Summary

The stock market’s recovery continued in the first quarter of 2021 as all major categories of stocks made new highs.  For the quarter, U.S. stocks gained 6.17% (as measured by the S&P 500).  That said, the quarter was anything but a continuation of 2020’s themes.  This year’s market rally strongly favored smaller and more speculative companies.  Why? Because larger, safer companies do not tend to decline as much when the economy slides into recession, and they tend to begin their recovery sooner.  As investors gained confidence post-vaccine roll-out late last year, the worst hit stocks of 2020 began rebounding with a vengeance.  Cyclical industries (industrials, financials, transportation, chemicals, metals & mining, for example) performed extremely well, while those companies that soared in 2020 because of their leverage to the “stay at home” theme (largely technology and consumer durables) sold off heavily starting in February.  This necessitated an unusual amount of trading activity in order to adjust to the new trends.

International stock markets also gained, though they once again lagged the U.S. considerably.  Despite a net gain of 3.48% overall, conditions significantly varied between regions.  Europe outperformed other foreign regions as its recovery seemed to be on the same trajectory as America’s.  Japan, heavily dependent on exports, was negatively impacted by the rising value of the yen.  After a strong start, China lost over -4% on the quarter when the authorities began cracking down on Chinese internet companies.  Factoring China and Japan out, however, Asia would have had the best performance.  Latin America (-5.32%) was devastated by its collectively awful response to Covid.

Expectations for stronger economic growth pushed up interest rates, leading bonds to a -3.37% loss.  This was the worst quarter for bonds in many years.  High yield bonds were able to eke out a 0.85% gain as yields of over 4% offset mild interest rate-related capital depreciation.  For lower yielding investment grade bonds, there was no such reprieve.  Long term (10 year+) bonds lost over -10%, global bonds shed -4.46%, and mortgages were off -2.90%.  Just a tough quarter all around.  Fortunately, bond have rallied in April. Activity

Where to begin?  For starters, we had to shift stock exposure from an overweight to growth sectors like technology to cyclical value sectors like financial services and industrials.  We also increased the weighting in smaller company stocks as the economic recovery is broadening out.  The international part of portfolios also had to change; if cyclical stocks are moving in the U.S., they will soon be moving in Europe and Asia as well.  That said, the aforementioned crackdown in China has put an important part of the emerging market story on hold for the time being.  This has necessitated a rethink in what kind of emerging market funds you want to own.  Bond duration had to be shortened during the quarter because of rising interest rates.  During periods of recovery, we tend to lower bond credit quality to benefit from higher yields.  Lastly, for more aggressive investors we have carved out a small niche for emerging technologies such as digital assets.

Outlook

“It’s tough to make predictions, especially about the future” – Yogi Berra

At any given time, an experienced investment analyst can tell you what the markets expects.  For example, currently when interest rates rise, it is generally an expression of confidence in the economy.  This means economically sensitive areas of the market, like smaller capitalization and cyclical stocks, are expected to outperform.  On the other hand, if interest rates decline, it is probably due to concern about the economy, which means investors will prefer large, non-economically sensitive stocks that can thrive in a recessionary environment.

I can also tell you that investors expect that the economy will take off once the Covid crisis is truly behind us.  Pent-up demand for travel and leisure is expected to be off the charts.  Reflecting this, hotel company Marriott recently exceeded its previous price peak of $151.50 set in December 2019, and online travel giant Booking Holdings just hit an all-time high almost $300 higher than its pre-pandemic peak.  I am not saying either stock couldn’t go higher, but they appear to have already priced in the economic recovery.  At the same time, the consensus holds that inflation will surge during the first half of 2021 as production tries to catch up to surging demand.  By the fourth quarter, however, supply and demand are expected to come into equilibrium such that the near-term upward pressure on interest rates will dissipate.   In other words, the market is being driven forward almost relentlessly by the expectation of strong future growth but very modest interest rate increases.  Again, this might happen, but it makes me nervous when the market prices in the best-case scenario because I hate having more to lose from things going wrong than I have to gain from things going right.

This “goldilocks” narrative could be threatened by either weakness (Covid doesn’t fully go away and service-related businesses only partially recover) or by strength (the recovery drives up demand for everything from lumber to gasoline to plumbing services, and this results in sharply rising inflation).  Stocks tend to perform best in the early stages of an economic recovery, but you cannot stay in the early stages indefinitely.

Commentary

Recently, we have fielded a lot of questions about bitcoin and other cryptocurrencies.  Investors should know that financial professionals are under two limitations when discussing anything from an investment standpoint (be it Dogecoin, non-fungable tokens, or Hummel figurines).  The first is that as professionals we must have a reasonable basis for our opinion and are liable for that opinion (not unlike a doctor or an accountant would have if they gave general advice without understanding the client’s specific situation).  We are not free to just have an opinion.  The second is that our specific knowledge- that which we study and are tested on- has to do with matters that are quantifiable, such as “If a bond yields 5 percent and has 4 years remaining until maturity and inflation is steady at 3%, assuming no default risk, what should the price of the bond be?”  The equilibrium price of novel assets like Ethereum does not fall into that category because the price is purely a function of investor sentiment and supply/demand dynamics. Thus, we struggle to formulate a reasonable opinion.

Valuation questions that are purely matters of supply and demand are much harder to give good answers to, because it is difficult to forecast demand for something that has existed for a very short time.  When it comes to gold, a metal that has been a storehouse of value for close to 5,000 years, some of us may be willing to hazard an educated guess because there is some historical basis to work with.  We know it tends to correlate negatively to real (inflation-adjusted) yields, but beyond that the price of gold tends to venture into political/sociological territory (i.e. how do you feel about the near term prospects for your country?).  Therefore, when you ask us about Bitcoin, a cryptocurrency with a lifespan far, far shorter than that of gold, we tend to think “not only do I have no idea where it is going, but I am taking a certain risk having ANY opinion on it”.  Regulatory agencies have given us no guidance in terms of what we can say, but we know they are monitoring this area closely.

Determining the intrinsic value of any asset is difficult. Securities analysis training emphasizes cash flow valuation techniques and teaches analytical processes that when applied correctly, should help improve decision making.  It does not promise to always be right.  When it comes to determining what an asset’s underlying value is, I can use my training as a CFA to determine what I believe to be a reasonable estimate.  It may or may not agree with the market’s price for the asset, just as a gambler might advise you not to hit on 17 at the blackjack table only to see you draw a 4.  Statistically correct but specifically wrong.

To be clear, price and value are often used interchangeably but they are in fact two very different things.  Value, assuming you have the correct information, is a matter of expected future cash flow and mathematics.  Price, on the other hand, is a function of the dominant market narrative and supply/demand curves.  It probably belongs in the realm of soft sciences like psychology and economics, where people may behave rationally but are under no requirement to do so.  Case in point: Gamestop, the mall-based software retailer, had a market capitalization of $1.2 billion on January 8th, 2021 and $11.1 billion on April 19th.  I cannot justify the more than 9-fold increase in the price of that stock based on the cash flow prospects for the company, so I confidently believe that the current price ($164) does not represent good value.  I have no idea what the actual price will do.  Thirty, fifteen, or even five years ago I might have said that I expected that the price would decline.  Today, with rock bottom borrowing costs, essentially free trading, and easy access to information about what everybody else is doing (especially in the options market), all bets are off.  I can tell clients what I believe to be the prudent thing to do in the sense of risk versus reward because having spent thirty-five years in this business I understand how many ways the market can move against you.  Sometimes, however, people will take crazy risks anyway and they will pay off.

<1> MSCI EAFE in US dollars

<2> On the other hand, if you ask about blockchain or distributed ledger technology, you ARE asking us a securities question.  It would be similar to asking us about cybersecurity or genomics in the sense of “what do you think about these areas in terms of growth or investability?”, and we can feel more comfortable giving you an answer because we have researched these areas and can meet the standard of “reasonable basis”.

<3> Source: YCharts.com

<4> There is a delicatessen in New Jersey that does less than $50,000 in annual revenue that the stock market values at $101 million as of April 19, 2021.

Disclosure

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

Summary

The stock market’s recovery from the COVID-influenced market sell-off in March accelerated last quarter as multiple pharmaceutical companies announced successful vaccine trials.  This news enabled investors to put a timeline on a return to normalcy.  They responded by shifting some of their assets away from firms that were doing well in the pandemic to those businesses that should profit most from the pandemic being over.  As a result, “value” as an investment discipline actually outperformed “growth” in the fourth quarter by 16.2% to 11.4%<1>, though the full year results remained lopsidedly in growth’s favor (38.5% to 2.8%).  Energy and financial services were the strongest sectors of the market last quarter gaining 27.8% and 23.2%<2> respectively, but neither managed to break even for the full year 2020.  Technology’s middle-of-the-pack 11.8% return kept it in first place for the full year with a 43.9% gain.  Investors have made technology easily the largest of all the eleven sector groups.

With a late surge, emerging market stocks just about equaled the S&P 500’s 18.4%<3> 2020 gain.  China led the major EM countries with a 29.5% gain for the year, but like the U.S. tech sector tapered off in the fourth quarter as EM investors shifted to Latin America and India.  Developed foreign markets trailed the U.S. for the year but outperformed it in the fourth quarter.  Both Europe and Japan gained over 15% in the final quarter compared to the S&P 500’s 12.2%.  The dollar was very weak in the fourth quarter, which almost always really helps foreign market performance.

The U.S. bond market returned a very strong 7.5%<4> last year as yields plunged in response to the Federal Reserve’s efforts to prop up the COVID-ravaged economy.  Only 0.7% of that return came during the fourth quarter, however.  Bond yields bottomed in late summer and rose modestly thereafter such that long term Treasury bonds actually declined in price in the fourth quarter.  The exception was inflation protected bonds (TIPs) which responded well to the fear that all the monetary stimuli would eventually prove inflationary.  TIPs were the best segment of the bond market in 2020, gaining 11.0%.  Investment grade corporate bonds were a close second at 9.9%.  High yield corporate bonds were the best performing segment of the bond market last quarter, rising 6.4%.  They finished the year up 7.1%.

In the wild year that was 2020, it should probably also be noted that gold rose 20.9%<5>.   Its return was negative in the fourth quarter, however, as the world began to look beyond the current crisis.

Activity

The vaccine news in late October sparked a surge into economically sensitive companies on the belief that they would be the biggest beneficiaries when the pandemic ended.  Therefore, the trade in the fourth quarter was to sell safe assets (such as bonds and certain stock sectors) and buy aggressive ones (small cap, value, and emerging market-oriented equities).  While the market moved somewhat away from the celebrated FAAMG group (Facebook, Apple, Amazon, Microsoft, and Google), it still strongly favored smaller disruptive firms like Square, Veeva Systems, Carvana, Datadog, Enphase, and Lemonade.  These are very speculative stocks which in many cases have negative net income (net losses).  We tried to find managers who we thought would be able to navigate this exciting yet dangerous segment of the market, and found ARK, Morgan Stanley, and Alger among others.  We also built up our international stock weighting by adding to both emerging and developing markets.  Many of our exchanges had the purpose of replacing defensive-tilting funds with those in the same category that were more opportunistic, because never in my career I’ve have I seen such a performance difference between established and unproven stocks – not even in 1999.  I don’t know how long the window will be open to maximize risk, especially since it usually closes with no warning, but it is certainly open now.

Figure 1: Growing Euphoria

Source: Peter Boockvar Outlook

First, given the divided political environment, I’d like to highlight the fact that we reminded our clients three months ago that the markets do not care about anyone’s politics.  Markets react to the outlook for future after-tax, inflation-adjusted corporate profits.  Period.  In the short run, the focus is going to be on COVID.  More specifically, did the market get ahead of itself in forecasting recovery or is it right to be looking beyond the pandemic?  I tend to lean toward the former, because the U.S. is behind where we thought it would be in terms of vaccinations at the same time that the virus is apparently becoming more contagious.  The narrative driving stock prices today is the expected pent-up demand post crisis.  While it is true that the stock market has not fully priced in economic recovery, it would still be in for an unpleasant short-term shock if we have to go back to a more severe quarantining environment.  The largest stocks in the S&P 500 have reached an average of 33 times forecasted 2021 earnings, which is in the top 1% of historic valuations.   Only time will tell if today’s investors were prescient or idiotic.  All I know is that it is really difficult to deploy capital for risk averse investors at today’s record high stock prices.  For more aggressive investors, I believe you have to take the risk and hope the current investment environment continues.

Figure 2: COVID Effect on Major Economies

Source: GZERO Media Commentary

The most significant development in 2020 was the rapid acceptance and adoption of new technologies.  The COVID crisis necessitated doing things from home, which dramatically compressed the time it would have taken companies like Zoom and DoorDash to become such a part of our daily lives.  In addition, it shortened the time it took concepts like gene editing and messenger RNA to become mainstream in medicine.  The resulting astronomical price gains in firms harnessing these technologies has led to a complete re-think in the investment community in terms of how we use terms like “growth” and “value”.  Nowhere will one find a better discussion of the evolution of the concept of value than Howard Mark’s brilliant piece, Something of Value<6>.  In it he argues against the simplicity of the traditional price-to-earnings or price-to-book-value approaches to value investing.  I will borrow from his essay liberally in discussing how I believe the stock market has evolved.

At the start of the previous century, it was commonly believed that bonds and preferred stocks were for investing and common stocks were for speculating.  The former paid dividends and had precedence in the event of a bankruptcy, while the latter offered much greater returns if the enterprise thrived.  During the first half of the 20th century, unfortunately, very few companies consistently did that.  Of the original 30 companies Charles Dow used to formulate the Dow Jones Industrial Average in 1896, only one (General Electric) remained an ongoing concern 100 years later – and now even GE has been kicked out.  In such an environment, Marks points out, the conservative “bird in the hand” type approaches tend to be favored.  The investors who became famous, most notably Benjamin Graham and Warren Buffett, were able to use a company’s financial statements to determine with a high degree of precision its present value.  In possession of that information, all one needed was the patience to wait for the company to trade a discount.  Given the manic-depressive nature of investors, “Mr. Market” routinely offered opportunities.

In the late 1960s, however, in response to technology (chiefly the transistor and the integrated circuit) offering improvements in communication and information processing, growth investing was born.  This discipline involved projecting how valuable a company implementing a new technology might become.  Marks stresses that this is inherently a more optimistic approach than value investing, but also subject to being wildly wrong (in both directions).  The first growth bull market came to a crashing halt in the early 1970s as the oil crisis and inflation pummeled the economy; many of those firms saw their orders dry up as the recession hit.  Growth investing got a second life in the 1980s with the advent of the personal computer, but it didn’t really explode until the commercialization of internet technology in the mid-1990s.  That was the biggest growth investing wave until the present one.

The importance of this lesson is not that each growth wave eventually met its end, but that each successive wave advanced growth as a discipline.  Growth investors realized that for companies to have a chance at long term success, they needed access to cheap capital and an investor base that would be willing to tolerate losses (sometimes huge losses) as the business “ramped up”.  That is the defining characteristic of the growth bull market of the 2010s and most especially of the market since the 2021 COVID plunge. Save for the electric vehicle credit, for example, Tesla actually lost money on each car produced until very recently.  Investors have been willing to focus on the future, so losses have been no obstacle for either the stock price or the company’s ability to raise more money by issuing stock. Revenue growth and market penetration have taken precedent.

One of the biggest takeaways from Marks’ letter is that there are so many more people in the investment industry right now relative to last century and more importantly, that they have access to almost infinitely more powerful technology for crunching numbers.  It is extremely difficult, therefore, to generate any advantage from understanding a given company’s financial statements better than anyone else.  This bull market has been led by those whose visions of what these new companies could become was boldest.  All of this being said, it is a completely open question as to how investors would respond to a sharp correction that targeted these new, disruptive companies (note that the COVID sell-off almost from day one punished older, more established company stocks worse).  Would investors hold their ground if Roku and Airbnb stock fell by half while PepsiCo and Caterpillar were going up<7>?  I have never found investors to be capable of holding their convictions for any length of time during which they were losing money while others were gaining.

Marks’ article points out that despite Ben Graham’s reputation for buying companies at less than intrinsic value, his biggest winner in his lifetime was GEICO, a growth company.  Warren Buffett has also benefitted mightily from growth stocks such as Coca-Cola and now Apple.  Success today seems to require intellectual flexibility, or the ability to adapt to what the market was offering you at a given time.  We are rigidly non-dogmatic here at Trademark.  Like everyone else we can determine what is working in the investment world, but we strive to understand why it is working and under what circumstances might it stop working.  Today we have a bull market fueled by low interest rates and an implied promise from Federal Reserve Chairman Jerome Powell that he will continue to provide ample liquidity to markets.  The global economy will almost certainly be much stronger in 2021 than it was in 2020.  These factors seem to warrant paying a higher price for stocks than at any point in the past, and certainly more than I ever would have guessed I would be willing to pay when I started in this business more than thirty years ago.  A super-accommodative Fed doesn’t ensure that stocks won’t decline, but it does suggest that unless investors completely lose their heads that any decline is likely to be muted.  We should continue to be in an environment in which new companies with innovative products can thrive.

<1> Value and Growth performance using Russell 1000 Value and Russell 1000 Growth, per Morningstar

<2> Sector performance courtesy of JPMorgan’s Guide to the Market, 4Q20.

<3> International stock performance from MSCI via Morningstar

<4> Bond performance from BBgBarc averages via Morningstar

<5> Gold return taken from the DJ Commodity Gold Index again via Morningstar

<6> Published in Seeking Alpha, January 11, 2011

<7> Essentially, it was sector rotation that killed off the previous growth bull markets more so than outright recession.

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 gained 8.9%<1> last quarter as investors gained confidence that the worst of the COVID 19 crisis was behind us.  Ten of the eleven industry sectors gained ground, four of them by more than 10%.  The sole loser, energy, lost a whopping -19.7%.  This highlights the huge difference between winners and losers this year.  Technology stocks are up 28.7% and consumer discretionary stocks (think Amazon) are up 23.5% while energy stocks are down -48.1% and financial stocks are down -20.2%.  All of the industries associated with higher dividends (energy, financials, utilities, and real estate) are down, while the next three (consumer staples, communication, and health care) are up only single digits.  2020 has been about buying companies poised to grow from the surging online economy.  This just makes sense given our new COVID world.  The problem for investors is that many of these companies – Roku, Shopify, RingCentral, for example – are still losing money.  Others like Zoom and Tesla trade at price-to-earnings multiples north of 500.  For context, the long-term price-to-earnings average for the stock market is around 16-17.  There is no way to determine whether or not the online economy companies are fairly priced, since so much optimism seems to be baked into their stock price.  Therefore, it is our belief that they are less of an investment and more of a speculation.

Overseas, the returns were also pretty good.  The MSCI All world ex-USA rose 6.2%<2> in dollar terms, with Europe gaining 4.5%, Japan gaining 6.9%, Asia ex-Japan soaring 10.7%, and Latin America falling -1.3%.  Just like in America, the more the region featured technology the better it performed.  Those areas that were more natural resource dependent, such as Australia, Russia and Latin America tended to lag.  A world caught in recession where demand is falling is likely to continue to see weak commodity prices.  At the opposite end, Taiwan (all tech, no resources) rocketed up 16.5%.

Bonds are starting to feel the economic recovery as well.  Modestly rising yields all but wiped out the quarterly gains on treasuries while riskier categories of the bond market had yields high enough to register very decent returns. (Remember, as yields rise bond prices decrease, and vice versa) Overall, the bond market gained 0.6%.<3>  Inflation protected Treasuries (TIPs) soared 3.0% as inflation expectations rose.  Straight treasuries gained just 0.1% at both the short and long ends of the maturity spectrum.  Corporate bonds gained 1.5% as a whole, with A rated bonds up 1.1% and high yield “junk” bonds up 4.6%.  Emerging market debt returned to positive territory on the year with a 2.4% gain.  The relatively weak performance of the U.S. dollar this past quarter improved the return of foreign bonds to dollar-based investors.  It should be noted that more than 100% of the bond gains in the third quarter came in July and August; yields were backing up in September and that has continued into October due to expectations of a stimulus package.

Activity

As it became clear last quarter that the economy had bottomed in the second quarter, we began to take our cash levels down.  Not that we believe the economy is “out of the woods”, so to speak, but the market clearly wants to position itself for the post-COVID environment.  There is no question that the COVID crisis accelerated the adoption of online shopping and networking, so any investment strategist would be remiss not to incorporate that into their portfolios.  Of course, more aggressive portfolios can take greater risks on new and unproven companies.  The trick this year has been getting return for more conservative portfolios, because dividend-oriented stocks are still largely underwater.  In some client accounts, we added hybrid securities – investments which have characteristics of both bonds and stocks, such as convertible bonds – to try to improve returns.

Outlook

Politics can bring out strong emotions and biases, but investors should tune out the noise and focus on the long term. Many factors influence the long-term return of the stock market, but the party in the Executive Branch of government doesn’t seem to be particularly important. See Figure 1. As long as the government continues to function post-election, we’ll be okay.  The markets cares about corporate profits, both short and long term.  They will adjust to whatever reality they are presented with, but I can tell you the ONLY scenario they really fear is a protracted period of uncertainty.

Figure 1: S&P Returns Through Presidential Cycles

Source: Affiliated Managers Group

The main areas of uncertainty today are the length of the pandemic and whether or not our government is able to pass an economic stimulus package that includes direct transfer payments. The recipients of those payments tend to be lower income individuals who spend them quickly thereby spurring real economic growth. Therefore, if 2021 brings a reliable vaccine and a robust stimulus bill, we expect economically sensitive industries like machinery, banking, and energy to outperform technology and health care.

Commentary – Winning the Loser’s Game

Charles Ellis formulated one of the seminal ideas of investing in 1975.  Titled “The Loser’s Game” he argues there are two types of games, winner’s games (in which you play to win) and loser’s games (where you play not to lose).  A winner’s game, like golf, cannot be won by making par on every hole.  Each participant has to strive to do better than everybody else, which necessitates a fair amount of risk taking.  On the other hand, loser’s games, where Ellis believes investing falls, simply requires one to play not to lose.  Because there is no prize for coming in first, there are many risks Ellis argues investors should not take.  If you can avoid big losses, you can stay in the game (invested) for twenty or thirty years – maybe more if you’re young enough.  It’s almost impossible for your assets not to grow if your money is invested in a prudent manner for that long, he argues.

As you read the previous paragraph, you should notice two big caveats; “if you can avoid big losses” and “in a prudent manner”.  Of course, if you were to have bought Microsoft in 1986 and held it, or Apple in 1992, or Amazon in 1997, etc. you might laugh at the idea of caveats.  At some point your portfolio might have been 90% in that one amazing stock, and it still worked out for you.  Unfortunately, most of us are not going to have that kind of experience.  We are not going to find that home run stock way before everyone else, and even if we did, we would probably not be able to hold it during protracted downturns.  Would you have held Microsoft when it lost over 50% between December 31, 1999 and the end of May 2008?  Could you have held it while Exxon and other oil stocks were almost tripling over the same time period?  How about over the next nine months from June 2008 to February 2009, when MSFT would lose a further 40%?

The point is, building considerable wealth by finding and holding one or a small handful of stocks is very difficult.  It’s not something we can plan on.  Hindsight bias makes us think we would have held on to Microsoft but sold General Electric (which has lost over 80% from its peak), but we would probably be kidding ourselves.  If we accept that we are unlikely to strike it rich, we are left with managing our portfolio as a loser’s game – acting prudently and striving to avoid permanent loss of capital by employing diversification and patience.

Under all but the most dire historical circumstances, diversifying by industry type, market capitalization (company size), and geographical location has helped one avoid really big, permanent, losses.  More than four hundred years ago financiers put together syndicates to finance merchant shipping, because nobody wanted to be ruined if all their wealth was in one ship and it sank in a storm.  Today we can use asset classes such as bonds, precious metals and private real estate to better hedge against the risk of large losses.  The tools are there for us to “win” the loser’s game.  The trouble is, investors often are their own worst enemies.

It is very tempting to want to believe you can out-think everyone else.  For example, you may feel the impulse to sell due to the political party in charge of the White House. As we highlighted in Figure 1 above, that’s been a bad long-term strategy. Additionally, the idea that one can extrapolate industry winners from political events is just as misguided.  You couldn’t have done much worse than buying solar stocks when Obama was elected, unless you switched to oil stocks when Trump took office (in both cases you would have lost over half your money).<4>  Of all the harmful forms of conventional wisdom investing, election-related is among the worst.

Right now, investors are very enamored of technology stocks.  This makes sense given how rapidly we are adopting new technologies since the onset of COVID.  That said, the prices we are paying for MOST technology companies are ridiculous by any traditional valuation metric.  Every so often, the valuation rules are re-written to accommodate a hot sector – be it technology, pharmaceuticals, energy, etc.  This lasts until the expectations priced into the stocks get to a point where they cannot be supported by any growth scenario.  Eventually, investors start to realize that everybody else knows this too and the industry “reprices” significantly lower.  One cannot predict when we will reach that point, only that we always have in the past.  Nobody hands out free money<5> and the mathematics of recovering from steep losses are very daunting.

If this sounds a lot like the slow and steady wins the race argument, that’s because it is.  You want to be the “house” in Las Vegas, not the gambler on a hot streak.  There has been a huge, and growing, gulf between winning and losing stocks and industries over the past decade.  It reminds this multi-decade market veteran of past investment manias that ultimately didn’t end well, and so I recall Charley Ellis and his wisdom: keep your losses manageable.  Diversification doesn’t help you win the investing game, but if properly done it helps ensures that you won’t lose it.

<1> Source for all U.S. market and industry returns is JPMorgan Asset Management, 3Q20 Guide to the Markets, page 14.

<2> Source for region and country returns is Morgan Stanley Capital International, per Morningstar Workstation.

<3> Source: Barclay’s Aggregate Bond Index per Morningstar Adviser Workstation

<4> Using Invesco Solar (TAN) as a proxy for solar stocks and SPDR Energy Select Sector (XLE) as a proxy for the oil market.

<5> Once again Warren Buffett said it best “Nothing sedates rationality like large doses of effortless money” in Berkshire Hathaway’s 2000 Annual Report.

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

It probably comes as a surprise to no one, but the first quarter of 2020 was the worst first quarter in modern market history.  The stock market lost -19.6% during the quarter, but even that fact masks the truly awful stretch between February 20th and March 23rd in which the S&P gave up more than a third of its value.  That kind of drop from an all-time high (February 19th) is also unprecedented.  It was as if the stock market suddenly hit a brick wall.  The decline in international stocks was worse at -22.8% and downright terrifying in the small cap arena which was down -30.6%.  We all know why stocks went down but the speed of this decline was what was truly unique. It was augmented by computer trading programs. These trading systems had spent years over-investing in stocks because stock volatility continued to trend lower.  As volatility suddenly soared in March, stocks became an increasingly risky asset to hold, meaning more and more stocks needed to be sold in order to hit target volatility. This vicious feedback loop led to -6%, -7%, -9%, and -12% days in the S&P 500.  It was very hard to make a “good sale” on a very bad day, and this extreme market action spilled over into the bond market as well.

Bonds theoretically do not need the issuing company to thrive, as stocks do.  They just need the issuing company to remain solvent.  The price of bonds should be impacted by only two factors:  is the company able to service the debt (default risk) and does the interest I’m getting compensate me fairly for the risk to my purchasing power when I get my principal back (inflation risk)?  Last month, however, we saw bonds that had no risk of default plummet in value in an environment where inflation was of no immediate concern whatsoever.  The reason was liquidity.  In other words, owners of Treasuries, mortgages, corporate bonds, and municipal bonds were dumping them because they needed the cash to meet other obligations.  For example, many foreign governments sold U.S. Treasuries because they needed to push down the value of the soaring dollar versus their own currency to avoid a debt funding crisis.  Insurance companies and other financial firms sold all types of bonds in order to raise cash because they expected a surge in claims. That need to suddenly raise cash created a liquidity crisis in which, from March 9th to March 22nd, there just were not enough buyers for all the motivated sellers! As a result, bond prices became temporarily uncoupled from the underlying fundamentals of the issuing entity. This made portfolios a lot more volatile, for a few weeks, than they ever should have been.

In time, there will be enough buyers for the bonds and then some. One just has to remember that bonds don’t trade like stocks in the way that you always know at what price the market is trading and can expect to be able to buy or sell at that price.  They don’t flash bond CUSIPs across the screen on CNBC for a reason.  That said, massive government intervention into the bond markets did start to stabilize prices on March 23rd.  Treasuries and agency backed mortgages were largely able to recover by the end of March.  It would take another huge government intervention on the 8th of April to help bring the corporate and municipal sectors of the bond market more into line with actual default risk.

We are still not yet out of the woods with regard to the risk of the sell-off in stocks and bonds resuming, but for now investors believe in the Federal Reserve and the Treasury Department’s willingness to do whatever it takes to prevent a free fall in U.S. asset prices.  This has had a tremendous calming effect.

ACTIVITY

While we can’t say we saw the Coronavirus coming, we can take pride in having started the risk reduction process back in February.  We started by slashing broad stock market exposure through index ETFs, then in March continued to raise cash through the trimming of foreign and small cap stocks. We also went through all portfolios in order to replace funds that were performing poorly relative to their peers, or where we were not confident in their rebound potential.

As the government took steps to underpin the bond market later in March and into April, we began buying bonds with some of the cash that we had raised. We still have higher than normal cash levels in many portfolios, but now having bought the higher quality bonds we wanted that cash will go to stocks -when prices better reflect diminished earnings expectations.

OUTLOOK

We do not believe anyone has a playbook for where we are now. We believe that the economic damage done by the virus will be measured in months and years instead of days and weeks, so while we are happy that there has been a nice rebound in stock prices, we are playing the long game.  We believe that it will be extremely difficult for the government to get needed funds to all the sectors and sub-sectors of the economy quickly enough to avoid a very deep recession. Just like the 2000-02 and 2007-09 bear markets, we expect several rallies during the course of this bear market, all but the last of which will fail.

That said, the stock market has its own internal logic. It will often not go up or down when you think it should. One of its favorite tricks is to stampede investors in one direction and then quickly reverse itself in order to put pressure on those who got in or out late and are suddenly looking at losses (or missed profits). Despite today’s double-digit unemployment rate, if market participants believe that there are profits to be made in buying remote communications or anti-viral biotech stocks and/or squeezing those that are short or underweight stocks, the market can move higher for a while. That just isn’t a bet we want to make because at heart we are not traders.  We like to put the odds in our favor. Right now, we believe that means overweighting bonds and cash because we know that the government is actively purchasing them. This has the effect of putting a floor underneath prices. You can’t make money in bonds nearly as fast as you can in stocks but your odds of a significant loss are much lower.

COMMENTARY

When we wrote our Commentary three months ago, there were a few points we really wanted to make. We obviously didn’t expect the market to sell-off immediately, but we knew both valuation and investor sentiment were extremely high, and we knew that particular combination was traditionally associated with market peaks, not bottoms. We presented two charts, the first of which showed the stock market being 130% above its long-term regression line, which was the highest reading in history. Chart 1 below is an updated version of that chart through April 1st.

Chart 1

Source: A Perspective on Secular Bull and Bear Markets by Jill Mislinski.

The second chart highlighted investor sentiment with CNN’s Fear and Greed Index flashing extreme greed. Chart 2 is updated through April 20th below.

Chart 2

Source: www.money.cnn.com/data/fear-and-greed/

The problem with these indicators as a timing tool is that the same factors were present in January 2018. In that instance we got a 10% correction and then new highs by September. As any Minnesotan knows, hearing the ice creak does not necessarily mean you are about to break through it. But you don’t ignore it either.  This time, with the added weight of a global viral pandemic, we broke through hard.

Both valuation and investor sentiment have retreated considerably at this point, but stocks are still higher than their long-term averages. This is not the what the bottom of a bear market looks like. At generational market bottoms, like we saw in the 1930s and 1970s, investors are not thinking about how much they can make in the darlings of the moment (today Amazon, Zoom Video, Netflix, etc.); they aren’t thinking about the stock market at all.  They have been so badly burned by false rallies that they have given up.

The positive point to consider now is that with lower stock prices, we can think in terms of stocks being able to provide mid-to-high single digit annual returns going forward. This is an improvement from the mid-to-low single digit annual return expectations that we started the year with. We have begun to nibble at stocks in some portfolios, but we also believe more downside volatility is likely. Before this bear market is over, we may get the opportunity to buy stocks with double digit return expectations. Again, we are currently more attracted to bonds because of the higher probability of (modest) success. It is our continuing aim to provide attractive risk-adjusted returns to our clients. When it is not possible to accurately measure risk, as is the case today, you can expect us to err on the side of caution.

Thanks for your continued trust in our management,

Mark A. Carlton, CFA

The Standard and Poors 500 Stock Index, per Morningstar Workstation

International stocks as measures by MSCI EAFE and small cap stocks by the Russell 2000 Index, both per   Morningstar Workstation

Note: If it were possible for any government to get all the money and resources necessary to all of the sectors that need them efficiently, then capitalism is probably not the best economic system.

Annual Notice

As a registered investment adviser, we provide certain important information to you on an annual basis, which is included in this Annual Notice. Our most recent disclosure statement as set forth on Form ADV Part 2 and 2b is now available. There have been no material changes since the February 11, 2019 Form ADV Part 2 brochure. If you need a copy at any time throughout our relationship, please call us at (866) 944-0039 or send an email to john@trademarkfinancial.us. A copy is also available on the Internet at our website, www.trademarkfinancial.us. Additional information regarding our firm is also available at www.adviserinfo.sec.gov. Please contact us or your financial adviser immediately if there are any changes in your financial situation, investment objectives, email address, or if you wish to add or modify any reasonable restrictions to the management of your account. As always, should you have any questions or require any additional information regarding this Annual Notice, please do not hesitate to contact us.

We also asked, at the end of the last commentary, “in an environment where most investors are fully committed, who does the buying if there is a mad rush to get out?”  Unfortunately, we got our answer. The adage that markets take the stairs up and the elevator down was proven once again.

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 third quarter of 2019 paled in comparison to the previous two quarters as global weakness and trade fatigue combined to depress returns.  Even a widely expected September rate cut could barely elicit a “ho-hum” from investors.  While corporate profits once again exceeded expectations for most companies, future guidance was not very encouraging.  CEO’s cited trade uncertainty and difficulty finding qualified job applicants as their biggest concerns.  This was especially true among smaller companies, who seemed to have had a more difficult time attracting talent than their bigger rivals.

With this in mind, the large cap S&P 500 was able to post a 1.7% quarterly gain while the smaller cap Russell 2000 shed -2.4%.  As a sign of how much trade has impacted market performance over the past year, large company stocks are up 20.5% for the first three quarters of 2019 but up only 4.2% over the last full year (trade concerns hit the market hard in 2018’s final quarter).  Small cap stocks are up 14.2% year to date but down -8.9% over the past twelve months.  Though all eleven S&P industry groups have gained year-to-date, three (energy, health care, and materials) were down last quarter.  Energy’s -6.2% decline was by far the worst.  Technology’s 31.4% gain is best on the year, but two interest rate sensitive sectors (utilities and real estate) were the big winner last quarter.  Read this as a vote of little confidence in the economy – a rapidly growing economy consumes more energy and raw materials and its demand for credit to finance expansion usually drives interest rates up, which tends to hurt utilities and real estate the most.

With the point having been made about the importance of trade, it is no surprise that foreign markets lagged both last quarter and year-to-date.  The -1.1% decline last quarter knocked foreign market returns down to 12.8% for the year in dollar terms.  Japan, which is not currently in a trade conflict with the U.S., gained 3.1% last quarter.  Europe and China, which obviously are, lost -1.8% and -3.8% respectively.  Latin America, a major supplier of raw materials to China, dropped -5.6%.  Canada posted a 0.4% gain last quarter and has a strong 21.5% gain for the year.

Low interest rates continued to be a tailwind for the bond market.  The Aggregate U.S. Bond Index rose another 2.3% last quarter, running this year’s net gain to a stellar 8.5%.  High yielding corporate bonds gained 1.3% last quarter, while much safer short-term U.S. Treasuries were up just 0.6%.   Emerging market debt was all over the place last quarter, but according to Barclays the aggregate return was 1.3%.  The key to return last quarter was to take as much interest rate risk as possible (in order words, long maturities).  This is easiest to accomplish in the government and municipal sectors.

ACTIVITY

Almost all of our trading activity last quarter was due to individual security performance.  We did not make any structural shifts in either the stock or the bond sides of the portfolio.  We increased gold exposure a little bit while reducing or eliminating managed futures in the accounts that had those positions.  In aggressive portfolio we made some small adjustments to sector ETFs.  That said, the far greater part of our activity was improving portfolios through replacing or trimming laggard positions.

OUTLOOK

Nobody knows what lies ahead for the financial markets.  Not me, not Ken Fisher, not Jim Cramer; nobody has a crystal ball.  Under the best of circumstances, forecasters have to try to predict the rate of economic growth and the direction of interest rates (which is a hard-enough job as it is).  Today our job is even more difficult.  We have multiple trade battles and (as of this writing) an impeachment inquiry to try to predict the consequences of.  There is really no precedent for the complexity and uncertainty we face.

That said, to have made portfolios defensive has thus far proven to be a recipe for under-performance.   While the headline risks are well-known, the stock market has held up very well when you consider that investors have been, in aggregate, selling stocks and buying bonds.  Markets might go sideways when investors are pessimistic, but I’ve never seen general pessimism make them plunge.  Plunges almost always happen when investors get overly optimistic about stocks and then get disappointed.  Given investors modest dislike for stocks today (relative to bonds) the worst I can foresee in the next few months is a period of moderate weakness (and a surge to new highs would not surprise me at all).  Of course, my crystal ball is still on backorder!

COMMENTARY – QUESTION AND ANSWERS

Here are four questions we’re frequently asked that I’d like to address.

Why do you hold cash (given that money market yields are so low)?

We like to hold some portion of every account in cash due to investor liquidity needs and for quarterly management fees.  Beyond that, we hold cash because of its “optionality”.  In other words, it’s ability to be deployed wherever we want at a moment’s notice.  One conceptual use of cash is as a hedge.  Imagine there was a development that was an obvious and immediate negative for the market.  The ability to immediately use cash to buy an ETF with a negative correlation to the market would enable us to quickly hedge part of the downside.

Why doesn’t the market always decline on bad news (and why does it sometimes drop when there is good news)?

Markets do not move on news per se.  They move on the news relative to what the market was expecting.  An interest rates cut that everyone expected does not create a market rally.  The information was already priced in.  An interest rate cut that was merely hoped for can create a rally.  If say 30% of investors did not expect the cut and were therefore positioned for disappointment, the cut forced that 30% to change their strategy (most likely to buy) which helped drive the market higher.

You may have heard the phrase, “buy the rumor, sell the news”.  The meaning of this is that once news is out and absorbed by everyone, it has no more power to drive markets.  It follows that if you sell into bad news, you are betting that others have not yet absorbed the bad news and will be sellers once they do, thus you are beating them to the punch.  Either that or you are betting that the bad news is just the beginning of much more bad news to come.

What is a reasonable rate of return expectation for the next ten years?

This is a very difficult question. As I referenced above no-one has a crystal ball and I agree with Yogi Berra when he said, “it’s tough to make predictions, especially about the future”.  I would approach it by asking what I thought I could expect from the stock and bond markets and then average those two returns.  That said, we track market predictions from seven different highly respected asset managers, including Research Affiliates, MFS, Blackrock, JP Morgan and GMO.  Each of those managers devote tremendous resources to estimating future market returns. At the end of 2018 their 10-year annualized U.S. stock market return expectations ranged from -4.2% to 7.7%. That’s a giant range. And remember, the people creating those forecasts are very bright and work hard to make reasonable estimates. If we take the average of all their predictions, our 10-year return expectation for the U.S. market is 3.5%, annualized. You might now ask, how helpful is that figure? We’d answer not very. It just strengthens our belief that no one truly knows where the market is headed, and successful investors will remain invested in a globally diversified portfolio of stocks and bonds consistent with their unique risk tolerance.

Why do you make small movements in response to market turmoil (why don’t you just sell everything when markets are in decline)?

Because we never know how bad the turmoil is going to be, and we cannot assess how fast authorities will act to restore confidence.  There are times, perhaps 5-10 per year, when we sense the market is vulnerable.  Maybe there has just been a weak economic report.  Job growth was less than expected or consumer confidence declined, for example.  Or maybe it was something technical, like the stock market rallying to a point just short of its previous high, then selling off sharply.  Most experienced market professionals will get a kind of “thin ice” feeling when things like this happen.  In my experience, however, these things lead to meaningful (10% or more) declines maybe only one time in five.  The truth is that most 3% declines don’t turn into 10% declines, most 10% declines do not turn into 20% declines, and most 20% declines do not turn into 50% declines.  Statistically, selling into weakness is going to be wrong, and you will wind up buying back in at higher prices than you sold out at.  Knowing this, I might want to trim or shed the position I had the least confidence in going forward but selling everything just means I might turn a small mistake into a large one.

Vanguard recently published some research on the effects of selling during periods of volatility. A hypothetical 60% stock 40% bond portfolio that stood at $1 million on the morning of November 1, 2018, would have lost -5.7% of its value by Christmas Eve. Yet selling the portfolio at the time and fleeing the markets, even briefly, would have cost an investor tens of thousands of dollars in two months, as stock recovered all of their losses by the end of January. See Exhibit 1.

Exhibit 1

Source: Vanguard

The other reason we don’t was hinted at in the first sentence of the last paragraph.  Because the authorities have decided over the last decade or so that market declines were intolerable.  It is important to note that this did not happen previously.  The Federal Reserve was tasked, prior to 2008, with regulating the supply of credit to prevent depressions and inflationary outbreaks.  Today when stocks decline more than about five percent, investors and the financial media scream for the Federal Reserve to cut interest rates.  September’s rate cut did not come in response to any measured economic weakness.  Unemployment has trended down since 2008 and is at a five-decade low of 3.5% for goodness sake!  No, the recent rate cut came because many investors feared the trade war was slowing down global growth enough that the effects might spill over here.  Stock investors needed pro-active reassurance that the Powell–led Fed “had their back”.

Some of you may interpret this as a reason to be extra aggressive.  After all, if the Fed is going to ride to the rescue of stock investors every time they get into trouble, being aggressive may feel as though it just isn’t that risky anymore.  Certainly, that has been a profitable strategy over the last ten years.  Those that have generally not taken extra risk (we count ourselves in that number) are concerned that cutting rates and “quantitative easing” would not be very effective if a full-blown crisis arrived.  The best analogy is probably the forest fire.  Years and years of putting out small economic “fires” may mean that the big one will be much worse when it finally occurs.

Thanks for your continued trust in our management,

Mark A. Carlton, CFA®

Return data courtesy of S&P and Russell, respectively.  S&P is the proxy used for large company stock returns and Russell for small companies.

Industry/sector returns are courtesy of S&P.

Foreign returns courtesy of MSCI international per Morningstar.

Bond returns courtesy of Barclays per Morningstar.

U.S. stocks represented by CRSP U.S. Total Market Index. U.S. bonds represented by Bloomberg Barclay’s U.S. Aggregate Float Adjusted Index. Global stocks represented by FTSE Global All Cap ex US Index. Global bonds represented by Bloomberg Barclay’s Aggregate ex-USD float adjusted RIC capped index. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Disclosure

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

SUMMARY

The second quarter of 2019 is in the books, as they say, and it was another good one for both stocks and bonds.  US equities once again outperformed both non-US developed and emerging markets equities. The key to market gains was Federal Reserve Chairman Jay Powell’s capitulation on interest rates.  Ordinarily, the Federal Reserve does not cut interest rates during a period of strong market performance for fear of stoking investment speculation.  Nowadays, however, restraint is an old-fashioned notion.  Investors have understandably reacted to the idea that credit would become both easier to obtain and less expensive in the same way a child would if you told them that there would be two Halloweens this year.  Yay! More candy!  See Exhibit 1 for a market summary.<1> Concerns about trade wars, Iran, North Korea, etc.  have all taken a back seat, at least for now.

Exhibit 1: Second Quarter Market Returns

According to JPMorgan, financial, materials, and technology were the three best industries gaining 8.0%, 6.3%, and 6.1% respectively.<2>  Only one sector declined last quarter, health care (-2.8%).  The yield on the 5-year Treasury note declined by 47 basis points (bps), ending at 1.76%. The yield on the 10-year Treasury note fell by 41 bps to 2.00%. The 30-year Treasury bond yield decreased by 29 bps to finish at 2.52%.<3>

Interest rates plunged during the quarter as investors began to anticipate interest rate cuts.  It is somewhat paradoxical to argue that the economy is strong yet continued economic growth requires ever lower interest rates, but here we are.  Every category of bonds rose, with riskier ones tending to gain the most.  Emerging market debt has done the best this year since lower interest rates reduce the relative attractiveness of the US dollar, causing its exchange rate to decline.

International markets rose last quarter for the most part.  Economically speaking, there was a fairly sharp deterioration in the Euro area with Germany contracting the most.  In the emerging world, the economies Taiwan and South Korea fared the worst.  It is no coincidence that these three countries depend on exports – which were strongly affected by the ongoing trade conflict between the U.S. and China.  That said, European stock markets mostly performed quite well due to massive interest rate declines (in many cases to less than 0%).  Russia and Argentina had two of the best performing stock markets in the first half of 2019.

ACTIVITY

Given the decline in interest rates and resulting impact on markets, the only “wrong” asset to have last quarter was cash.  We reduced the cash position in many portfolios by adding marginally to both stocks and bonds.  In bonds, interest rate sensitivity was a positive, so we tried to lengthen duration by adding longer term treasury bond exposure.  On the stock side, we increased our weighting to funds that emphasized certain sub-sectors that were thriving – insurance within the financial services sector, payments processing (think Visa, Paypal, and Mastercard) within the consumer discretionary sector, and data infrastructure within the real estate sector (think cell towers).  Oh, and owning funds that over-weighted Microsoft and underweighted Alphabet (Google) also helped.

OUTLOOK The average person might still be a little skeptical about this year’s stock rally, but active investors aren’t.  A lot of money has been committed to the markets over the last several weeks as Fed Chairman Powell’s decision to reduce short term interest rates is seen as a done deal.  How can a professional not be “all-in” knowing a rate cut at the July 31st meeting is all but assured?  As such, there is a very real risk that investors will “sell the news” once the cut is announced.  Three decades in this business has trained me to be cautious when I know everybody is on the same side of the trade.  While there might be a pick-up in volatility in the short run, I don’t see a significant correction as long as interest rate cuts are on the table.  In fact, I wouldn’t rule out a 1999-style upside blow-off as investors contemplate the possibility of several rate cuts before the 2020 election.  This is not a contradiction; I’m just describing two very different but highly plausible scenarios.

On one hand, despite the U.S. stock market’s having gained roughly 20% so far this year, investors are not especially exuberant.  If they go all-in on the idea that we will have very low interest rates and unusually high profit margins for years to come because the Federal Reserve is all powerful (when it comes to using monetary policy to fight off recession) then we could go much higher.  On the other hand, most areas of the US stock market are already expensive based upon historical levels of interest rates and cash flow.  If the economy slumps and the Fed is unable to revive it with its monetary tactics (and as a result the “all-powerful Fed” narrative crumbles) the downside could be considerable.

HOW THE INVESTMENT WORLD HAS CHANGED

When I began the Chartered Financial Analyst program in 1993, the financial industry was firmly convinced that the stock markets were efficient.  In other words, if a stock sold for $50 per share, you could be sure it was worth $50 per share, because if it sold for $47, investors would rush to buy it and if it sold for $53, they would rush to sell it.  Another name for this process of determining a stock’s intrinsic value is price discovery.  The only way to outperform the market was to discover something about the company or its industry that was not common knowledge and therefore not priced in.  As a result, large investment firms sought preferential access to company management, while less well-connected analysts either pored over financial reports looking for a clue everybody else missed or made visits to a company’s suppliers and customers.

By the end of the decade, however, investor behavior had radically changed.  Internet mania was in full swing.  Conventional analysis could not explain why investors should pay three-digit prices for companies that were losing money, yet that is precisely what they did.  Almost nobody was still selling overpriced companies short – to do so was financially suicidal.<4>  After all, while there was no value-based justification as to why PMC Sierra (PMCS) was trading at $140, you couldn’t be sure it wouldn’t go to $160 or even $200.  Price was a completely separate thing from intrinsic value.  As such, it might be reasonable to buy PMCS if it broke above $150 (thereby confirming that momentum was intact) but you certainly wouldn’t buy it at $90 (because that price would only be reached if something disastrous happened to the stock or the market as a whole, in which case the stock could go a lot lower).  And that is exactly what happened, not just to PMCS but also to Palm and Sun Microsystems and Lucent and ADC Telecom and so many more.

Famed investor Warren Buffett likes to say that when stocks drop he rejoices like other people do when peanut butter or dish soap prices drop, because he can buy more and save money.  And that makes intuitive sense; everybody should want to buy low and sell high, right?  Not anymore.  It has become a buy high, sell higher world.  A low price suggests there is something wrong with the company; perhaps it can’t compete in today’s digital world.  A high price means just the opposite.  Companies can see their stock appreciate, even to comically high levels, if they can control both the float (number of shares available to be traded) and the narrative (the commonly held idea about how a company will perform in the future, largely as a function of how it is positioned to benefit/suffer from the way the world is changing).

When a company’s narrative matters way more than what its financial statements say, there is tremendous room for error.   Though it isn’t a company, let’s think about Bitcoin.  The bitcoin narrative is that it is the currency of the future.  It rose exponentially because nobody could really tell you what it was worth, but everybody knew that in the future we’d probably all be using it.  Who was to say it wasn’t worth $15,000 per coin? Or $50,000 for that matter?  Yet when the narrative broke (as fears grew that world governments were going to outlaw it) and it started falling in earnest, there was no natural level that would support it.  Would it stop at $7,000? $4,000?  $100?   Who knew?  As Ben Hunt wrote in Epsilon Theory, “the only determinant of price for a non-cash flowing thing is Narrative”.<5>

By contrast, a bond gives you a series of payments and then at maturity you typically get your principal back.  You can use basic math to put a value on that income stream.   Similarly, companies generate a stream of revenue through sales.  If this revenue exceeds the cost of generating it (including taxes and depreciation), you can put a value on the excess cash flow (we call it earnings or net profits) whether they are used to pay a dividend or buy back stock or simply retained on the balance sheet.

Investment assets are generally valued on the basis of the present value of all expected future cash flows.   Cash flow should, theoretically, temper one’s ability to attach a ridiculous valuation to a stock because you can always use math to determine what future cash flow expectations are embedded in the stock.  This is something you cannot do with a Picasso or a 1955 Mickey Mantle baseball card because they are non-cash flow producing assets.  Occasionally, however, investors make outlandish projections about the future growth of a company because they fall in love with the narrative.<6>

The valuation today of Beyond Meat, for example, suggests investors expect a very high growth rate, persistently generous margins, and very little competition.  Yet the essence of capitalism is that if a new company takes the market by storm it attracts competitors which fight it for market share and depress profit margins.  The fundamentals cannot in any way justify a price which as of 7/12/19 is 100 times sales, but a small float and an extremely enthusiastic narrative have pushed it up over 6-fold since the May 2019 IPO. Beyond Meat, along with Tesla and Uber and most of the cannabis companies and many other nonprofitable companies now public, constitute an increasing share of today’s stock market.  Yet they trade at valuations that may have very little support if market sentiment – the broad market narrative – should turn negative.

Don’t get me wrong, our world is changing rapidly and those firms that can innovate or position themselves to benefit from the innovation of others may well have a very bright future.  But words like “disruption” are being thrown around like “clicks” was twenty years ago (especially in the private equity sphere).  We are again, I fear, over-projecting the rate at which the world will change.  In doing so, we expect profits from new disruptive companies to arrive sooner and be larger than they probably will be.

Investors believe that low interest rates are their friend because they enable securities to trade at higher prices – because the present value of future cash flows is higher when interest rates are low.  The problem is that low interest rates destroy market discipline.  PMC Sierra and Bitcoin could not thrive in a high interest rate environment because investing in non-interest-producing assets gets tougher as rates rise.<7>  Low interest rates are enabling private companies to get financing without going public, and when they do go public it is under terms (often without voting rights and at aggressive valuations) that are designed for speculators, not investors.

I began my financial career when the structure of the market (floor traders, high liquidity, proprietary trading desks, low investment turnover, etc.) encouraged price discovery, which favored stable prices.  Today’s market structure (high turnover, algorithmic trading, low institutional liquidity, etc.) has evolved to favor momentum trading, which is inherently MORE risky even though it is usually LESS volatile on a day-to-day basis.  Rising stocks keep rising and falling stocks keep falling.  Intrinsic value is meaningless. When a stock goes up steadily for a long period of time, we tend to see it today as less risky than a stock that has been choppy and/or gone mostly sideways because we have learned to focus on an asset’s price trajectory – not on its value at the current price.  In doing so, we risk dramatically overpaying when the investment climate changes.

We are doing our best to be sensitive to the current (bullish) narrative while also being aware of how quickly investor attitudes can change.  Momentum can suddenly reverse.  We believe we’ve done a good job lately of participating in the low interest rate/disruptive technology led bull market.  That said, knowing the risks as we do, we will get defensive from time to time as the factors that are driving the rally appear to weaken.  It’s a balancing act, and we are never going to get it perfectly right, but we believe it is a more client-friendly alternative to the steep periodic losses that the buy-and-hold approach offers.

Endnotes <1> Source: Dimensional Fund Advisors. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index ), Emerging Markets (MSCI Emerging Markets Index ), Global Real Estate (S&P Global REIT Index ), US Bond Market (Bloomberg Barclays US Aggregate Bond Index), and Global Bond Market ex US (Bloomberg Barclays Global Aggregate ex-USD Bond Index ). S&P data © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2019, all rights reserved. Bloomberg Barclays data provided by Bloomberg.

<2> 3Q19 JPM Guide to the Market

<3> Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Market segment (index representation) as follows: US Stock Market (Russell 3000 Index), International Developed Stocks (MSCI World ex USA Index ), Emerging Markets (MSCI Emerging Markets Index ), Global Real Estate (S&P Global REIT Index ), US Bond Market (Bloomberg Barclays US Aggregate Bond Index), and Global Bond ex US Market (FTSE WGBI ex USA 1−30 Years ). S&P data copyright 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. MSCI data © MSCI 2019, all rights reserved. Bloomberg Barclays data provided by Bloomberg. FTSE fixed income © 2018 FTSE Fixed Income LLC, all rights reserved.  Source: Dimensional Fund Advisers

<4> A short sale happens when an investor borrows shares from another market participant and sells the shares prior to hopefully buying them at a lower price at some point in the future. At its core, it’s a bet the stock will decrease in value.

<5> Epsilon Theory – The Spanish Prisoner, 07/05/2019

<6> Thirty years ago, stocks that ran way ahead of intrinsic value would have been sold short.  Today, new companies often offer to the public a small fraction of the stock issued, with insiders holding onto the majority of the stock.  This makes shorting very difficult, because being “squeezed” (or forced to buy back the stock at a higher price) is a significant danger when the “float” is small.

<7> If interest rates are 2%, for example, I forego very little income investing in something that pays 0%.  I just have to believe it will appreciate more than 2% annually.  If I believe it will appreciate 10% annually, and my borrowing cost is 3% over short term rates (2%+3% = 5%), I would be justified in leveraging my exposure to that asset.  If, however, interest rates are at 6%, the equation is very different.  I have a much more significant income penalty to make a non-yielding investment.  Leverage is so expensive (9%) that the investment is hardly worth the risk.

Disclosure

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

Summary

Stocks rebounded sharply in the first quarter as investors reacted favorably to the Federal Reserve’s change of heart on interest rates.  When Fed chairman Jerome Powell said back in early January that the rate hiking cycle was over and that the Fed’s balance sheet was not going to contract any further, the market abruptly stopped pricing in recession for 2019 and instead started discounting a profit recovery later in the year.  Over the years we have discussed the importance of liquidity – greater liquidity tends to be better for risk assets; this is yet another example of how a positive change in market liquidity can lead to a strong rally.

Arithmetically, last quarter’s 13.65%<1> S&P gain does not completely erase the previous quarter’s -13.52% loss<2>, but it sure feels a lot better.  The small cap Russell 2000 gained 14.58% last quarter but is still down -8.56% over the previous two quarters combined.  See Exhibit 1. That said, I don’t think anybody really hoped we could erase those steep fourth quarter losses in just three months.  Markets are sometimes said to take the escalator up and the elevator down, so when stocks rise almost fast as they previously fell, that tends to be a good sign.  In my experience, at least.

Exhibit 1

S&P 500 and Russell 2000, 9/30/2018 – 3/31/2019

Source: YCharts

It is also encouraging that international markets largely kept pace with the U.S. market’s advance.  In fact, in local currencies many foreign markets performed better.  There really wasn’t any poorly performing major foreign market last quarter, despite evidence that global growth was slowing.  According to Barrons<3>, world equity funds were up 11.64% (in dollar terms) last quarter.  China led the way, while India and Latin America were among the bottom performers.  Despite the fiasco that is Brexit, European stocks rose 10.38%.

It was also a good quarter for bonds.  Falling inflation and a more friendly Fed created a favorable environment for every area of the bond market.  High yield bonds performed the best with a gain of over seven percent<4>, but even short-term treasuries, the least volatile bond category, gained 1%<5>.  That is an unusually good return for one quarter, considering bonds have averaged 2.74% per year over the last five years<6>.

Activity

We didn’t over-react to stock market weakness during the fourth quarter of 2018, and as such were not in the position of being forced to buy back into the market at higher prices during the first quarter (not that we didn’t add a little here and there).  There were a few moves to be made at the beginning of the year in foreign stocks (which we had trimmed late in 2018).  We also increased our exposure to international bonds more recently once the U.S. Fed signaled an end to the interest rate tightening cycle.  That takes the pressure off foreign central banks, making it easier for them to cut rates in response to the weakness in their economies without worrying about currency depreciation (and capital flight).

Outlook

Going forward, we are looking for a catalyst to break out to highs above those we saw in September and January of 2018 (approximately 2935 on the S&P 500).  Investors are hoping that a comprehensive trade deal between the U.S. and China will be that catalyst, but the market may well view the trade deal to be a “buy-the-rumor, sell-the-news” event absent meaningful and enforceable intellectual property guarantees.  Good luck on that!  In the meantime, I believe the U.S. stock market will eventually challenge the old highs on lack of bad news more than anything else.  Stocks are still expensive on a price to sales and price to cash flow basis, but decent investor demand combined with corporate stock buybacks continues to provide a tailwind.  The concern I have is that the November through April time period is traditionally more favorable for stocks than the May through October period, so a failure to make new highs by Memorial Day (should that occur) may cause market psychology to deteriorate.  That said, if Fed policy remains easy, market liquidity is plentiful, and signs of imminent recession are scarce, we will probably not get defensive in any major way.

Commentary – It IS Different This Time Editor’s Note: This commentary takes inspiration from Ben Hunt’s April 17th issue of Epsilon Theory, titled “This is Water”

Quite a while ago I wrote a Commentary entitled It’s Not Different This Time.  My thesis was that although technology stocks were behaving as if we had entered a new era in which profitability did not matter, eventually companies that don’t generate net profits don’t survive.  The idea of the title came for one of my mentors, who very early in my career told me to be extremely careful every time I heard the words ‘It’s different this time”, because it’s never different this time.  His point was that we are in a perpetual market cycle of recovery-optimism-euphoria-anxiety-panic-capitulation-recovery.  The details change from cycle to cycle but those human emotions don’t.  Insofar as the discussion relates to investor behavior, he was absolutely right, of course.  That said, there is another way to look at market cycles of the past and to conclude that it is, in fact, quite different this time.

Ben Hunt’s article, which everyone should read, makes the point that capitalism works because of its dynamism.  A company or an industry thrives because underlying conditions turn favorable or because it creates those conditions.   Those industries or companies are therefore able to generate higher profit margins.  New companies then enter that space to try to capture a share of the higher profits.  Also, employees of the higher earning company want to be paid more as a result of the higher profits they are helping to generate.  Eventually these and other factors combine to push margins back down.  Reversion to the mean also works in the opposite direction.  Poor financial results in an industry drive firms out of business and wages down, such that surviving firms have an improved competitive landscape.  Hunt goes on to state that if economic dynamism is lost due to “financialization”, or the ability to generate higher profitability without having to sell more products or services, it isn’t really capitalism any more.  He cites dramatically reduced corporate tax rates and super low interest rates as factors that have allowed corporate management to say to employees essentially “you are not the reason for our excess profits, so we are not sharing them with you.  We are reserving them for shareholders and for ourselves, as we have been smart enough to leverage these low interest rates and buy the right politicians”.

So here we are.  In an environment of low inflation, low productivity, and low growth.  Where running large deficits does not lead to spiraling inflation.  Where the Federal Reserve can essentially keep the business cycle out of recession almost indefinitely by expanding credit.  And where a few investors have said to me lately (more or less), “if this is all true, why not turn the “risk knob” up to 11”?

Fair question.  I guess the best explanation is that my investing career began in 1986.  I remember October 19, 1987, when stock dropped -22.3% IN ONE DAY.  I learned a strategy (in that case it was called portfolio insurance) that involves selling when the market drops a certain percent may work for a small group of people, but if EVERYBODY adopts the very same strategy it will not work for ANYBODY.  I learned on August 2nd, 1990 when Iraq invaded Kuwait that you can focus on a myriad of geopolitical hot spots and still fail to forecast the one that blows up in your face.  I remember in 1998 how the smartest financial minds in academia made more than four billion dollars disappear in the Long Term Capital Management fiasco.  From that I learned that just because you create a model that says a certain event should occur no more frequently than once in 10,000 years doesn’t mean that it won’t happen (or that your model is correct).  From the late 1990s tech wreck I learned that if the markets reward revenues instead of profits, eventually people will sell dollar bills for 99 cents.  From the financial crisis of the 2000s I learned that just because a particular aggregate price had never declined before (in this case housing) doesn’t mean it never could.  We all also learned from Chuck Prince of Citigroup that Wall Street firms will do things they know are stupid as long as everybody else is doing them.

The point of all this is to say that every time the market has indulged in behavior that suggests it believes it has found the key to perpetual prosperity there has eventually been a train wreck.  We just had a -19% stock market correction because the Federal Reserve raised the federal funds rate to 2.5%!  Forty years ago it took double digit interest rates to cause this big of a decline.  In 1987 an increase to 7.25% on September 22 helped precipitate the crash.  In 2000 rates peaked at 6.5% in May.  In 2007 interest rates only needed get to 5.25% to burst the housing bubble<7>.  It appears that interest rates have to keep falling or we cannot sustain the bull market.  Obviously, there is a wall out there that we will eventually hit since there is a lower limit to interest rates (such that easing won’t work anymore).  Japan found that level, and Europe seems to have as well.

What I hope you take from all of this is that we recognize that the dominant paradigm has shifted.  The 3-5 year business cycle of thirty years ago is a thing of the past.  The belief that a bull market must end because a certain amount of time has passed has proven unfounded.  Today investors and the Fed no longer fear inflation, corporate America no longer fears debt and in fact believes leverage and low taxes solve everything.    All that said, human nature has not changed.  Losses lead to prudent behavior which lead to gains which lead to increasingly reckless behavior which eventually lead to spectacular busts.  We are committed to investing in a globally diversified portfolio of stocks and bonds which we believe will help cushion portfolios during a major downturn. When you have short business cycles as we did in the 1980s and 1990s the rewards for avoiding the busts arrive regularly.  When cycles stretch for a decade or more as they do now, those rewards are much less apparent.  Having experienced what I have over thirty plus years, I have a certain respect for risk because I know how quickly large gains can turn to losses.  What global central banks have been doing is a great experiment.  There is no historical precedent for this much corporate and government debt.  I hope this works out well for all of us but I have my doubts<8>.  And because of that, I’m going to err on the side of caution.

<1> S&P 500 and Russell 2000 performance are per Morningstar Workstation

<2> You would still have a -1.72% loss

<3> Barrons Quarterly Issue, 4/8/19

<4> BBgBarc US Corporate High Yield, per Morningstar

<5> BBgBarc 1-3 Yr US Treasury, per Morningstar

<6> BBgBarc Aggregate Bond, per Morningstar

<7> Kimberly Amadeo, Fed Funds Rate History with Its Highs, Lows, and Chart, thebalance.com 03/21/2019

<8> Because the unavoidable byproduct of financialization is economic inequality, and this is leading to political instability across the developed world.

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.

Annual ADV Notification

As a registered investment adviser, we provide certain important information to you on an annual basis, which is included in this Annual Notice. Our most recent disclosure statement as set forth on Form ADV Part 2 and 2b is now available.  There have been no material changes since the February 28, 2018 Form ADV Part 2 brochure. If you need a copy at any time throughout our relationship, please call us toll free at 952-358-3395 or 866-944-0039 or send an email to john@trademarkfinancial.us.  A copy is also available at our website, www.trademarkfinancial.us.  Additional information regarding our firm is also available at www.adviserinfo.sec.gov. You should always contact the financial advisor listed on this quarterly statement immediately if there are any changes in your financial situation, investment objectives, email address, or if you wish to add or modify any reasonable restrictions to the management of your account. As always, should you have any questions or require any additional information regarding this Annual Notice, please do not hesitate to contact us.

Summary

Stocks had a rough quarter worldwide.  In fact, 2018’s poor performance has raised the question as to whether or not the post-financial crisis bull market was over.  Stocks declined during the summer of 2011 and again from late summer 2015 through mid-winter 2016, but both times they rallied sharply after the low was put in.  This reinforced the strategy of “buying the dip”.  2018 saw a correction in the first quarter followed again by “dip” buying which pushed the major market averages once again into record territory by the end of the third quarter.  Immediately thereafter, a second sell-off began.  The fourth quarter decline was deeper from top to bottom (-19.8%)<1> than the previous ones and the breadth (the percentage of stocks making 52-week lows) was greater as well.  In other words, almost no stock was spared (especially not the large consumer technology stocks that made the most money for investors on the way up).  The fact that the ten percent first quarter decline was followed up so soon with an even larger decline is not a good sign, but it is not conclusive.  It does warrant additional defensiveness, we believe.

The S&P 500’s -13.52% decline in the fourth quarter is the worst quarterly performance since the fourth quarter of 2008, and day-to-day volatility in December rivalled that of 2008.<2>  Small company stocks fell an astonishing -20.02%.<3>  Ten of the eleven industrial sectors declined, with only utilities able to claw out a small gain (1.4%).<4>  Energy plunged -25.1%,technology lost -17.5% and industrials fell -17.3%.<5>  For the full year, the S&P 500 index fell -4.38% and the small cap Russell 2000 was down -11.01%.<6>

International stocks actually provided a bit of a diversification benefit in the fourth quarter.  Developed international market stocks fell -12.54%, but emerging markets lost only -7.47%.<7>  Over the full year, however, the declines were -13.79% and -14.58%, respectively.<8>  The question of whether the U.S. stock market could continue to do well when foreign markets were doing so poorly was ultimately answered in a negative fashion.  That said, the fact that emerging markets only lost about half of what U.S. stocks did in the fourth quarter might mean that EM has become so cheap that the downside from here is rather limited.

High quality bonds such as treasury and agency-backed mortgages were the beneficiaries of the weakness in stocks.  The Barclays Aggregate bond index rose 1.64% last quarter to end the year up 0.01%.  Both high grade corporate bonds and lower grade “junk” bonds lost money in the fourth quarter and over the full year.  The best place to have been last year in bonds was the safest – short term Treasuries (1.89%).  Short term municipal bonds also performed relatively well (1.76%).  International bonds lost over -5.17% in 2018 on the strength of the U.S. dollar.<9> Activity

Volatility increased dramatically during the fourth quarter, which kept us quite busy.  There were plenty of things to do in terms of making portfolios more conservative, including raising cash, replacing or reducing funds that aim to outperform the market on the upside (but often lose more in down markets), reducing or eliminating exposure to lower quality corporate bonds, and increasing exposure to low volatility and/or dividend-oriented equities.  We also took advantage of the sharp sell-off in international stocks in 2018 to do tax loss harvesting.  Taxable investors probably noticed substantial changes in December.

Outlook

I wrote last quarter that there were potential catalysts in both directions.  The downside catalysts won out.  The Trump Administration did not strike a deal with China (although it pretended to do so after the Argentina summit).  As a matter of fact, Vice President Mike Pence’s October speech was more of a “double down” on the trade war than an olive branch of any type.  The government shutdown seems likely to drag on, which will reduce first quarter 2019 GDP.  On the other hand, lower interest rates (the 10-year note, which a lot of consumer loans are tied to, is down to -2.72%) and lower gasoline prices are helping the consumer.

Given the above, it is difficult to foresee a strong first quarter performance from the economy.  The three hopes for investors are that 1) the double-digit market decline last quarter is already more than reflected in current market prices allowing for a rebound, 2) that the relatively minor economic slowdown market pundits are calling for in 2019 doesn’t turn into a full-fledged recession, and 3) that the government eventually re-opens and lawmakers again provide policy certainty, which would allow businesses to make their investing and hiring plans for the rest of the year more confidently.

Commentary – Mr. Market

For every asset there is a tug of war between people who want to buy and people who want to sell.  Prices are set, effectively, by those who change their mind and trade accordingly.<10>  Buyers and sellers (“market forces”) are usually slightly out of balance requiring the marginal buyer to pay a little more or the marginal seller to accept a little less than they’d like. The side that capitulates and accepts the market price depends on conviction, which can be fragile and fleeting. It can be influenced by economic data, a rumor, company specific information or oftentimes just the gut feeling of the market participant.

At the beginning of 2018, a growing global economy and corporate tax reform combined to raise the outlook for corporate profits.  The demand for stocks was high relative to the supply (shares that people were willing to sell), so excess demand allowed sellers to demand increasingly higher prices.  One of the interesting characteristics of investments (be they stocks, art, or bitcoins) is that a sharp rise in prices tends to increase demand as investors project even higher prices.<11> The converse is also true, as stocks decrease in value investors project that trend into the future. Behavioral finance calls this recency bias.<12> Exhibit 1 shows the US Investor Sentiment Index (the percentage of investors who are bearish or expecting lower prices) plotted against an ETF tracking the S&P 500. You can see that as the ETF decreases in value, the percentage of bearish investors spikes. It’s a visual representation of recency bias.

Exhibit 1

Source: YCharts.com

Famous investor Warren Buffett quotes his mentor, Benjamin Graham, as saying that “Mr. Market” is like a manic-depressive business partner: “Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.  For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and we can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.”  Buffett concludes: “Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.” <13>

CNBC, Fox Business News, Bloomberg, and a host of others authoritatively opine daily on what is driving the Mr. Market’s mood.  The explanations always seems to makes sense, but they are seldom of any real value to investors.  If you think about it, the news has been largely the same over the last five months – the trade conflict with China, a fairly strong but modestly slowing domestic economy, the toxic political climate, among a host of other things and yet we saw stocks soar in late summer, plunge throughout the autumn and then turn sharply upward again after Christmas.  It is sentiment, the tug of war between fear and greed, that moves Mr. Market.

We have been navigating the markets for more than three decades, helping investors to keep their calm no matter how Mr. Market feels.  We know that money is a very emotional issue for many people, which makes what we do – helping to dampen Mr. Market’s mood swings by applying both valuation and sentiment analysis – so important when markets appear to be irrational.  Drawdowns (paper losses) are inevitable.  As an investor you must be prepared, both intellectually and emotionally, for sentiment to occasionally turn negative and your portfolio to decline.  Being able to make clearheaded decisions in difficult times is what separates successful from unsuccessful investors.  Trademark tries to turn adversity to your advantage by investing in globally diversified portfolios of stocks and bonds that we hope dampen Mr. Market’s mood swings and allow you to remain invested.  We thank you for allowing us to help guide you through these difficult periods.

-Mark A. Carlton, CFA

Endnotes

<1> From the market high in the S&P 500 on September 20th to the low on December 24th.

<2> Blackrock Returns Comparison, December 2018

<3> As measured by the Russell 2000 Stock Index

<4> Sector performance courtesy of S&P Dow Jones

<5> As measured by Dow Jones US Sector Indices, Blackrock Returns Comparison, December 2018

<6> Source: Blackrock Returns Comparison, December 2018

<7> As measured by MSCI EAFE and MSCI EM, Blackrock Returns Comparison, December 2018

<8> As measured by MSCI EAFE and MSCI EM, Blackrock Returns Comparison, December 2018

<9> All bond category performance data is provided by Blackrock Returns Comparison, December 2018.

<10> The person who owns Tesla and believes it is worth $500 per share doesn’t move the market any more than the person who thinks it’s worth $100 and doesn’t own it.

<11> This tends not to be true for objects of consumption, such as steak or peanut butter, where rising prices invite substitution.  Investments are not fungible in that way.  If you want to participate in a stock rally but think prices are too high, you don’t go out and buy bonds.  If you like Apple products and want to profit from their increased use, you don’t go out and buy Home Depot or Nike stock.

<12> Recency bias is the tendency to think that what’s been happening lately will keep happening. One of a group of Behavioral Financial Biases that can cloud investors’ judgment. Recency Bias can cause investors to stay in stocks or other instruments because they have been performing well, despite warning signs like historical or relative high valuation. On the other hand, this bias can also keep investors from buying when stock prices are low, as in early 2009, because for months stocks had been falling and under Recency Bias one would expect that to continue. Source: YCharts.com

<13> Berkshire Hathaway Annual Letter to Shareholders, 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

Summary

Stocks rebounded last quarter – at least here in the U.S.  Trade war fears drove up the value of the dollar on the idea that tariffs would lower America’s trade deficit, which would mean fewer (and therefore more valuable) dollars in the world for commercial purposes.   The U.S. economy depends a lot less on importing goods than most countries, so it can better afford less inter-national trade in favor of more intra-national trade.  That said, most institutional strategists believe that a full-on trade war will not happen; this is a big reason why the Russell 3000 gained 3.89% last quarter.  As a firm responsible for protecting investors’ principal, however, the trade conflict makes us nervous.  History is full of disasters that just didn’t seem all that bad at first.

As mentioned, U.S. stocks enjoyed a nice rebound from the first quarter’s modest loss.  The first half of 2018 saw a gain of 2.95%.  If you are an old school Dow Jones Industrials fan, stocks rose just 1.09% and are down -1.05% for the first half of 2018.  On the other hand, if you set your course by the technology heavy NASDAQ index, stocks rose 6.61% during the second quarter and 9.37% through June 30th. Obviously, what you owned made an unusually large difference last quarter, a fact I will elaborate on in the Commentary section.  Small cap U.S. stocks were a beneficiary (the S&P 600 is up 9.39% through last quarter), to a large extent, of the trade war fears in that they are less likely to be major exporters than larger companies.

The performance of foreign equities in dollar terms was pretty awful.  Emerging markets (-7.96%) were hit the hardest by trade concerns.  The issue is that certain countries borrowed substantially in dollar terms, which allowed them to pay less in interest costs because the buyers of those bonds then carry dollar risk, not lira or peso or rupee risk (just to name a few).  The risk is that if the dollar rises sharply (as it has recently) the issuing country has to exchange a lot more of its currency for (the same amount of) dollars in order to pay the bondholders.  This was felt most acutely in Brazil, Argentina, and Turkey, but everybody else suffered as well.  While Latin America was the biggest loser at -20.86%; there were no winners in dollar terms.

Bonds came oh-so-close to breaking even last quarter, losing just -0.16%.  This brought their year-to-date performance to -1.62%.  It was just a tough quarter for conservative investments as bonds, utility stocks, real estate, and dividend-oriented equities all declined.  Floating rate debt managed to eke out a modest gain last quarter, as did short term bonds.  Interest rates have now climbed to where the yield on short term debt is now high enough to overcome the negative effects on principal.  The best performing sector of the bond market was high yield municipal debt, which rose over one percent.  Emerging market debt lost a staggering -5.4%.

In some accounts we keep a very small amount in gold and/or commodities as an inflation hedge.  This detracted modestly from performance over the course of the quarter.

Activity

With the dollar suddenly strong, job one was making sure we were not overly exposed to emerging market stocks or bonds.  Because of their favorable long-term potential and diversification benefits, we did not eliminate those positions.  Nobody rings a bell when a sector hits bottom, and in fact often the rebound from sharp sell-offs can be quite strong.   Our second priority was making sure we had enough exposure to the higher growth areas of the market, such as small cap stocks and momentum growth stocks.  In an environment where the combined performance of every sector except information technology was essentially zero (see Item 1), you absolutely had to own some tech.  The third priority was making sure the duration of the bond portfolio was low enough such that what you might lose to rising interest rates was more than compensated for by yield.  This was true of both taxable bonds and municipals (where it still pays to take a little extra credit risk).

Item 1

Source: Seeking Alpha Outlook

My crystal ball is even hazier right now than usual.  The two biggest issues for the stock market at present are interest rates and trade policy.  The fact that after surging in the first quarter interest rates were little changed last quarter helped investors feel more at ease.  Investors are concerned about the trade war, but they seem to be operating under the idea that it is a mixed blessing for the U.S. while a devastating blow to foreign countries.  Pundits talk about winners (companies and industries that do not export) and losers (companies that export) while assuming every foreign company is a trade war loser, because the performance difference between U.S. and non-US stocks was 4.63% last quarter!   That thinking fails to understand that in local currencies foreign markets rose 3.47% last quarter.  The bottom line for me is that I can’t see the current strength of the U.S. continuing beyond another quarter or two.  As our currency appreciates, our exports are becoming too expensive to foreign buyers. Eventually this will translate to lower sales and profits for our exporting companies.

That said, stocks have gotten a bit of a reprieve from interest rates as the trade war has intensified, because investors assume it will slow down the global economy.  There are those that now think the Federal Reserve will only hike rates one or two more times this economic cycle, which, if true, would be stock friendly (as long as the global economy doesn’t slow down too much).  Goldilocks, you’ll recall.

I think one of two different scenarios will play out.  One is that the trade issues will be resolved and the stocks, countries, and currencies that depend on world trade will bounce back strongly.  In this scenario the global slowdown will prove to have been a “breather” that sets us up for two or more years of expansion (much like the late 2015/early 2016 slowdown pushed interest rates down and fueled a two-plus-year market rally).  The other, less likely scenario in my opinion, is that the stock market already reached its cyclical peak on January 26th.  That view comes from the fact that U.S. stocks as a whole have not been able to make a new high since then, and neither investor optimism nor market breath is nearly as strong as it was.  At some point the U.S. may go from being the only port in the storm to just another country in a bear market.

Commentary – The Tortoise and the Hare

Economic conditions change often drastically from one market cycle to the next, but human nature doesn’t change much at all.  There is a certain path we as investors almost always follow as the cycle progresses.  Coming out of a recession, nearly all stocks go up because every company’s earnings are expected to improve, yet investors are fearful and therefore underperform.  Once investors are sure the recovery is for real, they look for companies that have relatively better growth prospects while they reduce their holdings of companies they held primarily for safety and yield.  This progresses in fits and starts (because economic data is never a smoothly ascending or descending line) until the peak of the cycle.  At that point, all of the market’s net advance is fueled by earnings growth-oriented companies.  Defensive companies, like those in the utility or household products industries, decline in value because investors don’t prize safety anymore.  Even modestly growing companies see their shares stagnate as overconfident investors focus on the biggest winners.  With fewer and fewer stocks carrying the market, the burden of the expectations placed on those companies ultimately becomes too great.   Over-owned at this point, they suffer the largest declines when the next recession hits and investors turn back to the safety of stocks that pay a nice dividend and are less likely to disappoint.

While it is never possible to know exactly where you are in the cycle, it is significant to note that the top ten technology and consumer technology stocks accounted for 122% of the S&P 500’s gain in the first half of 2018 (see Item 2).  The cumulative performance of the other 490 stocks in the S&P 500 was less than zero. Item 2

Source: Seeking Alpha.  Data as of June 28th, 2018

We might generalize the performance of growth stocks and dividend stocks as hares and tortoises respectively.  When they are both at their best, it is difficult to see why anybody would bet on the tortoise.  Unfortunately, hares have a nasty habit of sleeping and otherwise getting distracted while tortoises just plod on toward their goal.

At least they used to.  Over the past several years the hares have built a huge lead over the tortoises.  So large in fact that even though tortoises have won more races historically than the hares, nobody seems to believe the hares will ever lose again.  “Things are different this time”, they argue.  “Hares are more focused now, and the race course contains obstacles that hares can more easily get over, and the length of the course and the temperature, etc.”  All of which may be true, but the fundamental nature of a hare is that they are not meant for long races.  That which drives rapid growth is very difficult to sustain over time, whether you are a rabbit or a multi-billion-dollar corporation.

Will today’s hares (Amazon, Apple, Netflix, Facebook, etc.) have endurance?  Time will tell.

So how does this apply to your portfolio?  Obviously when the hares are running strong you want to have some exposure there.  On the other hand, hares surrendered more than half their value in the 2008 -09 financial crisis AND during the 2000-02 technology crash.   Your risk with the tortoises is not so much what you lose in a crisis but what you don’t make in the expansionary phase when hares are doing so well.  A well-diversified portfolio contains both tortoises and hares, but it is human nature that while we get frustrated both with plodding turtles and sleeping hares, we tend to favor hares over tortoises because their potential speed is higher.  They can make us the most money in the least amount of time.

This presents a challenge for most investors.  If they want to participate in the current rally they must own the popular stocks that are almost certain to fall the most after the cycle peaks.  If they want to play it safe, they are going to probably earn very little until the cycle turns.  Growth stocks gained 7.28% in the first half while value stocks lost -2.22%.  Furthermore, the sub sector of growth stocks that focus on momentum rose almost 8.86.   The allure of growth is understandably extremely strong right now.  That said, if experience teaches you anything in investing it is that great returns never come from doing things that are psychologically easy.  Following the herd is comforting for long periods of time and then it becomes terrifying during those times when the herd is in full panic.

So please remember this if the temptation gets strong to sell the tortoises and load up on hares.  We are at the part of the cycle where expectations for certain “hares” are very high.  Diversification may not make a poor man rich, but it will also not necessarily make a rich man poor.  We strive to blend assets that have strong growth potential (but are currently quite expensive) with those that are cheap and promising (but currently facing challenges) and others that are reliable (but not that exciting).  We don’t always get that balance just right, but we never lose sight of why it is important to try in the first place.

Thanks for your continued trust in our management,

Mark A. Carlton, CFA®

That said, adopting from the outset the notion that trade deals have a winner and a loser and we intend to win makes it very difficult to negotiate, because by definition you are demanding that the other side(s) agree to lose.

Russell 3000 stock index, the broadest measure of U.S. stock return.

Performance figures for all stock market averages are per Morningstar.

Source: S&P Dow Jones Index Dashboard: US, June 29, 2019

Source: MSCI Emerging Market Index per Morningstar

Source: Barclay’s US Aggregate Bond Index

Emerging Markets Hard currency debt, per Lipper (Barrons, 7/9/2018)

Counting Amazon and Netflix as tech stocks, not consumer discretionary stocks.  Per SG Cross Asset Research.

https://seekingalpha.com/article/4185933-high-tech-small-world

3.98% on the Russell 3000 vs -0.75% on the MSCI World ex-US Index. Source: Dimensional Fund Advisers

MSCI EAFE net return, local currencies (per Morningstar)

Source: https://seekingalpha.com/article/4185933-high-tech-small-world

https://seekingalpha.com/article/4185933-high-tech-small-world

Not for aggressive investors who will buy the “hares” and endure the inevitable periodic bouts of high volatility, nor for the very conservative investors for whom an all-tortoise portfolio will provide modest income and “sleepability”.

Source: S&P Dow Jones Index Dashboard: US, June 29, 2019.  As measured by the S&P 500 Growth and S&P 500 Value indices.

Source: S&P Dow Jones Index Dashboard: US, June 29, 2019.  As measured by S&P 500 Momentum index.

Disclosure

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

Summary

The stock market’s long quarterly winning streak ended in the first quarter, but the loss was less than one percent.  Probably more significant than the market’s loss in the quarter was the return of volatility – something we hardly saw at all in 2017.  Since the market peak on January 26th the market has made more than two dozen daily moves of more than one percent.  The question for investors is whether this new more volatile period will be resolved favorably with markets ultimately going on to new highs, or whether this signifies the beginning of the end of the bull market.

The actual loss for the S&P 500 was small, -0.76%.  What was so distressing about the quarter was the fact that stocks were at one point up more than 7.5%.  There was almost a “melt-up” in stocks in January after the corporate tax cut was enacted, as analysts scrambled to raise earnings guidance for 2018 and afterward.  Stocks shrugged off rising interest rates until the 10 year note flirted with 3% after the January jobs report; at that point, however, they began to care a great deal!  After bottoming on February 9th stocks began to recover.  They had erased about two-thirds of their 10% post-January 26 decline when the President announced trade tariffs.  This prompted threats, retaliation and ultimately a second journey into negative territory, which is where we finished the quarter.  Such volatility is historically normal.

Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 33 years out of the 39 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.

Exhibit 1

Foreign stocks largely followed the same trajectory as U.S. stocks last quarter.  Developed markets closed with a loss of -1.53%, while emerging market stocks posted a 1.42% gain.  The best region last quarter was Latin America with an 8% gain, followed closely by “frontier markets” – those countries with markets too small to be included in the emerging market index.  Canada and Australia brought up the rear with losses of 7.3% and 5.7% respectively.  Exhibit 2 highlights last quarters broad market returns. Exhibit 2

Bonds reacted to the prospect of greater economic growth and higher fiscal deficits in the future the way you would expect – they sold off sharply.   The decline was as much as -2.5% by the end of January, but as the trade war increased the chance of a global economic slowdown, bonds rallied somewhat in March.  The bond index ended with a total return of -1.46%.  The only broad fixed income category to post a gain was floating rate debt.  High yield bonds lost a bit more than the benchmark, with longer term government and corporate bonds coming in last.

Activity

In the wake of the sharp increase in volatility, we examined the risk in each portfolio.  We had been letting profits run throughout 2017 and into 2018 because interest rate conditions were benign and stock price momentum was so strong.  In late January the former changed and soon after the latter did.  In response to rising interest rates we reduced duration in the bond part of portfolio by selling longer duration funds and replacing them with shorter maturity bond funds (especially those with floating coupons).  On the stock side we substituted cyclically sensitive stock funds for those that emphasize dividends.  As the declines spread from bonds to stocks, we began trimming stock exposure back to a neutral weighting.  In this environment, short term debt is becoming more attractive since it fluctuates very little and its yield is very close to that of U.S. stocks.

Outlook

2017 was an incredible year for investors.  Both U.S. and foreign markets gained more than 20%, and at no point did we experience a drawdown of 3%.  At some point, we all knew that period of near market perfection had to end.  We feel that global economies are not growing fast enough to support 20% annual profit growth, and with global central banks finally reigning in credit supply, liquidity won’t support those kinds of stock price gains either.  That phase of the market cycle is most likely over.  From here, we can hope for further earnings-driven market gains, but price-earnings multiples (the price that investors will pay for a dollar of earnings) appears richly valued and may even have peaked.  The danger is that they will shrink from here.  Such an environment warrants a more cautious stance.  Also, as recently as December 2016 the yield on Treasury Bills was around 0.25%.  Today, after five interest rate hikes, it is closer to 1.50%.  Since the yield on the S&P 500 is less than 2%, choosing to be a saver (as opposed to an investor) is once again a viable option.

In short, the combination of higher interest rates, a less friendly liquidity environment, and better competition from fixed rate investments creates a more neutral environment for stocks versus the strong tailwinds we’ve had in recent years.  Add in trade friction and political uncertainty and arguably stocks could be poised for decline.  We are monitoring the situation carefully.  Technical indicators are still positive – at the margin, investors would rather buy dips than sell into strength.  At long at that remains the case we are probably not going to under-weight stocks.

Commentary – Why We Didn’t Turn Bearish and What It Would Take

Sometimes the market goes down and investors wonder why we don’t just sell everything and go to cash until things blow over.  This is a good question, so I want to go over it again.

There are times every year when market conditions seem to warrant a decisively more conservative stance.  Typical arguments for doing so may be based on excessive market valuation, a political event, an economic change or even the threat of military conflict. Frequently it will be an outright decline in stock prices.  In my thirty-plus year career in the investment field I would guess there have been close to a hundred times I’ve thought about getting significantly more defensive.  That said, only in about six-to-eight of those instances would that have turned out to be a good decision.  The truth of the matter is that the U.S. stock market has an upward bias.  Betting against it has generally not been very rewarding.  If one is going to attempt to outperform the stock market by selling high and buying back lower, therefore, one must carefully pick their spots.  The odds are strongly against successfully doing so, and there is no one that can claim they have demonstrated this skill repeatedly.

What do I mean by an upward bias?  Exhibit 3 illustrates that between 1926 and 2017 annual market returns were positive 75% of the time. Exhibit 3

Stock prices are in the long run closely tied to corporate profits and corporate profits tend to rise over time.  Additionally, the government likes to see stock prices rise and therefore has an incentive to take steps to both increase the likelihood of price gains and more pointedly, to arrest any significant stock price decline.  Along those lines, it has been strongly believed over the past ten years that Fed Chairmen Bernanke and then Yellen would intervene to support stocks if necessary.  Another structural positive for stocks is the amount of savings relative to the supply of stocks.  Low interest rates have provided an incentive for companies to borrow money to buy back their stock in order to raise per share income.  This creates the bullish dynamic of too much money (demand) chasing too few shares (supply), which Economics 101 tells us leads to higher prices.   Finally, betting against stocks (short selling) is more complicated because shares must be borrowed prior to sale and that can be expensive.

If all of this has you feeling that stocks are a pretty good bet most of the time, you are reading this right.  Since stocks have so much going for them, there would need to be several negatives in place to warrant underweighting them in portfolios.  Here are some the factors that might cause us to reduce our stock weightings:

Valuation.  We would have to believe that stocks were so overvalued such that a value-restoring market plunge was far more likely to occur before earnings could rise enough to justify current prices;

Technical weakness – in other words, falling prices.  More than just falling prices, in fact, but the confirmation that investors were becoming disenchanted with stocks via a drastic change in investor sentiment.  This would involve stock prices making a series of lower highs and lower lows.

Liquidity impairment – whether through a surge in interest rates, a recession, or a major corporate bankruptcy, this is a condition where asset holders worry about being able to sell what they own at current prices and banks worry about the value of that which they hold as collateral.

Rising interest rates – because of the negative effects they have on corporate profits and price-earnings ratios.  Rising interest rates negatively impact the profitability of most companies plus they make financing a leveraged portfolio more expensive.

Serious economic weakness – a mild slowdown might easily be offset by falling interest rates, but typically rates can’t fall fast or far enough to offset the damage of a serious recession because profits my fall below the level needed to service existing debt.  Also, banks may not be willing to provide capital to other entities if they are worried about their own solvency.

Global conflict – most conflicts can be and are resolved without economic damage because each side understands what it stands to lose.  On rare occasions a conflict between major powers occurs because one side can no longer accept the status quo and the other side is unwilling to accommodate the other.

The biggest problem with opportunistic selling is that there is seldom any kind of signal in terms of when to buy back.  Valuation is a very relative thing; nobody rings a bell when a recession ends or liquidity conditions ease.  Experienced managers may get a “feel” but that is hardly something you can quantify nor is it a recipe for a repeatable investment process.

As far as today is concerned, the most negative aspect to the broad market is that it’s generally considered overvalued but it’s been overvalued every month since late 2012 (with the possible exception of January and February 2016).  The market is not technically as strong as it was three months ago but most measures are still positive.  Interest rates are rising on a six- and twelve-month basis, but they are actually flat to lower over the past one and three months.  The other concerns are just not there, though we can’t rule out that the current trade spat becoming a full-on trade war.

To sum up, stocks have an upward bias over the intermediate and long term, so to warrant under-weighting stocks in portfolios, there needs to be very compelling reasons to do so.  Fortunately, that just doesn’t happen very often.  Over time, we have adapted our processes to create a higher bar in terms of what needs to happen for us to turn defensive.  We believe that has helped us to capture more of the market’s upside in the recent past, and will continue to do so going forward.

Thanks for your continued trust in our management,

Mark Carlton, CFA©

Jill Mislinski, dShort, Advisor Perspectives April 13, 2018.

S&P 500 Index total return per Morningstar

In US dollars. US Market is measured by the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

MSCI EAFE Index (developed markets) and MSCI EM Index (emerging markets) per Morningstar

S&P Dow Jones Indices

Source: YCharts.com

BBgBarc US Aggregate Bond per Morningstar

S&P Dow Jones U.S. Index Dashboard, March 29, 2018

Performance per Morningstar; volatility data per JPMorgan Guide to the Markets, 1st Quarter 2018.

Source: Dimensional Fund Advisors, Market Declines and Volatility

According to Trading Economics, the annual increase has averaged over 7.4% between 1950 and 2017.

It is not clear yet what Chairman Powell would do; that might be behind some of the more recent volatility

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As a registered investment adviser, we provide certain important information to you on an annual basis, which is included in this Annual Notice. Our most recent disclosure statement as set forth on Form ADV Part 2 and 2b is now available.  There have been no material changes since the 1/19/2017 Form ADV Part 2 brochure. If you need a copy at any time throughout our relationship, please call us toll free at 952-358-3395 or 866-944-0039.  A copy is also available at our website, www.trademarkfinancial.us.  Additional information regarding our firm is also available at www.adviserinfo.sec.gov. You should always contact the financial advisor listed on your quarterly statement immediately if there are any changes in your financial situation, investment objectives, email address, or if you wish to add or modify any reasonable restrictions to the management of your account. As always, should you have any questions or require any additional information regarding this Annual Notice, please do not hesitate to contact us.

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.