The stock market recovered most of its losses from the sharp, interest-rate related sell-off in early February.  That said, the bounce appears to have stalled without having made new highs on a broad market basis (the NASDAQ did make an all-time high on March 13th).  This is in spite of the fact that interest rates peaked in the third week of February.  They have been falling lately as this month’s inflation numbers have not confirmed the stronger numbers from last month.  See Figures 1 and 2 below.  I am going to address how we currently feel about both that bond and stock markets in the near term, and what we are doing in portfolios.

Figure 1

Source: S&P 500, YCharts.com

Figure 2

Source: US 10 Year Treasury Note Yield, YCharts.com Bonds

1. Reacted violently to strong economic reports all through the month of January and into the third week of February;

2. Broke through their 2017 high points across the maturity spectrum;

3. Threatened in the case of 10 and 30-year bonds to technically signal a conclusive breakout (ending the 30+ year bond bull market), but ultimately backed-off;

4. Rallied on oversold conditions in the last week of February, gave up that rally, and are trying again to rally on some economic weakness (retail sales) and the possibility of a global economic slowdown tied to trade wars.
   Given the terrible performance of bonds since the beginning of the year, the recent rally has been underwhelming to say the least.  The 10-year note has to break back below 2.80% to signal that the near-term outlook is even neutral.  A break back below the 2017 high yield of 2.64% would confirm the “goldilocks” market environment had returned and would probably be bullish for financial assets.  High yield bonds have not performed well lately, which may not be a good sign for economic health overall.  The same can be said for the rising LIBOR rate.

   Stocks

5. Plunged to their 200-day moving average on February 9th;

6. Rallied hard late that day and for the next week;

7. Have been grinding their way sideways to higher over the last four weeks but remain well below their January 26th

8. Volume and breadth during the rally period have not been as impressive as they were prior to January 26th, and VIX has remained north of 15 (higher than it was at ANY point in 2017).<1>
   Two thoughts.  One, almost all long term technical indicators are bullish.  There have been no major failures or breakdowns so far.  Bull markets generally experience consolidation periods, and, given the strong performance of stocks in 2017 we were way overdue for one.  Odds are, that is what we are going through now.  On the other hand, the stock market typically never goes straight from bull to bear – there must be a peak, a decline, and a failed rally before things really get going on the downside.  Because of the 10% sell-off last month, we now have the first two components (the peak and the decline) in place.  If the current rally fails to lift the broad market to new highs, the technical implication would be that the February 9th intra-day low may need to be re-tested.

   How We Are Positioning Now

   Prior to January 26th most of the negative market news focused on the historically high current valuation.  There was nothing fundamental or technical to suggest the market was at risk.  To that end, the most I could muster was to say that economic and market conditions were as good as they could be and maybe therefore it made sense to take some profits before things changed.  Today things have changed somewhat.

   The common conditions that have killed past bull markets – rising interest rates, foolish trade policies, etc. are on the visible horizon.   As such, more care is warranted now though I still believe that it would take several months of choppiness for the market to completely roll over.  Typically, investors who have been very well rewarded by “buying-the-dip” don’t suddenly become rally sellers in three weeks.

   That is all a prelude to say that we are increasing exposure to short term, medium quality debt at the expense of stocks and longer maturity debt.  We touched on reducing interest rate exposure in our last report, so I won’t go over that again, but it’s worth a read.  Modestly reducing stock exposure, both international and domestic, is a nod to the ideas that:

9. Valuation may not matter in the short term, but eventually it does;

10. Interest rates are probably at a point in the economic cycle where they are headed higher which is not a positive for corporate finances, and from here anything that would send interest rates meaningfully lower would probably also be very negative for stocks.

11. We may be headed toward at a trade war. Historically, trade wars have decreased overall economic growth while increasing inflation.

12. Central banks are beginning to “mop up” some of the excess liquidity they’ve provided to the markets for the last 6-9 years (depending on the central bank) via ultra-low interest rates and aggressive open market operations.
    The bottom line for stock investors is this:  Over the past nine years we’ve had just about all the good news one could hope for.  However, easy credit, corporate tax reform, and a collegial global trading environment are now behind us.  If corporate earnings don’t dramatically accelerate, what are the other potential upside catalysts?  A little caution at the margin is warranted.

    <1> The source for all bullet points is Telemet Orion

     

Disclosure

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

The continuation of the negative response of bonds to the strengthening economy and more importantly, to the normalization of interest rates, began to spill over into the stock market on January 29th.   Over the next two weeks, a historically normal level of volatility reasserted itself in the stock and bond markets.  I’d like to discuss what happened and how we are positioning now.

What Happened

In our view, the market surge from the passage of the corporate tax cut in late December through Friday January 26th was a “melt-up”.  Investors were euphoric, believing the stellar returns of 2017 would be repeated in 2018.  The S&P 500 was up about 7.5% for the year at the close that Friday.<1>  As is often the case, however, investor enthusiasm got out of hand.  Speculation in products designed to magnify returns on the upside led to steep losses as the market ran into a wholly predictable speed bump<2>.

Stocks declined modestly on the 29th and 30th as investors began to realize that 2018 might in fact see three or four interest rate hikes.<3> When the Labor Department reported a robust employment number on February 2nd, interest rates surged well above their December 2016 highs.  The stock decline gained momentum.  See Figure 1 below.

Source: YCharts.com

It should be noted at this point that about a decade or so ago financial wizards created an investment product called VIX, which enabled one to hedge stock risk by owning exposure to volatility.  If your stock portfolio declined for example, volatility (VIX) would theoretically rise, which would offset some or all of your losses.  Some years ago, however, those wizards introduced a product that did the exact opposite of VIX – in other words the security they created increased in value if volatility (VIX) declined.  Rather than a hedge, that security (VelocityShares Daily Inverse VIX, Ticker: XIV) is essentially a pure speculative bet that the stock market will continue to rise.  It is hard to imagine a better environment for this product than 2017; the stock market rose every single month last year and never declined as much as three percent at any point.  XIV gained 182% in 2017!<4>  At some point, however, things were bound to change.

Beginning last week, as interest rates rose, and stocks began to sell off, volatility soared.  Investors in various products that bet against volatility saw losses pile up and they flooded the market with sell orders to try to limit their losses.  The stock market buckled under the weight of forced selling Monday, Tuesday morning, Wednesday afternoon, and again on Thursday.  XIV, which closed at $136.73 on January 26th (up from just over $50 on New Year’s Day 2017), fell to $5.40 as of the close on 2/6 – a loss of over 96%!<5>

The past two weeks have wrung a lot of the speculative excess out of the stock market.  The economy and corporate revenue growth are strong, and it would be exceedingly rare for an economy hitting on all eight cylinders (so to speak) to suddenly blow out six of them.  There are almost always several months from the point of maximum market participation to the point where the whole market rolls over<6>.

Putting Volatility in Perspective

Volatility is a normal part of investing, and the markets certainly reminded us of that fact last week.  It’s important to keep a long-term perspective and recognize that to be successful investors we need to accept volatility as a necessary part of our journey.  Below is a look at the calendar year returns, intra-year gain and intra-year decline of the Russell 3000 since 1979.  As you can see, large swings higher and lower are a regular part of investing.

Source: Dimensional Fund Advisers

In taking a longer-term perspective we inherently accept the fact that capitalism works.  If that’s our fundamental belief, it’s easier to ride out periods of volatility.  Below is the distribution of US market returns since 1926.  The red blocks red represent years of negative total market return and blue blocks represent years of positive total returns.  As you can see there are more blue than red blocks; since 1926 75% of the time the market has produced positive annual returns.  Of course, past performance is not a guarantee of future results, but as investors we can use history as a foundation to inform our beliefs.

Source: Dimensional Fund Advisers

How We Are Positioning Now

We believe that for the time being interest rates will stabilize around current high levels.  These levels are not high enough to hurt the economy broadly speaking, but they will continue to cause problems for the companies and industries most sensitive to interest rates.  Utilities, real estate, and consumer staples stand out in this regard.  Here’s the real trick: these industries are typically the worst to own in a rapidly expanding economy but the best to own once the economy rolls over.  The recent sell-off has really improved the valuation characteristics of utilities and REITs relative to the overall market, yet they are still performing relatively poorly.  High dividend and low volatility strategies tend to emphasize those themes and most of those funds are under performing.  I don’t think that is going to change in the short run.  Investors may want to look at strategies that emphasize quality instead.  Quality probably won’t be a market leader, but it may give me some degree of downside protection without being too vulnerable if rates continue to rise

We believe the time has come to underweight bond duration relative to the Barclay’s Aggregate Bond Index.  Additionally, we are cautions with regard to below investment grade credits.  Over the last two weeks floating rate bonds held up well, while high yield gave up more than a percent-and-a-half.<7>  While we believe high yield may have a relief rally in the short term, this is not an area you want to overweight if you expect interest rates to rise.

The bottom line for stocks is this: if interest rates remain reasonably stable in the new higher range they have established in 2018, we believe stocks may once again resume their rally.  If not, and weakness spreads beyond utilities and real estate to the industrial and transportation sectors, we’ll have the first evidence the longer-term bull market may be ending.   Because stocks performed so well over the previous three months, short and long term moving averages are still confirming that the primary trend is upward – even with the recent decline.  For that reason, we believe that a modestly bullish bias continues to be warranted.

<1> Source: YCharts.com

<2> Some background:  With the economy performing well, the Federal Reserve no longer needs to take   extraordinary measures to support it.  They can continue to raise interest rates toward their natural level, which is a little above the rate of inflation (currently around 2.1%).  We are always told the stock market can handle rising interest rates.  There is always a point, however, when that is no longer true.

<3> The Fed has been telling us it expected to increase rates three or four times this year, but investors have become conditioned to the Fed losing its nerve and only hiking once or twice in a year.

<4> Per Morningstar

<5> Source: YCharts.com

<6> The broad market peaked about a year and a half before the overall market peak in 2000.  The interval was shorter in 2007.

<7> Source: YCharts.com HYG, BKLN 1/28/18-2/9/18

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.

Bonds made a move lower over the last couple of weeks most likely in response to the apparent inevitability of the new tax law lowering corporate tax rates. This development encouraged investors to believe that economic activity would be stronger in the future and that inflation would be higher.  As a result, the yield curve’s flattening trend was broken.  I’m not sure that this is a trade I would get behind at this point.  The fact is, bond yields have a strong seasonal tendency to rise in December as investors expect economic conditions to improve in the coming year.  In the last 9 years, only 2011 and 2014 have not seen bond yields rise in December.<1>  For me to get really bearish on bonds I would need to see the 10-year note yield break above 2.65% amid yield curve steepening, and stocks would have to be performing reasonably well.  This would tell me that investors were buying into a faster growth/higher inflation narrative, such that a healthy asset rotation was underway.  Bottom line: resist the urge to dump your bonds until a new trend toward higher rates is more firmly established.

My feeling about the stock market is this:  we are not trading on fundamentals, despite what all the 2018 Market Outlooks say.  We are trading on sentiment.  That sentiment has gone from mildly bullish to full-on greedy.  How else to explain Bitcoin and all the other crypto currencies?  If you ask enthusiasts it is about privacy and efficiency.  If you give them a beer and ask them again it is about making a ton of money in a very short period.  It has been my experience that get-rich-quick-trades like Bitcoin happen late in the economic cycle.  Whether it is people quitting their jobs to day-trade tech stocks (1999), people buying multiple properties for a quick flip (2006), or today’s crypto mania, there is confidence that the world is full of greater fools with the means and desire to buy things at an ever-higher price.  Such a cycle of emotionally driven investing never ends well.  The eventual popping of the bubble creates a negative wealth effect that can spill over into other assets and possibly into the larger economy.

It is easy to suggest that stocks have moved up this year because the economy is improving, and corporate profits are going to get a boost from tax law changes.  That isn’t wrong, but it isn’t the whole story.  The stock market has not experienced a down month all year.  That is highly unusual.  That tells me that something in our collective belief system has changed.  After all, stocks rose 37% in 2013 yet there were two down months.  Gains topped 30% in 1997, but there were three down months.<3>  Even when things were good, occasionally investors took profits.  That’s how healthy markets work.  The lack of even a three percent pull-back in 2017 tells me there is a certain “can’t lose” mentality at work.I fear that the end of this streak is going to result in a hard landing.  Not immediately, but ultimately.  As you recall, if you tried to buy the dip in 2001 or 2008, you got steamrolled.  There are no good selling opportunities on the right side of a parabola.

Bottom line:  I believe that it is a necessity to lighten up on stocks, and that also means to prepare yourself for the underperformance that results from lightening up early.   If we are lucky, we will be selling into the long overdue minor correction that sets the stage for the next leg of the bull market and will get the opportunity to buy a lower price.  Alternately, if the next leg down represents a structural shift in market sentiment we will be selling near the top of the latest parabolic stock move.

Commodities are the sector to watch.  If the global economy is truly in a sustained growth cycle, the price of energy, base metals, and other commodities should benefit.  If commodities don’t rally (and if interest rates cannot hold the recent rally), then economically we could be on shaky ground.  Historically, technology, biotech, utilities, and staples are the classic weak economy scenario industries and they have been relatively out of favor since the tax bill became more likely than not in early December.  Financial services, industrials, retail, and energy may currently be benefitting from the idea that 2018 may see a higher level of economic growth. I’m still skeptical that domestic economic growth will be higher in 2018.  I expect that energy and real estate will perform well in the first quarter because they appear to be the biggest winners from tax reform.  Since most technology stocks had a fairly low tax rate to begin with, they shouldn’t benefit as much from corporate taxes being lower (even with repatriation).

From our perspective, one of the better investment ideas this month has been frontier markets.  From reformer Cyril Ramaphosa’s win in South Africa to the continuing turnaround story in Argentina, this is where most of the positive global surprises are coming from.  My frontier markets preference is Ashmore (EFEIX/EFEAX).

-Mark Carlton, CFA

<1> Source: Telemet Orion

<2> John Mauldin’s Over My Shoulder, 12/18/17

<3> Source: Telemet Orion

<4> John Mauldin’s Over My Shoulder, 12/18/17

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 global stock markets seem “tired” right now.  It has been a very good year, with the S&P 500 up around 17% with dividends included and EAFE up just under 21%.  Yet EAFE is almost 2% off its October highs and the S&P 500, while less than 1% below all-time highs, also seems to be laboring.  The small cap Russell 2000 is close to 3% below its October high.<1>  See Chart 1.  That said, every index is well above its 50 and 200 day moving average, so the benefit of the doubt remains with the bulls.  The reason I felt compelled to write about the markets today is that the biggest impetus behind the strong stock advance in 2017 has been central global bank purchases of debt and in more and more cases, stocks themselves – and that impetus may be waning.

Chart 1

We all have been told that rising profits are behind the strength in stocks this year, and to some extent that is correct.  It is important to remember, however, that stocks rose from 2014 through 2016 on next to no net profit advance, so corporate profits and stock prices are not that highly coordinated in the short run.  Tax reform could help stock prices, but it is increasingly less likely that we will get reform and more like we will see tax cuts, which generally means that the same size pie will be sliced differently.  If, for instance, the tax burden is shifted more towards individuals and less toward corporations, then individuals will have less after-tax income to spend and therefore consumer-oriented businesses will suffer relative to those that sell to other businesses.  No, the thing that has moved stock prices for the last several years is central bank activity.  Buying debt to lower interest rates brings down borrowing costs, making everything from buying back shares to issuing new debt cheaper.  The fact that the stock market boom has been largely debt-fueled doesn’t make it wrong, but it does suggest there is a limit at some point.  Global central banks are at least talking about beginning to rein in excess credit.  The Fed is starting to do that here, and the European Central Bank has indicated that they will do the same in 2018.  The Bank of Japan has been extremely active in buying both its bonds and Japanese stocks this year.  The Japanese Government Pension Investment Fund hit its target weighting of 25% in Japanese stocks and is now “selling into strength and buying into weakness”.<2>  China stimulated their economy leading up to the recent Communist Party National Congress, but they are deleveraging now and at the same time interest rates there have recently surged to above 4%.  That is not a recipe for higher stock prices.

Bottom line:  The best is behind us.  Further gains are possible but the central bank tailwinds are all but gone and valuations are high.  Proceed with caution.

Reasons for concern:

1. This week’s IPO calendar lists 13 initial public offerings this week, the highest in a very long time. This doesn’t happen near market lows.

2. High yield debt has sold off modestly over the past two weeks. Stocks do not tend to rally for long when high yield bond spreads widen, for they are both sensitive to liquidity and economic health.

3. Emerging market debt has also had a rough couple of weeks. Rising interest rates due to strengthening economies eventually affects emerging market stock prices as well.

4. Low volatility is the best performing factor in November<3>. Utilities are the best performing industry group.  Both are up.  This suggests a bull market taking a breather.  If they were the best performing factors/industries and both were declining, I’d be a lot more worried.
   Other observations:

5. Latin American stocks have been selling off all quarter. They may actually be oversold right now, as the correction has taken them right back to the longer term uptrend line.

6. After rising for much of October and November, the Japanese stock market has now declined four days in a row.<4> Momentum can be fickle.

7. If you are looking at alternatives, merger arbitrage is a low risk, low return option which is more palatable in a low return environment. Of the choices available, the IQ Merger Arbitrage ETF (MNA) has done quite a bit better than MERFX or ARBFX over the last one, three and five years albeit with a little more volatility.<5>

8. Closed-end fund discounts had been in an 18 month period of narrowing, eventually rising to less than 6%.<6> This was great for closed-end investors, especially for those that owned leveraged bond funds.  Unfortunately, the trend appears to have topped out in October.  Closed-end funds are not having a very good November.

9. Internationally, growth has crushed value as a strategy in 2017.<7> You were either in the fast growing Chinese internet stocks (Alibaba, Tencent, jd.com) and Asian technology giants (Samsung and Taiwan Semiconductor) or you weren’t.  It’s nearly that simple.

10. Sometimes your benchmark is everything. Parnassus Endeavor (PARWX) is a large cap fund with an ESG mandate and a very good long-term track record.  It has generally been considered a large cap growth fund by Morningstar.  In that category, it has been in the bottom decile all year.  According to Morningstar, however, the fund crossed over into the large cap blend category in 2016 and is closer to the value end of the spectrum at this point.  As a large cap blend fund, its 18.3% year-to-date return puts it in the top quartile.<8>

11. Real estate got hit very hard in the second half of 2016 due to the problems of retail REITs (which are still down sharply), and have been fairly flat in 2017. That said, the group has made a sharp bounce over the past two weeks as the upward pressure on interest rates has moderated.  I wouldn’t chase the bounce, but I think this sector would become more attractive if the overall environment remains mildly risk-off.<9>

12. Gold is mostly a way of playing the notion that Central banks don’t have the spine to raise rates when inflation begins to take hold because the powers-that-be don’t want to risk recession. In the absence of inflationary pressure, central bankers can talk as hawkish as they want because they don’t have to “put up”.  Therefore, it is hard to see a near term catalyst for meaningfully higher gold prices.

13. Municipal bonds continue to outperform similar quality taxable bonds<10>. This has been true all year. <1> Source: YCharts.com

    <2> Source: https://asia.nikkei.com/Japan-Update/Foreign-buying-overrides-domestic-selling-to-lift-Nikkei

    <3> Source: Telemet Orion

    <4> Source: YCharts.com, iShares JPX-Nikkei 400 ETF

    <5> Source: YCharts.com, Investments measured by total return

    <6> Source: Barrons, November 13th, 2017

    <7> Source: YCharts.com as measured by total return, year to date return of the iShares MSCI EAFE Growth ETF and iShares MSCI EAFE Value ETF.

    <8> Source: YCharts.com as measured by total return, year to date return

    <9> Source: YCharts.com as measured by total return of the Vanguard REIT ETF

    <10> Source: YCharts.com as measured by total return, year to date return of the iShares Core US Aggregate Bond ETF and the iShares National Muni Bond ETF.

Disclosure

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

It has been a while since we sent out an update because from an investment standpoint, not much has changed.  There continues to be basically three scenarios for the market, and any individual security is a play on one, or at most two, of them:

1. The lower-for-longer scenario.  Some call this the Obama trade.  Slow economic growth and low cost of capital means that companies experiencing real sales growth can borrow cheaply.  They are going to be prized, no matter how expensive, because their growth rate can be projected into the distant future with little time value of money discount.  Most technology fits this description, as does certain media, industrial services, and consumer stocks.  Large cap growth is the best fit sector.

2. The cyclical expansion scenario. Some call this the Trump trade.  The idea is that economic stimulation via tax cuts and de-regulation will lead to a tradition cyclical growth phase, which will benefit companies more leveraged to the capital goods economy.  Think transportation, industrial production, financial services, materials, mining, and energy.  Small cap and value stocks may be the way to play this.

3. The recession scenario. The economy fails due to excess debt and not enough demand.  High quality bonds may be the best way to play this, although utilities, consumer staples, and certain high dividend telecom and energy stocks might also work out.  Very large cap dividend stocks tend to lose the least in down markets.

Since the first quarter of 2016 money has shifted back and forth between scenarios 1 and 2.  In other words, money didn’t leave the stock market, it was simply redeployed.  Hillary Clinton was a scenario 1 candidate, so when she lost scenario 2 stocks surged.  Since March the air has completely leaked out of the scenario 2 trade on the failure so far of the Trump administration to deliver on their promises.  Interest rates are back down to the levels that existed before the election and small cap stocks have almost no gain in 2017.  Yet markets are not pricing in Scenario 3.  Slow growth, high dividend stocks are still not attracting a bid.

Until something changes, money is likely to continue to flow to large cap growth stocks.  Capitalization has been the best predictor of return this quarter.  Look for very large cap stocks funds (yes, the American Funds Group should do well in this environment).  I am also using the iShares Morningstar Large Cap ETF (JKD), which has a ridiculously high average market cap of $126 billion.

Other Thoughts

In other matters, I’ve been watching gold lately and I am not impressed.  Year to date, the dollar has dropped 11.1% and 14.6% versus the euro and Mexican peso, respectively.  And gold can only gain 13%?  It’s up just 5% this quarter in a dollar free-fall?  See Chart 1. Many strategists such as Ray Dalio have been recommending gold recently due to economic and political dysfunction.  Maybe that will work out, but our experience is that when your thesis plays out but your investments hardly move, you need to get out of that trade.

Chart 1

I would like to pass along one of the best articles I have ever read.  Charles Gave did a brilliant job of explaining why low interest rates are not just no panacea for an economy, but over time a killer of entrepreneurship.  Low interest rates were what we needed to escape a frightening contraction that gripped markets in 2008, but extending them past 2010 has brought on a set of circumstances that are de-stabilizing both to the economic and political world.  I believe you will find it interesting.  At the very least, you will understand why scenario 1 has been so successful in this “recovery”.  You can access the article by clicking here.

Disclosure

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

Summary

1. Technology stocks have done very well this year but have run into some resistance.

2. After flirting with Energy and Financial Services, the market has settled on Health Care/Biotechnology as the new leadership group.

3. The Federal Reserve seems to want to reign in excess liquidity even as recent economic measures have been on the weak side.

4. A reduction in liquidity after a strong run up is the kind of thing that often leads to 5-8% corrections.

5. There is an outside chance the next correction could be trigger a financial “accident” through computer driven sell programs.The Next Correction

   I’m starting to sense that the next broad stock market correction is near.  If I am right, it will be in the 5-8% range.  My reasoning is as follows: technology stocks have led the market over the last few years.  Tech stocks benefit from low interest rates in that since they are expected to grow earnings at greater than market average rates, the present value of those future earnings is worth more.   In fact, the market  views some of the best known tech stocks like Amazon, Apple, Facebook, Alphabet (Google), and Microsoft almost as utilities in that they have a well-defined niche which helps them generate a high and growing stream of cash that may help to dampen the effects of a recession.  Yet it would appear that investors have pushed their prices up against the limits of their comfort zone.  Perhaps it was Amazon and Alphabet both reaching $1000 per share, but in any case investors seem to be saying lately that if the market is to move higher, other sector will have to supply the lift.  Financial Services and Energy tried and failed.  Financial stocks can’t rally with interest rates low and the yield curve flattening.  Energy stocks can’t rally with production rising more than demand.  Last week, however, health care and biotech stocks really surged.  They share with technology a growth bias and a relative insensitivity to overall economic growth.  See Chart 1.

Source: YCharts

The bottom line is that while health care may lead the market in the near term, stock prices overall might have to pull back a bit to entice more broad-based buying.  Investors did not take the Federal Reserve at its word after the last rate hike when they gave details on how they planned to gradually stop supporting the bond market with repurchases.  I believe that is a mistake.  I am not concerned about a 5-8% correction because statistically that kind of thing happens at least once a year.  My worry is that a run of the mill sell-off might be exacerbated by computer-based sell programs designed to automatically protect portfolios from rising volatility.

So while I don’t see an economic justification for a double-digit decline in stocks in the near term, volatility-based automated trading systems are a reason that we may have one anyway.  I would re-iterate that this would be a black swan; a normal 5-8% pullback is far more likely.  Investors have been lulled into a false sense of security by almost record low volatility, while the Federal Reserve seems determined to begin draining the market of excess liquidity.  A tighter Fed is definitely NOT priced in, so at some point that could cause some turbulence.  A little extra caution may be in order.

——-

Some of you might be familiar with the concept of “risk parity”.  This strategy aims to offset one type of volatility with another.  For example, for stocks the biggest risk is equity or economic risk, in other words, that the growth of the economy and therefor corporate profits will disappoint.  For investment grade bonds the biggest risk is interest rate risk, or the risk that bond prices will decline as interest rates rise.  Under most circumstances, a slowing economy leads to lower interest rates.  Therefore, what hurts stock prices might actually support bond prices.  The reverse is also true.

Risk parity holds that if we believe bonds are half as volatile as stocks and that long term government bonds move in the opposite direction as stocks, then a 2/3 long government, 1/3 stock portfolio might minimize volatility yet still offer an attractive return.  The problem comes in if stocks begin to decline and bonds do not exhibit the negative correlation we expected.  In that scenario, our bond gains would not offset enough of the loss from stocks.  As stocks fall and their volatility relative to bonds rises, risk parity funds would have to sell stocks in order to find a ratio where bond gains and stock losses were back in proportion.  Since, much of that selling is computer automated, you can easily see how selling could beget more selling, much as happened with “portfolio insurance” back in October 1987. 

Disclosure

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

Oftentimes I write updates after conferences in order to process and make sense of the information I have just taken in.  This is my attempt to make sense of SIC 2017, John Mauldin’s annual get-together.

The first thing I took from the conference blog was that unlike all of the last several years, there was no referring to the United States as the “cleanest dirty shirt” or “best house in a bad neighborhood”, or any other euphemism for the idea that although things weren’t going that well in the U.S., everyplace else was worse.  Several speakers brought forth the notion that in turning insular (cancelling trade deals, banning immigrants, etc.) America was ceding the future to China.  China, through its initiative to conduct more trade across the Eurasian land mass through its “One Belt One Road” construction projects, is replacing the United States as the global economic engine (meaning the most important nation to have trade relations with).

The second important idea many presenters shared was a sense of being in the “fat years” so to speak.  That means central banks are going to support the current economic recovery with expansive monetary policy and in some cases outright asset purchases until it works no more.  Therefore, expect to go a very long time until the next global recession (we have been sacrificing magnitude for length in our economic cycles since the 1980s).  But oh God, many presenters stressed, the next true global recession will be bad, because there will be nothing left for central banks to fight it with.  Furthermore, we will have to confront what will become obviously unserviceable sovereign debt and pension obligations at that point.  “Demographics is destiny”, Mark Yusko said (and many agreed), meaning we can see the wall that we are going to crash into but it is too late to do anything about it.  Before this cycle ends, however, Pippa Malmgren believes we may see a “melt-up” in stock prices.  Perhaps we are seeing that now.

International Markets

I had some concern that with the French election widely predicted to go to Macron in the days leading up to May 7th, the rise in European stock prices might be a “buy-the-rumor-sell-the-news” kind of thing.  However, that has not proven to be the case.  European stocks have continued to be strong performers, especially for dollar-based investors as the Euro has surged against the dollar.  As a result, we are changing our domestic to international ratio in portfolios from 2.5 to 1 to 2 to 1.  That means a 60-40 portfolio would move from 43% U.S./17% foreign to 40/20.  It doesn’t make me feel great that in essence we are moving in the same direction as everybody else, but it is a situation where valuation, momentum, top-down fundamental analysis, and technical indicators all agree.  There may be a need to consolidate recent gains (a correction of 2-5% could occur at any time given the approximately 15% gain this year), but it appears that the trend that favored the U.S. basically since the global credit crisis ended has finally begun to reverse.

Asian stocks have also been strong and I would not want to suggest Asia should be underweighted.  There are near-term concerns with China as efforts to curb money supply (in order to rein in speculation) could give the stock market a bumpy ride.  That said, China, India, and several other Asian nations are in a position to improve the quality of life for large swaths of their population, and in the West that has always coincided with strong financial performance.  Latin America, on the other hand, should be underweighted.  Though truly hopeful things are happening in Argentina, investable funds and ETFs are dominated by Brazil.   That just isn’t going to go well in the near term.

Growth vs. Value

Growth as an investment style has dramatically outperformed value so far in 2017.  See Chart 1. The predicted economic surge has not materialized, so investors have returned to stocks with predictable, non-cyclical growth.  With declining economic growth expectations, interest rates have fallen.  Two major implications from that: 1) financial services companies will earn less from lending, both in volume of loans and interest on those loans, so financial stocks may continue to under-perform, and 2) a dollar earned in the future is worth more, so we can pay higher P/E multiples for revenue growth-focused companies like Amazon.  Another thing hurting the value side is the terrible performance of the energy sector year-to-date.  Despite the OPEC agreement to maintain production limits for another nine months, it would appear that the world has all the oil and gas it expects to need.

Chart 1

Source: YCharts.com

Interest Rates

Perhaps the most difficult thing to do as a market strategist is forecast interest rates.  2017 predictions were near unanimous in calling for higher rates.  The only questions were how much and would the yield curve flatten or steepen.  It is unclear why interest rates have fallen this year as economic growth is still solidly positive and the Federal Reserve is still on pace to raise rates this year.  A very flat yield curve at very low interest rate levels would in theory be a worrisome sign from an economic standpoint.  It suggests that while economic growth may be mediocre, that is about the best we can do.  I thought short term rates would rise to reflect what we expected from the Fed over the next several months, and longer term rates would edge upward but not nearly as much.  I cannot intellectually reconcile plunging long bond yields and soaring stock prices simultaneously.  Stock prices are theoretically tied to corporate profits, which are positively correlated to economic activity.  Falling bond yields (rising bond prices) are usually associated with a decline in inflation expectations brought about by lower economic activity.  The only explanation that would make sense is that there just aren’t enough stocks and bonds in the world to meet investment demand.  Is this really true?  Have global central banks created so much credit in the banking system that the prices of all financial instruments are being forced higher?  If so, how and when does this end?  (In another words, how do they extricate themselves from this situation without creating a massive implosion of financial asset prices)?

Disclosure

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

I just returned from the Morningstar conference in Chicago.  I always find it interesting to compare each conference I attend to past conferences in order to determine what issues become more and less important over time.   The active-passive debate generated a lot of discussion.  Morningstar derives an important part of its income from rating mutual funds and would therefore likely be hurt by the demise of active funds, yet it threw out only modest support to the active fund industry (specifically Dodge & Cox and PRIMECAP Odyssey).  Ironically, greater support for active funds came from Blackrock, the owner of iShares, CEO Larry Fink.  Also, while it is no secret that growth as a strategy has run laps around value since the last recession, growth managers seemed to take index performance criticism more personally.  Value managers across the board acknowledged their struggles in this market but felt certain that their time would come.

There were two other areas that were prominent at the conference this time that were hardly even issues in the past, behavioral finance and sustainable investing.  When I began my investment career, Modern Portfolio Theory ruled the land.  Nobody dared say out loud that investors weren’t rational.  If two investors ever came to opposite conclusions, it had to be that their time horizons or investment mandates were different.  Or one had information that the other didn’t.   Today the industry seems to fully embrace the notion that investors (even professionals) have biases, and emphasis is now on how to recognize and use them.

Sustainable (or ESG) investing has flourished recently as it has emerged as a more palatable way of avoiding “bad” companies.  The goal of ESG investing is to invest in companies whose practices rank high in environmental, social and governance performance standards.  The environmental screen helps avoid companies (such as those in the coal industry) whose assets might become stranded as more climate-friendly power generation grows in usage.  Social seeks to avoid companies whose policies might generate unfavorable publicity and/or lawsuits, such as discriminatory hiring or anti-consumer practices (among other things).  Governance issues sought to expose the fact that in companies where employee relations were poor, minority shareholders were ignored, or executive compensation was excessive the stock tended to underperform.   Morningstar paid only the mildest attention to what it called “socially conscious” investing in the past, but is fully on board with sustainable investing today.

Nobody at the conference disagreed with the notion that stocks and bonds are both fully valued (if not expensive), but very few thought that the current environment (2% growth give-or-take and an inflation rate of under 2%) posed any threat to the bull market’s continuance.  The biggest risk factors cited were rising U.S. rates and a strong dollar.  Mildly disappointing GDP or retail sales are not going to kill the bull market.

Investing ideas:

1. Last winter in the wake of the market reacting to what it though President Trump would do, interest rates rose sharply. The 10-year Treasury bond briefly exceeded 2.6%.   Speculative trading positions were very short the 10-year as many projected 3% yields by June.  Fast forward to today and traders have closed those positions at a loss.  Trading sentiment among speculators is now that interest rates will go lower.   I think that sets us up for a test of 2.50% at the very least.  Now may be a good time to trim duration.

2. Another area I believe investors will prioritize is dividend growth. For a long time, investors preferred companies with excess free cash flow to buy back stock as opposed to paying big dividends because dividends are taxable.  Today there is a growing sense that stocks are so expensive that share buybacks in most cases don’t make sense.  For this reason, companies are increasingly opting to declare one-time special dividends (most recently Costco), and investors are rewarding that choice.

3. This is the part of the market cycle where it is the most difficult to hold value stocks. One value manager said that he understands that he is “asking people to own names that they will probably hate”.  Some people are better off acknowledging that they don’t have the stomach to be value investors and not investing that way in the first place, he said.  That avoids “bad exit under-performance”.

4. Dollar-based emerging market investors have been the biggest beneficiary of the fact that the dollar has been unexpectedly weak this year. A strong dollar forces countries that borrow in dollars to use up more local currency to pay bondholders, negatively impacting liquidity.  This is something EM investors have to watch carefully.  For the moment, however, the dollar decline is a positive for EM, and off-the-cuff tweets only make this situation better.  The risk factor here is a comprehensive tax reform package that would incentivize companies to repatriate overseas capital.  I personally believe value managers need an economic growth expectation of less than 0.5% or greater than 3% to regain favor versus growth.  A slowdown to less than 0.5% signals recession and would likely compress growth P/E multiples.  An acceleration to 3% or more signals the kind of strong expansion that encourages capital spending and makes cyclical stocks the biggest winners.  I believe neither is in the cards in 2017.

   Environment, Social, and Governance

Disclosure

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