The S&P 500 is up close to 4% since the last Update and about 6.5% since the June 3rd low.<1> And yet, nothing really seems different in terms of the economy or the trade outlook. We still have no resolution to the trade war with China, but much has been made of the fact that Trump might meet with Xi Jinping at which they might make a deal, which then might withstand public scrutiny when revealed, which then might actually be put into effect, which then might actually be adhered to by both sides. Sorry for the snarkiness, but I believe we are a long way from a meaningful trade resolution. What actually drove stock prices higher was the collapse of the growth narrative and the subsequent embrace of the multiple rate cuts narrative. U.S. economic growth of 3% plus was a two-quarter anomaly caused by lower corporate taxes and the buildup of inventory ahead of the potential tariff hikes. As the investment community adjusted to this and reduced GDP forecasts to 1.3%-2.3% growth for the next few quarters, interest rates collapsed. Multiple Fed rate cuts have now been priced into stocks. As you know, lower interest rates equate to lower discount rates which pushes the present value of stocks higher. We expect the current rally in stocks to last only insofar as the confidence in future rate cuts lasts.
We lightened up on stocks in May as they approached and subsequently broke through some technical support levels. Depending on risk tolerance, some of the proceeds went to cash, but some also went to bonds and gold. We did not increase stock positions during June as stocks rose. Both bonds and gold have had nice runs this month, though both might be overbought in the short run. As long as investors believe interest rate cuts are a when (as opposed to an if), it’s going to be hard not to make money in bonds. Gold benefits from the low and falling cost of carry<2> since it has no yield.
The IPO wave that we wrote about last month is still in our minds in terms of a late-in-the-cycle marker. This bull market has flourished on very mild enthusiasm so far. Bull markets tend to die when everybody gets euphoric. The economy is modestly weakening; that and low inflation keeps the wind firmly at the back of higher quality, dividend paying bonds and stocks. That is our emphasis today.
I have a chart in my office that shows investment metrics for the 20th century. Because of the Great Depression, there was a period of over twenty years (ending in 1954) that U.S. stocks yielded more than U.S. government bonds. In other words, companies had to offer investors high dividends to get them to buy their shares because stocks were looked at as being so much more risky than bonds. The return over the 50 years from 1950 to 2000 for stocks compared to bonds is comically lopsided in favor of stocks<3>. I think about that today as I look at Europe, where government bonds yield essentially nothing (or in some cases less!) while the average stock dividend is over 3%. At some point (don’t ask me when) I believe European investors will embrace stocks, if not for the growth prospects then for the simple fact of much more generous yields. I think of Europe post-financial crisis as being in a Depression of sorts. Maybe it takes them twenty years to rediscover equities like it took us last century. I believe that buying European stocks now might just be like buying U.S. equities in say, 1948.
Investment Observations
I am not necessarily recommending investing in India. I would just note that it is one of the most un-correlated investment markets you will find anywhere. Seriously, price movements are as random as managed futures funds, no matter how good or bad the day is for the rest of the world. IFN is the ETF, and WAINX are Indian funds I keep an eye on.
Not all FAANG stocks are crushing it. Alphabet (Google) is down -7.7% quarter to date (as of 6/25/19 market close).
Vanguard Wellesley is a conservative stock funds is worth noting. Strong relative performance, low expense ratio (0.23%) and low monthly Value-at-Risk (4.49%).
If one is contemplating high yield bonds versus floating rate debt today, pick the former. Yield spreads have improved due to strength in government bonds, while capacity to refinance existing debt is modestly better.
Doubleline is best known as a bond manager, but it’s Shiller Enhanced CAPE fund (DSEEX) is a large cap value/blend fund that has handily beaten the S&P 500 since inception (2013) at a similar risk and a 55 basis point expense ratio.
Gold mining mutual funds are up over 16% this month on average. Bullion ETFs are up 8.8% as of June 25th market close.
<2> In other words, the cost to finance ownership. When interest rates are very low, it is financially much easier to borrow to acquire a non-cash, non-interest bearing, flowing asset.
<3> Despite an incredible run in bonds from 1982 to 1998 as inflation expectations gradually receded, stocks rose more than five hundredfold over those fifty years versus under fifteenfold for bonds (my calculations based on Ibbotson annual return data).
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 Great Bull Market
The bull market began on March 9th, 2009, so at this point the Great Recession is completely gone from 10-year performance results. To a large extent, 10-year performance is positively correlated to the technology and consumer discretionary sectors as a percentage of the total portfolio. Over-exposure to energy and financial services generally correlates with under-performance, but not as dramatically. When I started in the securities business in 1986, there were no inherently better or worse industries from a performance standpoint. Technology was exciting, but the obsolescence risk was staggering (Amdahl, Ashton-Tate, Atari, and that is just a partial list of the “A” firms). Cyclicals rose more in expansions but also fell more in recessions compared with consumer stocks; yet both kinds of companies tended to have longer lifespans than tech firms.
Today it is very hard to argue against there being out-performing or under-performing industries. Name a tech company that has gone to zero in the last ten years – I can’t. Yet I can name several consumer product companies that are no longer around. If higher growth is not accompanied by higher risk, there is no reason to expect high growth not to outperform. Furthermore value, which is in essence a “reversion to the mean” strategy, is not going to work well in an environment where the “rich” keep getting richer, so to speak. I don’t see this changing until interest rates rise enough to inhibit the financing of companies that lose money for several years early in their development.
The Federal Reserve
The stock and bond markets today are being driven by the narrative that 1) the Federal Reserve is on hold indefinitely, 2) a trade deal with China is ultimately going to happen, and 3) corporate profits may recede in the first half of 2019 but will rebound sharply in the second half. This is in stark contrast to the narrative that was in place in the fourth quarter of 2018, which held that 1) the Federal Reserve was too restrictive such that their policies would cause a recession by the second half of 2019 (if not sooner) and 2) if that didn’t cause recession then the trade war would. Bond yields are no less inverted today than they were four months ago, but nobody is talking about inversion causing recession today. If the economy is growing yet yields are stable/falling (which is what we’ve been experiencing since January), it just doesn’t pay to be a bear. I believe the current resistance at 2815-2825 on the S&P 500 will be overcome shortly, and the next test will be 2875. From a sentiment standpoint, too many people got too bearish in December and now find themselves chasing this market as it rallies.
Winner and Losers
I wanted to see what we could learn about the market’s assumption from the winners and losers list from the first ten weeks of 2019. This is what I observed:
Internationally, growth continues to trounce value. Recently I did some work on two different international funds whose wholesalers had reached out to me. William Blair International Leaders (WILNX) is a foreign large cap growth fund. It’s five-year return is a cumulative 33.71% (5.98% annualized), which puts it in the 11th Hartford International Multi-cap Value (SIDNX), as you might surmise, is a foreign large cap value fund. It’s 12.77% cumulative five-year return (2.43% annualized) also lands it in the 11th percentile in its category.<1> When we think of value, we think inexpensive. Clearly something else is driving performance rather than an asset’s class’ proximity to “fair value”. This lends credence to the argument about the superiority of “growth” industries.
“Income” as a value factor is holding its own versus value funds using more traditional metrics such as low price-to-earnings and/or low price-to-book-value funds. Income is defensive in nature while traditional value (financial services, energy, metals and mining) is cyclical. This suggest that investors are still somewhat safety-oriented (or economy skeptical). It may also be the case that trade uncertainty has hit cyclical companies the hardest.
The bond market has totally gone “risk-on”. Here is the logic: If the Fed is no longer going to be shrinking credit supply either by hiking rates or by shrinking their balance sheet, risky borrowers are not so risky. Moreover, if they are more inclined to let the labor market “run hot” (meaning not treating every tenth of a point decline in employment as an existential inflation threat to be immediately stomped out) then inflation-sensitive securities like TIPs and gold have some room to run.
The strong dollar has not prevented foreign bonds from doing well. Inflation has been falling in many countries faster than the depreciation of their currencies versus the dollar.
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 is eye-opening to read the Market Perspective I wrote exactly two months ago. There was a real sense of dread back then as the global economy appeared moving toward recession while the Federal Reserve was still in tightening-to-fight-inflation mode. It is no surprise that December was such a poor month for investors given the near-term outlook at the time. Fortunately, the investment environment has changed considerably since then. The Federal Reserve backed away from its “autopilot” approach to interest rates while global economic indicators have been helped by lower oil prices and reasonably robust consumer demand. Rightly or wrongly, investors aren’t worrying about Brexit or the U.S.-China trade war right now. I can’t help wondering whether the pendulum will have swung back two months from now.
I say this because although the investment climate has gone from aggressively “risk-off” to fairly strongly “risk-on” over that past eight weeks, I’m not sure the big picture has changed all that much. The mental journey from (glass) half-empty to half-full (and vice versa) can happen quite rapidly. I believe it will be important this year to keep a big picture framework in mind so as not to tempted by market swings to rapidly toggle between aggressive and defensive portfolio positions. As we see it, the outlook is mixed with the following pros and cons:
Pros:
Interest rates are still fairly low by post WW2 standards, and there is current no significant upward pressure from either materials scarcity or labor (wages)
Oil prices have come down worldwide, putting downward pressure on inflation
The tax and regulatory framework in the United States is very business-friendly
The Federal Reserve is still taking cues from the stock market, suggesting it will be pro-active in any serious market decline
Valuations of emerging market and international developed market stocks appear to be, for the most part, quite reasonable Cons:
The maximum point of easy credit has been passed. However slowly, credit is being reined in.
The U.S. dollar remains strong, which removes liquidity from global economies
Economic inequality globally is at post WW2 highs, and this is fueling populism. At some point, perhaps sooner than later, tax policies are going to be less business-friendly
There does not appear to be a structural way out of the U.S.-China trade impasse. China can offer to buy soybeans, etc. but the bigger issue is intellectual property and China is extremely unlikely to give in on that issue. Its been the linchpin of their economic ascent over the last 35 years.
Corporate debt levels are very high, which stems from the attractiveness of boosting earnings by borrowing money at low rates to buy back stock. This (higher debt and less cash) reduces flexibility during a recession. A corporate treasurer focused on the long-term health of their business would ISSUE stock when valuations were high, not buy it back! With all this in mind, I intend to manage in what I believe is a neutral manner across portfolios as I don’t see any major valuation driven opportunities, long or short, to be exploited right now. That said, I believe:
An opportunity will exist later in the year to buy non-dollar denominated securities as the dollar peaks and heads lower.
Credit (lower quality, higher yielding debt) is doing well now as investors seek higher yields, but this is a window for traders (as opposed to a long-term alpha opportunity).
Gold will have a good year. Not because of inflation, but because by year-end most currencies will appear unattractive because of debt and poor economic policies. The dollar would already be falling due to our dramatically increasing deficit and capricious policy stances were it not for the even worse prospects for the Euro. I’ve been giving a lot of thought to why growth has out-performed value for such a long time. I’m going to expand on that topic in my next post.
-Mark A. 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.
The U.S. stock market has rallied nicely off its Christmas Eve low, but it is running into some resistance at the 2600 mark on the S&P 500. 2600-2700 represents breakeven for a lot of investor who came late to the party, so they may be looking to cash out when their loss is gone. Also, earnings season begins late this week. Investors are sure to be hanging on the commentary from CEOs and CFOs as to how demand looks in the first half of the year. Volatility could return.
Emerging markets have done well this year so far, both on the equity (3.7%) and debt (1.4%) sides.<1> Global investors have largely cheered the pullback in the U.S. dollar, which is being hurt by the government shutdown. I would not lean into this because the Brexit situation could easily move to the front pages from a currency standpoint, and China continues to report slowing conditions. Emerging debt may be under-owned right now, and it may have a good year, but expect the path to be very choppy.
Energy has been the leading sector year-to-date with an 8.1% gain.<2> Much of this is a bounce off an absolutely terrible 2H18, which saw oil prices fall from above $75 per barrel to under $50. The root of the problem in energy, that supply exceeds demand such that if any producer cuts production some other producer increases production to fill that demand, doesn’t appear to have changed. Almost certainly energy will not end 2019 in last place again, but I can’t see it being a leader either.
I believe that the U.S. tech sector is unlikely to lead in 2019. This sector, unlike most sectors in the U.S., really is exposed to China. China would very much like not to buy technology from the U.S. where it can get it elsewhere.<3> I am concerned that semiconductor chip stocks reflect the downturn in prices and demand (many have been halved since September), but the rest of the tech sector not so much.
Interest rates have come down quite a bit since September as the global economy has cooled off and the sharp decline in U.S. stocks has investors believing that the Federal Reserve is done raising rates. Maybe, but that doesn’t mean market rates are going to keep going lower. Doubleline’s Jeffrey Gundlach pointed out last Tuesday in his annual market webinar that the budget deficit is exploding at the same time as the Fed is selling bonds back to banks. This means investors are going to have to absorb an increasing supply of debt. That is not a recipe for lower bond yields (unless we actually do get a recession and money comes out of stocks).
Barrons published their annual Roundtable issue this week. If there was one thing the members of the Roundtable agreed upon, it was that the balance sheet of U.S. corporations and the U.S. Government have deteriorated sharply. Investors are focused on earnings, but the quality of those earnings are suspect due to very dubious accounting rules.<4>
Putting my market technician hat on, it would be unusual to see the market try to rally to new highs without first retesting the December 24th lows. Not impossible but unusual. Just keep that in mind if we do get through the 2700 level on the S&P 500 in the next two weeks or so.
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
Stocks
Economic growth appears to have peaked in early autumn. Unemployment is now starting to rise, judging by weekly claims. On the positive side, inflation is slowing as well and corporate profits are expected to remain robust in 2019. Markets have absorbed these pieces of information and are reacting to the prospect of further Federal Reserve rate hikes. That said, fundamentals are almost never leading indicators. Stock prices and the yield curve have historically been much better at forecasting downturns. The yield curve is flashing a bright yellow warning sign, having inverted in the middle of the curve. The stock market is now flashing red, with every index on a sell signal as current prices have fallen below their 50 and 200 day moving averages with the former having crossed below the latter, known in the world of money management as the Death Cross. The S&P 500 index was the last of the indices to cross over (which is did last Monday). Based on the above factors, it is Trademark’s belief that we have entered a bear market. We don’t know how long it will last, but we expect this period of elevated downside risk to continue.
It is my personal belief that America’s chaotic pursuit of its trade objectives is the main reason the market is weaker than the fundamentals suggest it should be. This creates a dilemma for investors. The trade situation could be resolved if both the US and China were willing to deal in good faith, so it is somewhat dangerous to be too bearish. On the other hand, this situation could get a lot worse if the planned and delayed tariffs ultimately take effect and the costs begin to be passed on to businesses and consumers (to some extent, this has already happened). Hence the volatility we see day in and day out depending on the latest report/rumor/tweet.
The strongest part of the stock market in recent weeks has been the defensives – utilities, real estate, consumer staples, and health care – but only the latter is doing anything in terms of profit growth. Technology, which has led the market since late 2015-early 2016 correction, appears to have run out of steam and looks over-owned and vulnerable right now. We may struggle until a new narrative and new sector leadership emerges. Utilities and staples, the best performers lately, do not lead a bull market.
I would love to recommend shifting money abroad, since valuations are cheaper and momentum in US stocks has broken down. Unfortunately, I can’t. Valuation is a poor short term indicator and overseas money has been languishing for four of the past five years. Fundamentally the “developed” markets look pretty bad. I would prefer to underweight developed markets even though they are inexpensive, because I don’t see a catalyst (either politically or in liquidity). China is being hurt by the trade conflict, is probably growing at the lowest rate in two decades, and it has a debt problem. Where China goes, so goes (most) emerging markets. That said, I’d still overweight EM vs. DM.
I have been surprised that financial services stocks cannot mount a rally with their forward P/E multiples in the neighborhood of 12x. Given the constraints put upon them after the great financial debacle ten years ago, most financial company balance sheets are in good shape. Perhaps the best way to play financials now is to own preferred stocks through a fund or ETF. Preferred stocks are higher up the capitalization spectrum so they are safer than common stocks and yields are around 5%. With the economy weakening, preferreds shouldn’t be hurt by rising rates (as they were in the first half of 2018).
Bonds
High quality bonds are having a decent quarter while both medium and low quality bonds are not. You get paid more for taking a little credit risk for long stretches of time until suddenly you don’t. This is such a time. Investors are getting nervous about the high levels of corporate debt in the US, so they are trimming exposure in corporates in favor of treasuries, mortgages, municipals, and to a lesser extent asset-backed bonds. Even international bonds have become less horrible as the dollar is buffeted by political concerns and signs that the economy might have peaked. In the third quarter it paid to trim duration as much as possible, but duration has been your friend lately. I continue to recommend having a little bit of interest rate sensitivity, but still much less than the benchmark. Whatever your duration, you do want quality. High yield corporate bonds have struggled this quarter but issuance has been restrained, so I think that sector is 75% through its down cycle. The risk is in floating rate corporate debt, which was overissued and overbought. Many have very weak covenants as well. You may want to consider a floating rate Treasury fund like USFR.
Other than that, I am optimistic about 2019 being a strong year for emerging market debt. I believe the dollar will contract as the economy slows, the political climate becomes more uncertain, and the soaring deficit becomes more of a concern.
Energy/Gold
The idea that the economy is peaking is bullish for hard assets to the extent that the dollar would be expected to roll over as well. Neither oil nor gold can do much when the dollar is strong. News flow can provide a short term bounce for either, but until the market perceives that the Fed is done tightening, one should underweight these sectors. We may get a hint of that on Wednesday when the Fed gives its post-meeting guidance. Gold might be the biggest winner at the point when the Fed signals that it is done, so speculative money might consider a small position now.
-Mark Carlton, CFA
——
On the morning of the December 11th the Dow opened up 350 points on President Trump’s tweet to “expect a trade announcement very soon”, then fell over 500 points in the next four hours as the markets discovered that there was no substance to the tweet. This follows the pattern established after the summit in Argentina on December 1st when we were told that we had a great deal with Chinese and it turned out to be light on specifics.
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 U.S. stock market posted another strong quarter, rising 7.20%. Once again, however, U.S. stocks were pretty much the “only game in town”. International markets were about flat on balance, with developed markets up 1.51% and emerging markets down -2.16%. Bonds were almost unchanged as the S&P U.S. Aggregate Bond Index rose 0.07%. The question on every investment professional’s mind lately is “How long can this performance divergence last”? At some point, many professionals believe, either foreign stocks have to rally or U.S. stocks need to decline because the performance and valuation gaps are almost historically wide. That said, the trend has been to overweight U.S. stocks and hope the point of transition is both gradual and resolved by foreign stocks rising.
If one was inclined to look for cracks in the armor of the current U.S. stock rally, it would probably be that small and mid-size stocks performed poorly in September. Midcap stocks declined -1.10% to finish the quarter up 3.48% and small cap stocks were off -3.17% in September to close the quarter with a 4.38% gain. By way of comparison, the S&P 500 was up 0.57% in September and 7.20% for the quarter. See Item 1. This suggests rising interest rates and tight labor markets might be beginning to have an effect, because one would expect smaller companies to have higher borrowing costs on average than larger ones, and less ability to “offshore” their labor.
Item 1
Source: YCharts
International stocks continue to be hurt by the strong dollar, especially in those countries with high dollar-denominated debt and/or higher oil prices due to the Iran sanctions (remember that globally oil is priced in dollars, so a 20% increase in oil prices plus a 10% stronger dollar means oil costs 32% more in local currencies). In addition, the Chinese-American trade war is clearly hurting the Chinese market while both Brexit and the new Italian government are two separate issues currently weighing down European stocks. Short of the U.S. capitulating on its tough trade stance, it is hard to see what would trigger a bull market in foreign stocks even though they appear to be cheap in comparison.
Bonds performed well earlier in the summer but that all ended in September (-0.48%) as it became clear that interest rate pressures were building. Less interest rate sensitive segments of the bond market, such as floating rate loans and high yield debt, managed to gain over one percent on the quarter. High quality municipal and treasury bonds each gave up less than one percent.
Activity
There wasn’t that much to do in July and August as the dominant bullish trend from the second quarter carried over. Bonds were quiet and the dollar actually declined, allowing stocks to continue their upward march. In September, as we approached the day (the 26th) when we expected the Federal Reserve to raise interest rates, markets got nervous. Seeing that this was playing out more in small company stocks, we took some profits in small cap ETFs in many accounts. We also reduced interest rate sensitivity on the bond side by trimming the PIMCO and Baird exposure in favor of short-term bond ETFs. Overall, we began to think more defensively.
Outlook
Since the end of the quarter a few strong economic reports on October 3rd and 5th helped push long term interest rates to their highest levels since 2011, and stocks subsequently buckled under the pressure. So far, U.S. stocks have given back a little more than foreign stocks this quarter, but nothing has emerging unscathed (save gold, which has trimmed its year-to-date loss from -8% at the start of October to less than -6%). At this point, potential catalysts exist for both a run at 3000 on the S&P 500 (again, involving a significant reduction in trade friction with China leading to a stronger renminbi and lower oil prices) and, alternatively, a continuation of the current sell-off (an escalation of the trade conflict leading to more dollar strength and less global economic activity). If I had to guess I would say that a deal eventually gets made that both sides can declare victory on, and markets rally (led by emerging markets). Call me cautiously optimistic.
Commentary – In Defense of Foreign Investing
What is the right amount of a portfolio to invest overseas? A purely neutral policy would put about 45% of one’s equity portfolio overseas because that approximates the foreign slice of global stock market capitalization. Item 2 from JP Morgan shows the global market breakdown by capitalization. But wait, why should we be neutral? Foreign stocks offer currency risk. Their economies are, generally speaking, not as robust. In some cases their accounting systems are not as transparent. Their overall profitability trails ours. It would seem therefore that the international weighting should be quite a bit lower than 45%, but how much lower? This is probably the biggest challenge in portfolio management right now. The implications are significant.
Item 2
Source: JP Morgan 4Q18 Guide to the Market
According to Morningstar, US stocks have a 10-year average annualized return of 11.97% through September 30th. This would be the return on the equity portion of your portfolio if it had no international stock exposure. If you diversified your equity exposure by capitalization (as global stock indices do), your annualized return would fall to about 9%. If you held a two-thirds domestic, one-third foreign exposure (as the average investment advisor does according to TD Ameritrade), your return would be a little better (about 9.8%). Tactically underweighting foreign stocks to just one-fourth of total equity exposure improved the return to 10.32%.
Is all this to argue that foreign stocks are a drag on returns and therefore should be excluded from portfolios? Certainly not. My investment career has included two periods in which foreign stocks dramatically outperformed U.S. stocks. The first was from 1985 through 1990, and the second from 2003 through 2007. Broadly speaking, one would have done better in foreign stocks from 1985 through 1994 and 2000 through 2009, so the periods of strong U.S. outperformance were 1995 through 1999 and 2010 through the present. The current period is very long by historical standards, which is why so many market pundits predicted that the strong performance of foreign stocks in 2017 marked the beginning of a new era. It is exceedingly difficult to successfully predict a major secular change – and it obviously didn’t happen in this case either. That said, if history is our guide it will happen at some point. If one waits until the rally is obvious, they will likely miss out on a significant amount of gains.
Item 3 illustrates why many professionals have been expecting foreign stocks to outperform. Historically there has been a fairly high correlation between foreign and domestic stocks, and the performance gap has never been particularly wide. Until now. As the chart shows, the U.S. has historically traded at a price to earnings premium to foreign markets of 1.6 times on average. That premium is 3.9 times today. Maybe you can argue our economic stability and military strength warrant a greater premium than 1.6x, but 3.9x seems rather extreme. It is the kind of thing you would expect to see if there was significant global turmoil.
Item 3
Source: JP Morgan 4Q18 Guide to the Market
On a global basis, non-U.S. stocks are 45% of total stock market capitalization. Tactically, Trademark has been under-weight foreign stocks by that measure. Depending on your risk tolerance, an average portfolio we manage is roughly 24% invested in non-U.S. companies today. As such, our portfolios clearly reflect the turmoil many foreign countries are experiencing. Yet we feel it is a mistake to write them off completely even though they have been a drag on performance this year. Overall foreign markets are significantly cheaper than ours and the growth rate of foreign economies is higher. Our policies (tariffs, taxation) have contributed to their difficulties in many cases, but it is foolish to believe that they can’t or won’t adapt. As investors, we should hope that they do, because the U.S. stock market is not likely to duplicate its 11.97% ten-year average over the next ten years.
Thanks for your continued trust in our management,
Mark A. Carlton, CFA®
As measured by the S&P 500, Source: S&P Dow Jones Index Dashboard, September 28, 2018
As measured by the S&P Developed Ex-U.S. BMI and S&P Emerging BMI. Source: S&P Dow Jones Index Dashboard, September 28, 2018
S&P Global Index Dashboard,9/28/18 is the source for both quarterly and year-to-date U.S. stock and bond returns.
As measured by the S&P U.S. Aggregate Bond Index. Source: S&P Dow Jones Index Dashboard, September 28, 2018
The value of the market as determined by aggregate stock share prices multiplied by stock shares outstanding.
Approximately 55% US, 34% developed foreign and 11% emerging markets (per JPMorgan and MSCI).
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
The Fed and Interest Rates
Interest rates are probably going up by 25 basis points later today. The market and I believe it’s a done deal. The interesting part will be the Fed comments regarding future policy action. Any sign that the expected December hike has become less certain or that next year’s rate hikes are “wait-and-see” are likely to be taken as market friendly, especially for the international stock markets. There is already a sense that the performance gap between U.S. and non-U.S. equities had reached historic proportions, and this helped fuel the international stock rally last week. The rally in international stocks will probably continue only insofar as the dollar correction lasts. A hawkish Fed on Wednesday means higher rates, a stronger dollar, and more international stock pain.
Diversification
It’s has been a difficult environment for asset managers who are philosophically committed to diversification. With domestic stocks ahead around 10% (all figures YTD through September 16th), any money allocated to foreign stocks (-4%), domestic bonds (-1.5%) or foreign bonds (-3%) is negatively impacting your returns relative to the U.S. domestic market which is most people’s market performance reference point. For example, a 60/40 portfolio invested 40/20/30/10 (domestic stock, foreign stock, domestic bonds, foreign bonds, respectfully) has returned 2.45% before fees. If you were a skilled tactician and over-weighted U.S. stocks while underweighting foreign stocks and bonds (50/15/30/5), you could have improved your return to 3.80% pre-fee. The point is, no diversified 60/40 investor should have any reasonable expectation of having earned even half of the S&P’s 10% return.
Some might respond to this by saying that they don’t care about diversification – “just give me the best return, I don’t care where it comes from”. The problem with this statement is that it assumes one can know where the best returns are going to come from. In retrospect, it has paid off handsomely to have investment in U.S. stocks over the past 9 years. Nothing else is even comparable. That said, it is in no way guaranteed that U.S. stocks will remain the best performers over the next 9 years (or even the next nine weeks). Below is an asset class return graph from J.P. Morgan. Each color corresponds to a different asset class. The white boxes represent a balanced portfolio. I include the chart to illustrate that year-to-year performance volatility of individual asset classes is high. Trying to pick the ‘winning’ asset class one year may lead to large underperformance the next year.
Source: JP Morgan 3Q18 Guide to the Market
It has been pointed out several times over the past few years (by myself and others) that valuations for most U.S. stocks are stretched; at some point that rubber band is going to snap. The reason advisors should care about this is that it isn’t the three or four percent that you have in emerging market debt that is going to destroy a client’s portfolio. That asset class is already off more than 10%; if it loses another 15% from here, that is only another 0.6% in a diversified portfolio. If, on the other hand, U.S. stocks finally come back to earth – say 25%, your 50% exposure is going to cause a -12.5% wealth reduction.
China and Tariffs
China would like to make a deal with the U.S. and is prepared to make modest concessions. The Trump administration wants major concessions, so that it can announce that the Chinese “caved”. The U.S. stock market has been betting on the former scenario. I do not believe that the latter scenario, that a deal isn’t reached and things escalate, is reflected in current market prices. Semiconductor chip stocks might be the exception to that last statement. They are off 7% since the first tariffs were implemented back in June.
The Long Bond
Watch the 3.22% yield level on the 30-year bond. That level provided support during past bond sell-offs. If it doesn’t hold, the yield on the 30 year could quickly move to 3.5%. more importantly, it could more decisively confirm that the great bond bull market ended in 2016 and the era of reflation is underway. This could also eventually light a fire under gold.
Corporate Debt
I am reading about a lot of concern regarding corporate debt levels. Issuing debt (to buy back equity) has been a very attractive way to boost earnings and stock prices over the past seven years because interest rates have been low. Rising interest rates will make that harder to service. Think about it this way: If a company had a $5 billion market cap three years ago with $2 billion in debt, it had an enterprise value of $7 billion and a leverage ratio of 40% ($2 billion/$5 billion). Let’s say the company aggressively borrowed to buy back its stock and was rewarded with a big P/E multiple increase. It now has a market cap of $10 billion with $6 billion in debt. The leverage ratio is now 60%, but we don’t care because we believe the company is a skillful manager of its balance sheet. Eventually, the economic cycle peaks and the stock price begins to fall. As the stock price falls, the leverage ratio increases, which makes the company look riskier. Soon we have a $7.5 billion company with an 80% leverage ratio ($6 billion/$7.5 billion). The company would like to pay down some of that debt because credit conditions are tougher now , but it isn’t exactly flush at this point, so all it can do is lobby the Fed to lower rates to help it out. The lesson is that high interest rates serve a purpose. When rates are high, companies are very careful about taking on debt. In an environment of permanently low rates, debt is taken on and rolled over, but never retired. Eventually it chokes the company (and by extension, the economy itself).
Tactical Speaking
Value is performing better than growth this month but I’m not ready to shift my portfolio just yet. I would scale back my overweight to momentum growth (if I had one)
International equity is cheaper that domestic equity and had a good week but I’m not changing my portfolio yet. Small cap developed international stocks and emerging market stocks are oh-so-cheap, but that is probably a 2019 story.
Large caps are outperforming small caps. I absolutely would reduce or eliminate small cap over-weights. From a Fed and a political standpoint, uncertainty is high. That favors bigger and more defensive stocks. The “small-is-better-shielded-from-trade-concerns” argument is played out.
The bull continues. Investors have responded to any and all bad news over the last six months not by exiting the stock market but by redeploying assets within the stock market. As long as that continues, side with the bulls.
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy
Economy
Famous hedge fund investor Stanley Druckenmiller is known for his assertion that it is liquidity that moves markets, not earnings. If that is the case, the current debacle in Turkey should be watched carefully. Turkish President Erdogan’s efforts to control rising inflation have blown up in his face. The Turkish lira has declined sharply over the past two weeks. Whenever you see major losses like this, you should ask yourself “who else is exposed?” Obviously Turkish consumers are hurt by a plunging currency because that will lead to soaring inflation on anything that needs to be imported. Turkish businesses that borrowed in dollars (most of them) are going to have a hard time. German and Italian banks, which are the biggest lenders to Turkey, are also understandably having a very difficult time. The currencies of other emerging market and frontier market countries continue to be hurt because in a crisis, investors tend to prefer the U.S. dollar and the Japanese yen. Even other developed markets have been losing ground over the past few weeks. Despite stabilizing over the past three trading days, we are not out of the woods yet. All eyes are on the Federal Reserve which has repeatedly signaled its intention to raise rates in September. This may very well spark a renewed run in the dollar and out of more vulnerable markets.
So far, the U.S. has by-and-large avoided the contagion that has engulfed most of the rest of the investment world. I cannot predict how long investors will continue to shift assets to the U.S.; I can only say that in the short term it makes sense from a tactical standpoint as both technical and fundamental trends are supportive. Valuations are not, of course, but valuation has never been a good timing tool. You may want to own emerging markets because they are currently priced to return much more than domestic stocks over the longer term, but you have to deal with the fact that every day other advisors and investors are throwing in the towel, depressing your share price. How much pain (underperformance) are you willing to withstand?
I would always rather buy an inexpensive asset with momentum than an expensive asset with momentum, so if I can offer any good news from a valuation/regression-to-the-mean standpoint, it is that growth, with its heavy tilt toward technology, has cooled off a bit lately. Investors have been willing to look at more cyclically driven shares this month, including industrials, transportation, and retailing. On the more defensive side, pharma and real estate are doing better. I feel much better about investing today (at less than 1% below January’s all-time high) knowing there are other pockets of strength outside big tech. I believe the S&P 500 will break the January high this week, for what it’s worth. There is still so much liquidity out there, and it continues to look for a place in U.S. stock and bond markets. That said, I expect a pullback in September because it is a traditionally weak month and there will probably be jitters around the Fed and the midterm elections.
Jeffrey Gundlach of Doubleline recently articulated that there is too much money shorting long-term treasury bonds. I agree. Whenever there is a big speculative imbalance, something has to give. The short speculators in gold were recently proven right, but I agree with Jeffrey that the logic in the case of long bonds is flawed. The Fed can raise short term rates to a point where the yield curve inverts because inflation is still largely contained and because an inversion isn’t as predictive as it was in the days before massive central bank intervention. If you are a bank in Germany or Italy right now and you are concerned about your balance sheet, the 3% you can earn on a 30-year T-Bond is AAA-rated, yields much than 30-year European sovereign debt, and is likely to appreciate (at least near term) versus the euro. I believe demand is going to keep long rates under control unless our economy slows dramatically (and I don’t see that happening in 2018).
Mutual Funds
This is a good time to remember that when you invest with the American Funds family, your equity funds typically have more international exposure than their peers. Growth Fund of America has 13.3% in foreign stocks, almost exactly double that of large cap growth competitor T. Rowe Price Blue Chip Growth. Not a judgement on either fund, just a heads up for those that might be interested in their total foreign exposure.
The strength in the economy has really helped high yield municipal bonds outperform higher grade munis. The latter offers more inflation risk and less credit risk, but credit has been surprisingly strong this year so investors have been generally rewarded for taking that risk. I believe that will continue.
Mairs and Power, a St. Paul Minnesota based investment management firm focusing on companies in the upper Midwest, got stomped by their peers over the last several years due to their overweight in industrial firms (which are more prevalent in this part of the country). The Growth fund (MPGFX) is putting up some category topping numbers this quarter.
Lastly, you may consider hedging some international exposure by using IHDG (Wisdom Tree Hedged Quality Dividend Growth ETF) in place of a non-hedged international ETF (VEA or SPDW) or a blue chip foreign fund like Europacific Growth.
Source: Morningstar Adviser Workstation
Disclosure
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy
Emerging Markets
I am nervous about emerging markets. EM can handle a gradual strengthening of the US dollar to a point, but not the sudden surge that we have seen lately. For an EM issuer, owning debt in dollar terms means that as the dollar appreciates, the amount of local currency needed to service that debt rises. This leaves less currency in the local economy, so sudden significant dollar appreciation is like a sudden recession. This plays out first in vulnerable economies and/or those countries whose debt profile favors dollar-denominated debt over local currency debt. Turkey and Argentina have been hammered recently and Brazil is struggling as well. This could ultimately spread throughout EM debt and equity markets, so the situation bears careful watching. I still believe that investing in both asset classes is a prudent long-term asset allocation decision, but you always have to be aware that currency instability can occur at any time so periodic sell-offs like this are a WHEN, not an IF. Those that are more tactical in nature will sell at times like this and they will buy into rallies, just as they did last year. It’s the nature of the beast.
In the emerging market debt space, I believe that Doubleline Low Duration (DELNX) and Ashmore EM Short Duration (ESFAX) are worthy of consideration. Both funds, by nature of their short durations, have outperformed longer duration alternatives, which is to say they have lost less. If you want to make a tactical call on currency rates, you should consider a to shift to a hedged foreign bond (non-EM) like PIMCO (PFOAX) or the Vanguard or iShares ETFs (BNDX, IAGG).
On the EM equity side, less volatile funds may be a good way to access the asset class right now. On the mutual fund side, I believe American New World (NWFFX) has performed relatively well. iShares Currency Hedged EM (HEEM) is the defensive play on the ETF side. A word of caution that frontier market funds like Ashmore Emerging Market Frontier Fund (EFEAX), , are especially vulnerable right now.
Commodities
Commodities tend to perform well in an environment where economic growth is increasing, such as we have now. Interestingly enough, gold does not. Gold isn’t really an industrial metal, so unlike copper or aluminum, demand doesn’t meaningfully pick up as GDP rises. Furthermore, the expectation that the Federal Reserve will hike several more times this cycle means that real (inflation-adjusted) interest rates will continue to rise. If you can earn a positive after-tax return in a safe security like a Treasury note, why do you need gold? It is my belief that the time to own gold is when the economy begins to roll over such that the Fed can’t raise rates any further even though the inflation measures are still rising. In other words, when real rates are falling or negative.
A couple of commodities funds that you may want to research further are PIMCO Commodities Plus Strategy (PCLAX) and Doubleline Strategic Commodity (DLCMX). The former is more aggressive and as such has better performance in 2018. If you’re interested in a more eclectic offering the LoCorr Long/Short Commodity fund (LCSAX) is one to look at. It’s a managed futures fund with the ability to go in either direction. The managers tend to avoid financial futures (stocks or interest rates) which have really tripped up a lot of managed futures funds in recent years.
I also believe it’s a good time to be cautious in the energy sector despite the nice run-up over the last two months. The oil futures curve is in backwardation implying the market expects oil to fall steadily through the rest of this year and 2019.
Interest Rates
Interest rates have been rising recently due to economic strength and the Fed unwinding its balance sheet. The 10-year note hit 3.10% on May 16th, the highest level since July 2011 (yes, higher than at any point during the 2013 “taper tantrum”)<1>. There is an element of “boiling frog risk” here, in that nobody knows exactly how high is too high for stocks to shrug off. At the close of the market on May 16th, however, the 5-year T-note had a yield of 2.94% while the S&P 500’s yield is 1.94%<2>. As people begin to realize that they can earn 3% yield in Treasury notes, I tend to believe that will begin to weigh on equities. Not calling a top, just saying be careful. Since 2009 we’ve been in an environment where there has been no return for savers. Today there finally is although the yield remains modest. It will be interesting to see if reluctant investors become savers again the next time stocks sell-off.
Election Related Seasonality
Seasonally, the six months leading up to mid-term elections tends to be one of the worst times to invest in the four-year presidential cycle. Perhaps this is because the party in office tends not to do well and that creates policy uncertainty. In any event, I just wanted to pass that along.
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
A Correction?
The longer we remain below the January 26th high in the S&P 500, the more significant those highs become.<1> The term “correction” applies to a market decline that follows a market high. The implication is that the market’s longer term uptrend is intact, but it is just undergoing a period of consolidation. The longer the market goes without making a new high, the more that implication becomes questionable. If the “correction” has been fairly shallow and steady, so much the better in terms of the likelihood of breaking out to new highs. On the other hand, if the correction consists of a sharp fall, a rally that fails to reach the old highs, and another decline back to the lows of the initial decline, that is not as good. A correction that turns into a prolonged pattern of lower highs and lower lows is ominous. So far this correction has not seen lower lows, so the bulls still have the benefit of the doubt.
Continuing that thread further, growth stocks made new all-time highs on March 9th while value stocks continue to significantly underperform year to date.<2> See Chart 1 below. Furthermore, growth stocks did not have a closing low in late March or April that was below the February 8th closing low, whereas value stocks have had three. I must conclude that the much awaited (hoped for?) shift to value has not occurred. I have been tempted by the correction in “FAANG” stocks to change my models more toward value, but the supporting evidence is just not there. Dividend-oriented stocks tend to lose less on poor market days, but if a real shift had occurred, non-high yielding value stocks (financials, for example) would outperform on rally days.
Chart 1, Source: YCharts.comSmall Company Stocks
I do not think that small company stocks are particularly cheap, nor would I have interest in them from a cyclical standpoint (I believe we are late in the economic cycle and small caps do not typically perform well in recessions). That said, ever since the President brought trade sanctions to the top of his priority list, small caps have significantly out-performed large caps.<3> See Chart 2. The reason is simple – small caps are much less likely to earn a significant portion of their income from exporting, so they are less vulnerable to retaliatory measures. It is hard to foresee this issue going away anytime soon, so at this point I think it would be a real mistake to be underweight small company stocks.
Chart 2, Source: YCharts.com If one is going to increase small company exposure, what would one sell and what would one buy, you might ask. I am no fan of increasing my overall stock weighting, so the proceeds have to come from stocks. I believe the argument can be made to reduce large cap US. stock exposure by 3% and reduce international stocks exposure by 2% (1% each developed and emerging; trade wars hurt everybody). I would increase U.S. small cap exposure by 2-3% and I would put the remainder in floating rate debt and/or cash. Floating rate gives me a better yield/return, but cash gives me optionality in the case of a sharp sell-off.
Short Term Debt
Short term debt instruments have seen a nice rise in yields lately. This is because the Federal Reserve has been raising interest rates and because LIBOR has been rising for a variety of non-alarming reasons. The two-year treasury note now yields more than the S&P 500. See Chart 3 below. Increasingly investors are asking themselves if the high volatility, modest return expectation they have for stocks is better than the safe yield they can get from government bonds or CDs. A high percentage of the gains U.S. stocks have experienced over the last several years has been from multiple expansion (as opposed to earnings growth), because investors felt there was no alternative. That attitude is fading.
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