this: if market spirits change in a hurry, how is everybody going to get more defensive in an orderly manner?  In other words, in an environment where most investors are fully committed, who does the buying if there is a mad rush to get out?

-Mark A. Carlton, CFA

<1> Standard & Poors per Morningstar Workstation

<2> International developed stocks: MSCI World ex-USA Index , Emerging market stock: MSCI Emerging Market per Dimensional Funds

<3> Sector performance per JP Morgan 1Q2020 Guide to the Markets

<4> Foreign market performance per JPMorgan 1Q2020 Guide to the Markets

<5> Bond and currency performance per JPMorgan 1Q2020 Guide to the Markets

<6> Russell 2000 broad market performance per Morningstar Workstation

Disclosure

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

What a difference a year makes!   The year-over-year gain from Christmas Eve 2018 to the same day in 2019 was close to 40%!<1>  We went from a panic over both Fed interest rate policy and the trade war with China to being completely relieved on both fronts.  The markets were certainly buoyed last year by a Fed that not only cancelled planned rate hikes but later cut rates three times.  The “quantitative tightening” that began in December 2016 was decisively ended.  We know now that rates will be maintained at unusually low levels until either inflation soars or we have an asset price bust and conclude that super low rates were the cause.  In other words, since neither event is imminent, you can expect low rates for the foreseeable future.

It should always be remembered that markets may sell off 5-10% at virtually any time for almost any reason.  In an environment in which liquidity is the main determinant of trading patterns on any given day, a shallow sell-off can happen at any time.  That said, the path of least resistance when liquidity is plentiful, and the Fed is friendly, is upward.  The kind of market pullbacks to worry about occur when the investing public has used up a lot of its “dry powder” and is very enthusiastic.  Despite the market surge in 2017, we really didn’t see a pull back until January 2018.  The 10% correction from February to March of that year flattened the “animal spirits” allowing for the market to recover those losses gradually over the next six months.  Gradual gains are the best kind, in terms of future performance.  Surges tend to lead to speculative excess then hard declines.

I believe we are at an inflection point now.  It’s my opinion that stocks will either endure some profit taking in January or the current rally will intensify. If we experience a market contraction, it will allow low conviction investors to sell thereby laying the groundwork for a healthier intermediate term advance as those investors ultimately buy back into the market. If the current rally intensifies, I believe a blow-off-top scenario in which a hard, painful, correction becomes likely.

Current Positioning

It appears that the bulk of investment strategists see the economy improving in 2020 and as a result see little upward pressure on interest rates and commodities like oil and metals.  We are seeing a little of that now, though I don’t like trading on any trends at the end of the year because they easily could be reversed early in the new year.  (It should be noted that there was very little tax motivated selling in 2019 because there were not a lot of losses to take).

I am not leaning into any “reversion to the mean” trades right now.  By that I mean I’m not presently overweighting value or small caps or international stocks now, despite the popular theory that these groups have underperformed for years and are therefore likely to outperform going forward.  The economic powers-that-be seem willing to deploy everything at their disposal (including negative interest rates) in order to make sure we never have a full market cycle, so betting on a recession (which punishes all investors but those in richly priced and money losing businesses the most) doesn’t seem to make a lot of sense.  Eventually it absolutely will come but trying to predict when is just too hard.

Big Picture Thoughts

1. 
   

   If you are bullish on the market because of the U.S. China trade deal, you are misguided.  This is a public relations deal to placate the public in both countries.  The reality is that the United States has decided to pursue a “we win, they lose” economic policy to combat the “they win a little, we win a lot” economy policy China has pursued for the last 25 years or so.  There is no way an investor can consider this change bullish.  I’m not saying the change is right or wrong, I’m saying that the U.S. will now pursue policies that hurt China economically just as long as they are expected to hurt us a lot less.  That is a meaningful departure from Bush-Clinton-Bush2-Obama, and it will NOT lead to greater global growth.  For more read the current Economist article “Poles Apart”.

   
   
2. 
   

   We are in an era of monetary policy asymmetry, which means that the Fed will be quick to pursue monetary solutions to economic weakness, but they will be very slow to react to inflationary pressures. In the short run this is positive for stocks, as maintaining excess liquidity encourages speculation (it is cheaper, and the consequences of failure are less severe).  In the long run, it hurts the economy because it encourages companies to channel cash flow into financing activities (buybacks, dividends) as opposed to more productive areas like research and development.  Why does this matter?  Lower economic growth.  Today the U.S. has a hard time staying above 2.5% GDP growth (consensus for 2020 is 1.8%), whereas the second half of the 20th century saw growth average over 3% annually.  Growth employs more people and leads to rising wages; financing activities benefit shareholders (hence the record high share of pre-tax national income earned by the top 10%)<2>.

   
   
3. 
   

   I recently read an article on China Mobile<3> which discusses the reasons investors don’t want to invest in emerging markets value as a theme. The article discussed how a Chinese state-owned enterprise (SOE), is being handcuffed by the Chinese government (which wants all three domestic telecommunications companies to flourish).  The author points out that if a company operates more efficiently but is not allowed to earn an excess return for its superior execution, what is the point?  Very often close analysis reveals that “value” stocks have low P/E multiples for a good reason.

   
   
4. 
   

   I am as excited by the strong performance of the technology sector as anybody else, but there is a maxim that states that the more capital that flows into a sector, the lower the long term returns in that sector. Tech has drawn a LOT of money over the last few years which is great, but I’m old enough to remember how much it took in between 1995 and 2000 and how well that went for investors who got in late.

   
   

    

   
   
   

<1> Source: YCharts.com, S&P 500 Total Return, 12/25/18 – 12/25/19
<2> Source: Bureau of Labor Statistics as cited in JPMorgan’s Guide to the Markets 1Q2020, p 19.
<3> China Mobile, A State-Owned Enterprise with State Mandated Mediocre Results, Gene Chan, 01/02/2020

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