Summary

There is really nothing negative one can say about 2017 in terms of the stock market.  Returns were great almost anywhere one invested.  A lot of market-friendly events occurred – Emmanuel Macron’s victory in France turned the tide against nativism and spurred a 25.32%<1> gain in Europe; China stimulated its economy ahead of the 19th Communist Party Congress, leading to a 41.18%<2> return; and the United States passed a tax reform bill that lowered corporate taxes from 35% to 21%, contributing to a 21.83%<3> gain for the S&P 500.  Interest rates remained low enough to support both stock buybacks and takeovers, and perhaps most importantly allowed companies to continue to use debt markets to raise needed cash instead of diluting investors by issuing stock.  All of this left most people asking by year end, “How long can this continue”?

For the most part, risk was really rewarded last quarter.  Conservative investments made money – they just made a lot less.  Utilities gained just 0.2% while Technology rose 9.0%, for example.<4>  In an environment where stocks exhibited the least amount of volatility in modern history, investors were emboldened to take on more and more risk.  That also played out internationally through emerging markets, which surged 7.44%<5> on the quarter and 37.28% for the year.  Energy and telecommunications each managed to post a gain last quarter though both sectors lost money for 2017.<6>

Bonds made modest gains in the fourth quarter.  The main bond index rose just 0.39%<7> to finish the year with a 3.54% gain.  Riskier sectors such as emerging market debt and high yield corporate debt led the way for the full year, but it was more conservative sectors like municipal bonds and inflation protected securities that did the best in the fourth quarter.  With interest rates perhaps having made a significant bottom in 2016, there is an increasing belief that the long bond bull market is over.  If this is indeed the case, then bond investors need to be more opportunistic now.  Using long duration bonds to bet on yield curve flattening was a good strategy until recently.  Overweighting foreign bonds to benefit from a falling U.S. dollar is working right now.

Source: Dimensional Fund Advisors, Q42017 Quarterly Market ReviewActivity

Activity last quarter primarily centered around reducing the cash position in moderate and conservative portfolios.  Aggressive portfolios already had lower than normal cash positions.  That said, we did try to find room in larger portfolios for a new fund that invests in hard assets such as infrastructure, agricultural land, and timber.  The Versus Real Asset Fund gives us access to those asset classes in a mutual fund format that we expect to have low correlation to the stock or bond markets, and have very little volatility.  At some point this bull market is going to end, and we want to own some assets that cannot be dumped wholesale when greed turns to fear.

Outlook

There are echoes of the late 1990s in today’s stock market.  In those days the narrative was about how technology was going to revolutionize communications and commerce (it did, but that didn’t justify paying hundreds of dollars per share for companies with negative cash flow).  Today the narrative is about global central banks being run in service to global equity markets such that another -50% plunge in the stock market is unlikely.  Again, while there is some truth to this in terms of central bankers trying to be conscious of their effects on markets, at some point the stock market will have a significant decline.  Narratives are powerful because they contain elements that are undeniably true as they seek to explain day-to-day investor behavior.  A bullish narrative, for example, inhibits selling.  Investors both bought and sold stocks in the late 1990s, but what was significant was that they bought a lot more technology stocks than they sold.  Today’s central bank narrative has prompted investors to sell out of individual stocks and more niche-oriented mutual funds and to buy the stock market as a whole through index funds.  The problem is that no narrative can be sustained forever.  Eventually economic conditions will deteriorate to the point where central banks cannot (or will not) support very higher stock prices.  Thus, investors will participate in the bull market as long as it lasts, but it is also 100% certain they will participate in the subsequent decline.

As far as when that might occur, we are watching interest rates as well as market breadth and a host of other market internals.  These suggest stocks are likely to go even higher, at least in the short run.  We have written on numerous occasions that stocks are expensive, but valuation does not drive short term performance.  For those of you that are concerned about geo-political events, they rarely drive market performance either.  Markets have no good way of discounting the risk of a war with North Korea, for example, so they choose to ignore the situation unless and until it becomes critical.  There is a part of me that really wants to sell and lock in these stock market gains, but I will only do this incrementally unless we get a market or interest rate-based catalyst.

Commentary – Leaning Against the Wind

In a market that seems to do nothing but rise day after day, the question for all money managers becomes how to add value.  Other than through the highly risky strategy of leverage, all one can hope to do in a very strong market is to keep up with it.  In an asset management program in which the maximum amount of portfolio risk is capped, we will not be able to keep up with an index on an after-fee basis because we can’t take more risk than the index.  It is tempting in such circumstances to convince oneself that risks are very low.  That way, one can justify a higher equity weighting and therefore come closer to index performance. In other words, if stocks exhibit very low volatility over an extended time frame, then they must not be very risky.  The problem is that market volatility has over time proven to be mean reverting.   Put another way, periods of low volatility ultimately give way to periods of high volatility, and vice versa.  Viewing the market with a perspective of years and decades instead or days and weeks, one understands that a pronged period of abnormally low volatility does not decrease your chances of experiencing a sizable loss, in fact it increases your chances.  From this it follows that a good investment strategy should involve “leaning” against the prevailing sentiment of the time.

Think about the times where market sentiment was the most extreme in either direction.  In April 1999 the Dow Jones Industrial Average passed 10,000 for the first time.  This wasn’t a “sell everything” moment (short of an impending asteroid collision, it is hard to think of what would be), but it was a good time to reflect on the odds of stock prices being much better or much worse two or three years hence since they had trebled over the preceding six years.  Stock would still rally another 15% over the next several months, but a “lean against” strategy of taking some profits would have saved a considerable amount over the next four years.  Similarly, the stock market went into a virtual free fall in October 2008 after Lehman Brothers failed.  The Dow briefly went under 8,000 on October 10th, 2008 before closing at 8,451.  With stocks roughly 40% below their peak just one year and one day earlier, it was hard to imagine that the downward trend could still be going two to three years hence.  Leaning against the tide at that point admittedly would have been difficult.  The market didn’t ultimately bottom until the following March (at 6,547), but buying at 8,451 would have looked great just two years later as the Dow rose back above 11,000 (to say nothing about how good it looks today)!

The point is, nobody knows when or where the market is going to make a meaningful top or bottom.  Investor sentiment is possibly the most reliable indicator that we are approaching an extreme.  Greed really seems on the rise today judging by the rapid rise of stock prices, the absence of any even modest correction since Brexit, and the surge in both cryptocurrencies and the stocks of any company claiming to have exposure to them (or to Blockchain, the technology that drives them).  It seems to me that right now is a good time to step back and think about how much better things might be two or three years hence relative to how much worse they could be.  The stock market is up two-and-a-half times from its October 2011 low; maybe we will eventually get a treble this time as well.  That fact is that neither we nor anybody else is going to call the exact top without being extremely lucky, so we must plan on the most likely scenario which is that we don’t meaningfully reduce stock exposure until is clear that there has been a significant change in market conditions.  I can promise you that we won’t be the only sellers on that day.  If this bull market ends with a long period of sideways action like in the late 1960s, missing the actual “top” won’t matter much.  On the other hand, the speed at which technology stocks collapsed in 2000 or financials in 2008 was breathtaking.

Economically speaking, we are an eight-cylinder engine hitting on all eight cylinders right now.  I’m not saying it can’t get better, but I am saying it can’t get much better.  Perhaps the current mood of investor enthusiasm for stock could become even more crazy and people might quit their day jobs to trade Bitcoin and Ethereum futures, but I think we agree that we are a lot closer to the greed end of the sentiment spectrum than the fear end.  It’s time to plan for the end of this wonderful, powerful bull market.  As an asset manager, Trademark is constrained both by how much and how little risk we can take.  Asset managers are tacticians.   When market momentum and breadth are very strong, and sentiment is trending in the right direction, as is the case today, history suggests stocks are going to do well in the near future.  So, tactically, that is the way we have positioned portfolios.  At Trademark we attempted to (1) alter asset class weightings (the mix of stocks/bonds/cash) in response to increased risks and (2) use mutual funds and ETFs whose strategies are less volatile than the overall market.  That said, we will never move portfolios to 100% cash, no matter the circumstances.  Your advisor can work with you to determine how much risk you need to take to meet your goals and how much potential principal volatility you can stomach.   Now is the time to have a discussion with your adviser about how much risk is in your portfolio.  We believe it is time to begin leaning against the tide by getting a little more conservative right now, but ultimately that decision should be the result of a discussion between you and your advisor.

As always, thanks for your continued trust in our management program.

-Mark A. Carlton, CFA

<1> MSCI All Country Europe net return is US dollars, per Morningstar

<2> MSCI China all share index net return in US dollars, per Morningstar

<3> Standard & Poors 500 Index total return (including dividends) per Morningstar

<4> S&P Sector Indices per JPM Guide to the Markers, 4Q2017

<5> MSCI Emerging Markets net return in US dollars per Morningstar.

<6> S&P Sector Indices per JPM Guide to the Markers, 4Q2017

<7> BBgBarc US Aggregate Bond Index per Morningstar.

Disclosure

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

Summary

U.S. stocks rose for the seventh consecutive quarter.  The S&P 500 stock index added another 3.09%, bringing its year-to-date gain up to 9.34%.  Mid and small cap stocks lagged large caps again this past quarter, rising just 1.97% and 1.71% respectively.<1>   Investors have preferred the relative stability of larger companies this year over the growth potential of smaller firms as prospects for infrastructure spending and tax reform have lessened considerably.  Technology has been the strongest industry so far this year, while energy has been the weakest.

Foreign stocks performed very well in the second quarter as growth accelerated (especially in Europe) at the same time that the dollar fell against most major currencies.  This enabled dollar-based investors to gain another 7%+ in European stocks and another 8%+ in Asia (ex-Japan) stocks.<2>  The only part of the world that disappointed over the last three months was Latin America (1.74%), where Brazil was again enveloped in a corruption scandal.  Emerging markets as a whole still gained 6.12%, led by Chinese internet stocks.

Bonds almost had a fantastic quarter, but remarks by the head of the European Central Bank on June 27 stopped the rally in its tracks.  Yields on the 10 year U.S. Treasury Note fell from 2.39% to 2.12% in the first 86 days of the quarter, producing a price gain of over three percent.  After Mario Draghi’s remarks warning the bond market that the ECB was going to taper its bond buying, yields surged to 2.30%.  This cut the return for the full quarter to 1.45%.<3>  Global, municipal, and high yield corporate debt gained modestly more than that, but short term bonds and inflation-protected bonds did quite a bit worse.  Investors do not seem to be afraid of inflation right now, but they are really dismissive about credit risk.

We have written before about how the market has been drifting up each quarter not so much on signs of economic strength but on the continued decrease in fear.  The less volatility the market expects from stocks (or any other asset class), the more of it investors are willing to hold.  Behavioral finance calls this phenomenon Recency Bias.  As volatility continued to decline, investors were willing to increase their U.S. stock holdings modestly last quarter.   The real change was in Europe and emerging markets where the volatility decline was much more dramatic, leading to large inflows into those areas.

Activity

When the big picture (as far as the stocks and bonds markets are concerned) does not change, we do not do very much.  Our activities tend to be limited to monitoring performance and replacing underachieving funds with alternatives that are more in step with current trends.   This past quarter, that usually involved replacing funds with a defensive bias (such as Low Volatility ETFs) with alternatives that are better able to take advantage of a rising market.    At the margin we increased international stock exposure by one to three percent, nothing major.  Europe looks a lot better than it did three months ago economically and politically, but Latin America has been moving in the other direction.

Outlook

As long as the economy grows at a 1% to 2.5% annual rate, the stock market is in its comfort zone.  In that type of economic environment stock prices tend to move higher no matter how expensive they are to start with, because it’s assumed corporate profits will also grow.  If growth slows to less than 1%, the market worries about profits such that only companies thought to be recession resistant –consumer staples, utilities, and select internet companies – will hold up.  On the other hand, if the economy grows faster than 2.5% the market tends to worry that the Federal Reserve will reign in liquidity to prevent inflation from breaking out.  Financial services, energy, transportation, and materials stocks can still do fairly well with GDP above 2.5%, but most other industries do not.  We are carefully watching bond yields and central bank policy statements for signs that we might be moving out of the market’s comfort zone.  We know this will happen at some point, but it just doesn’t seem like that time is close at hand.

Commentary – Goldilocks and The Pigs

Market rallies tend to last as long as credit remains cheap and easily available.   This allows companies to borrow at rates they can easily repay.   Speculators tend to make, or increase, bullish bets because their expected rates of return are far above the cost of borrowing.  By expanding its balance sheet to unprecedented levels, the US Federal Reserve has done an excellent job of providing the economy with enough cheap credit to fuel an economic expansion that has lasted over eight years.  By keeping the economy in a modest 1.0% to 2.5% annualized growth channel, the Fed has helped the U.S. stock market post gains not justified by corporate earnings.  As a result the market has re-entered valuation territory last seen in the late 1990s.  Apparently, our collective confidence that the Fed can continue to keep us in this “Goldilocks” environment remains intact.  We now run the risk that investors are over-confident in the Fed at the same time the Fed may be looking to reduce their impact on markets.

As most of us know, the U.S. Federal Reserve took radical steps in 2009 to bring the country out of a deep recession.  The most significant step they took was to expand the national balance sheet by buying much of the debt they issued.  This had the effect of lowering interest rates, since they reduced bond supply while demand was unaffected.  Many expected that this would produce inflation, so gold soared between 2009 and 2011.  Other world central banks (save Japan) chose to fight recession by cutting spending.  By 2012, the results were clear – the American economy was recovering without any significant upturn in inflation, while austerity brought the Europeans to the brink of economic ruin.  As the American experiment was acknowledged to be a success, the European Central Bank began to follow our lead, and gold plunged.  To this day our economy has continued on its low growth, low inflation path, while other developed economies appear to be in the earlier stages of their economic turnarounds.

Unfortunately, one of the side effects of the Fed’s success is that investors now have a high degree of confidence that they need not fear inflation or recession.   Greed is replacing fear.  Speculative activity is again at high levels.  And once again the financial services industry is creating complicated and risky speculative vehicles such as inverse volatility ETFs.<4>  This doesn’t necessarily mean the market is headed for a correction but it suggests, if history is any indication, that we are probably in the later innings of this particular game.

The increase in speculative activity has not gone unnoticed.   Central bankers here and in Europe have recently cited the desire to “normalize” interest rates.  They do not explicitly say that they are trying to curb speculation, but in the absence of inflation that is the most logical explanation.  Reigning in overly generous liquidity conditions may well be prudent, but it is not financial markets friendly.<5>  It involves reducing credit available to banks (and by extension investors), and that means lower bond and stock prices.

The Federal Reserve and eventually other central banks have the task of gradually normalizing their impact on financial markets and economic activity. This means that at some future point central banks will once again allow markets to determine where interest rates ought to be.  They want the path to normalization to be as smooth as possible so as not to create a market panic (remember, both bonds and stock prices are elevated due to their actions).  This is going to be a delicate task, so expect the management of market expectations to involve them seeming hawkish one week and dovish the next.  If you are beginning to feel like investors are being “herded” more or less like livestock, you are catching on.   In other words, “farm pigs” have eaten considerably better over the last few years than the wild boars that have fought the Fed.  However when credit conditions finally begin to tighten, the farm is going to be a lot less pleasant place to be.

One of the most important things to understand about modern economic systems is that stability tends to lead to instability, and vice versa.<6>  Too much stability for too long and we get complacent.  This breeds overconfidence that leads to speculation and eventually financial excesses.   All of this builds until we finally reach a breaking point (known to economists as a Minsky moment).  The Goldilocks conditions that allowed stocks and bonds to perform so well are ever-so-gradually being reversed by central bankers, who know the markets have become dependent on their generosity.  They would strongly prefer not to trigger a crash, but market greed might make that impossible.   The economy is currently in no danger of breaking out of its comfort zone, but a stock market that goes up every week might create destabilizing conditions anyway.  This environment provides high reward potential but it’s built on an increasingly risky foundation.  There is an old market saying, “Pigs get fat; hogs get slaughtered”.

<1> Source: S&P Dow Jones Dashboard: U.S. Mid and small cap stocks as measured by the S&P 600 and S&P 400, respectively.

<2> MSCI Europe Index net return in US dollars; MSCI Asia ex-Japan net return in US dollars.  MSCI is also the source for Latin American and emerging market returns in the next two sentences.

<3> Barclays US Aggregate Bond Index in US dollars, per Morningstar

<4> In essence, a derivative vehicle that allows one to bet against volatility.  It (XIV) is up over 95% this year as this is written.

<5> At least in the short term.  If it helps us avoid a speculative crash, it will have been very friendly in the long term.

<6> This insight, the Financial Instability Hypothesis, is credited to Hyman Minsky who published a paper on it in 1992.

Disclosure

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

Summary

Stocks gained a little over 6% last quarter while bonds rose 0.82%.<1>  Stocks continued the momentum from late 2016 as corporate profit expectations remained high, while bonds benefitted from the idea that the economy would not grow at an inflationary pace.  There is a bit of a contradiction here – corporate profits probably cannot meet expectations without the economy growing fast enough to force interest rates higher – but for the quarter at least, investors got to have their cake and eat it too.  They also were treated to a rebound in foreign markets.  Currency traders sent the dollar lower last quarter as fears of a soaring dollar through protectionist trade policies faded.  Emerging markets, which lost the most post-election, gained the most last quarter.

Technology and health care became market leaders once again as investors observed that the economy under Trump wouldn’t be much different than the economy under Obama – steady but slow.  Sectors where expectations were higher, such as energy and financial services, had a disappointing quarter.  Real estate struggled because tough times in the retailing industry are leading to soaring shopping mall vacancies.  Utility stocks were a beneficiary of flight-to-safety buying when economically sensitive stocks faltered.

As mentioned, foreign stocks performed well versus U.S. stocks last quarter for the most part.  It was no more than a reversal to some extent of the “Trump Trade” that investors put on last November when they sold foreign stocks and bought U.S. small and midcap stocks.  Emerging markets gained 11.45% while developed foreign markets gained 7.25%.<2>  See Chart 1.

Chart 1

Source: Ycharts.com

Bonds earned a little bit more than their coupon payments last quarter as interest rates declined.  It paid off for bond investors to take extra risk, either in the form of high yield bonds (credit default risk) or foreign bonds (currency and sovereign risk).  Investment grade U.S. bonds returned 0.82%, while high yield debt rose 2.70% and emerging market debt gained 3.28%.<3>

The 30,000 foot view of the markets over the last 12 months is that various narratives have, at different times, pushed particular parts of the market higher or lower depending on whether that sector benefits from a stronger dollar or a weaker one or whether it benefits from a weaker economy or a stronger one.  In the end, none of the narratives have had staying power.  Stocks continue to meander upward because more money is coming in than there are reasonably-priced alternative places for it to go.  I believe that a decent percentage of it is from formerly bearish investors finally throwing in the towel.

Activity

The market has started to realize that a lot less is going to happen legislatively in the first half of 2017 than first thought.  As a result bonds, gold, foreign stocks, and “defensive” U.S. stocks are more attractive.  On the other hand, that realization has made inflation protected bonds (TIPs), the U.S. dollar, and economically sensitive U.S. stocks somewhat less favorable.  I’m not sure it is all that wise to do a lot with one’s portfolio now if the expected changes to taxes and regulations are only going to be delayed by a quarter or two.  As a result, we have been more focused on “intra-category” performance than making size or style shifts.

Outlook

Humans are incredibly adept at pattern recognition.  It is how our ancestors survived when we were not at the top of the food chain.  So when we observe the market rising despite relatively slow economic growth, we rightly conclude that economic growth does not drive stock prices.  For the same reason, we can rule out corporate profits – they have been relatively stagnant for close to three years in a rising market.  Therefore, the key driver to stock prices must have been low interest rates.  When interest rates are low enough that it is profitable to borrow money to buy stocks, stocks are probably going to go up.  Lack of economic growth or profit growth did not stop the S&P 500 at 2000 or 2200 so why would it stop the S&P now as it approaches 2400?

Similarly, we observed that every time something unexpected happened in the world over the last several months and the market opened sharply lower, someone (or more likely some computer program) bought stocks and the market actually finished higher.   It seems as though we are becoming conditioned to the idea that the correct response to a market sell-off is to buy and as such fewer people fear a protracted downturn.

It is widely believed that market over-valuation is not a sufficient catalyst to cause a market downturn.  However, while markets may stay above or below fair value for very long stretches of time, ultimately value wins out. If liquidity remains ample (and I don’t see it changing in the near term) and volatility remains low then stocks will probably grind higher even though just about every non-interest rate- related valuation metric tells us the stock market is considerably over-valued.   There just aren’t enough reasonably safe, reasonably liquid (meaning easy to sell) investment alternatives out there.

Commentary – Indexing versus Active Management

I honestly hope the Outlook section you just read made you a little nervous.  I hope you were thinking something along the lines of “how does this end?”, or “it can’t be this easy”.   More and more market participants are gaining stock exposure via capitalization weighted index mutual funds and ETFs which are investments whose purpose is to closely match the performance of an underlying index. Why?  Because it has been working and they believe it will continue to work.  For the first time in my thirty plus year investment career, the investment advisor community has basically given up on beating the market.  “If you can’t beat the market, join it” many say.  If there is one thing I’ve learned, however, it is that no investment idea works when it is embraced by everyone.

There are two primary reasons why indexing has worked especially well over the past ten years (1) it is an inexpensive way to invest in capitalization weighted benchmarks that have disproportionately benefited from the low interest rate environment and (2) superior performance among active funds has not persisted.

Indexing is based on the belief that taking the cost of trading into account, it is difficult (if not impossible) to outperform the market over time.  All investors together by definition are the market, thus for any given period some do better than the market as a whole and some do worse.   Even the better performers see their advantage eroded when the costs involved in buying and selling are taken into consideration.

Active management is based on the belief that investment management is a skill that is difficult to master and as such, superior returns are available to those who do.  The argument centers on the idea that the most skillful can add value through security selection and are therefore worth paying for their superior knowledge and process.  The “skill” argument was taken for granted until roughly ten years ago because it was so easy to cite the returns of Warren Buffett, Peter Lynch, Bill Miller or several others.  Today, however, nobody’s recent record looks all that spectacular.  The Fairholme and Sequoia funds, once revered in the fund industry, have suffered mightily.  As a result of the lack of high profile success among active managers lately, indexing through exchange traded funds (ETFs) has captured the lion’s share of new investment dollars.

While I understand why this has happened, I am becoming increasingly nervous.  Trademark has used capitalization weighted ETFs for years as a core portion of our portfolios.  However, with all the new money piling in, I begin to wonder whether or not those investors understand the risks they are taking.  As long as you make the assumption that the stock market is reasonably valued such that one can expect to earn a very high single-digit annual return by buying and holding a market based ETF, it is hard to argue with indexing as a strategy.  If you also assume that the past ten years are better indicators of the future than the previous twenty five in terms of the inability of one year’s best performers to sustain their edge, then once again indexing is the way to go.  On the other hand, if you see the market as being so overvalued that mid-single digit annual returns are a best case scenario going forward, then simply matching the market’s return doesn’t seem so appealing.

I will say again that high valuation is not a sufficient catalyst by itself to cause stock prices to fall.  That said, however, valuation is the best long-term guide to future stock price performance.  As I have argued many times in past commentaries, high valuation tends to lead to low subsequent long term performance and low valuations lead to high future performance.  It is true that when you buy at levels that are expensive relative to history, you are not necessarily punished by an immediate loss of principal.  Often in fact the market goes on to make new highs over the next several months or even years.<4>   On a fifteen year basis or longer, however, valuation is hard to beat as a predictor.  If you bought the S&P 500 in late 1999, only in the last three years or so would you have a gain in inflation-adjusted terms.

I also want to emphasize that active managers may not have merited the acclaim (or paychecks) the best of them received in the 1990s, but they aren’t idiots either.  The more that stocks are purchased due to their inclusion in a capitalization-based index as opposed on their individual merits, the more scope there is for a manager to outperform by doing deep analysis.  However, it may take longer for their discovery to be rewarded.  In addition, it is much more difficult to add value when you are one smart person competing against a hundred or a thousand other smart people trying to determine what Apple is going to earn next year than it would be if indexing reduced your competition to fifteen or twenty (maybe only two or three if you were researching Donaldson or Fastenal).  The skill of stock picking is bound to matter a lot more if the market as a whole is performing poorly (as it was in the 1970s and early 1980s) such that the extra value that someone who can read a balance sheet and income statement can provide is valued once again.

To sum it all up, it’s important to state that this commentary is not to argue against indexing per se.  We use indexing extensively, especially in smaller portfolios.  The point is to observe that historically anytime a sector, investing style, or strategy becomes almost universally applauded it tends to end badly.  Its merits are well-known while its drawbacks are minimized or ignored altogether – until the event occurs in which they become obvious to everyone.  We are in the ninth year of an upturn that began in March, 2009.  It stands to reason that a strategy that has kept investors fully invested with minimal investment costs would be popular.  And as I suggest at the end of the Outlook section, I’m not looking for this bull market to end imminently<5>.  What I am saying is that at some point in the not too distant future this bull market will end, and success at that point will probably require a different approach than the one that has been so successful over the past eight years.  Trademark Financial Management stands ready with both the historical knowledge and the intellectual flexibility to modify our approach to the indexing versus passive management debate to take advantage of different market environments.

We thank you, as always, for your confidence in us.

Mark A. Carlton, CFA®

 <1> Stocks as measured by the S&P 500 Index and bonds as measured by the Barclays US Aggregate Bond Index.  Source: YChart.com

<2> Emerging markets as measured by the MSCI Emerging Market Index and Developed Markets as measured by the MSCI Europe, Asia, Far East Index.  Both indices include dividends and are stated in U.S. dollar terms. Source: YChart.com

<3> High yield bonds as measured by the Barclays High Yield Corporate Index and Emerging Market Debt by the Barclays EM Aggregate Index.  Source: Morningstar Adviser Workstation

<4> Alan Greenspan made his famous “irrational exuberance” comment in December 1996, more than three years before the market peaked.

<5> Typically the market makes a top over several months, and there is no evidence as yet that the topping process has begun.

Disclosure

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

Summary

The U.S. stock market rallied to new highs last quarter.  Investors appeared to be nervous leading up to the election, but whatever concerns they had quickly faded against the promise of lower corporate tax rates and reduced regulation.  Investors didn’t buy everything, however.  They enthusiastically bought smaller companies and those more sensitive to an economic upturn but they seemingly lost interest in larger, safer companies.  The Russell 2000 small cap index rose 8.83% last quarter and many financial services companies gained more than twice that.  On the other hand, the NASDAQ 100 Index rose just 0.09%, and dozens of funds in the large cap growth category actually lost money in the 4th quarter.  Both Amazon and Facebook dropped more than 10% as technology fell out of favor.  So we have to look at the S&P 500’s 3.82% quarterly return as averaging out some spectacular performance and some very dismal returns.  See Chart. Please note that on the chart we display the returns of ETFs that track the underlying indices because those are the returns an investor would experience.  Please see the endnote for more information.

Chart 1

Source:YCharts.com

Whatever one might say about U.S. stock performance, however, it was quite a bit better than what one received elsewhere.  In fact, every single region outside the U.S. experienced a decline last quarter in dollar terms – that includes Europe, Asia (including and excluding Japan), Latin America, and emerging markets as a whole.  And mind you, even before the quarter began the U.S. had been soundly trouncing world markets.   The ten year annualized return on U.S. stocks is 7.07%, according to Russell, while the ten year annualized return on stocks outside the U.S. is 0.75% in dollar terms.  That is more than 6.3% every year for ten years!  As you can see in Chart 2 the difference in returns is stark.  Even if you allow that some of this is due to the effect of a stronger dollar, this has to create, at some point, an incredible opportunity to shift into foreign stocks.  U.S. stock out-performance also occurred in the 1990s, leading to a multi-year period of foreign stock strength from 2003 through 2007.

Chart 2

Source:YCharts.com

Bonds were also weak last quarter.  Interest rates surged on the belief that the Trump Presidency would mean greater economic activity and higher inflation.  The Barclay’s Capital Aggregate U.S. Bond index shed -2.98% (the ETF shed -3.12%).  Municipal bonds declined even more (the Barclay’s Municipal Index  declined -3.62% while the index tracking ETF shed -4.43%) on the idea that a lower tax rate would reduce their attractiveness on an after-tax basis.  Foreign also had a rough quarter as the strong dollar hampered securities with foreign currency exposure.  High yield corporate bonds managed to eke out a small 0.86% gain.  See Chart 3.  After such a poor quarter for bonds, sentiment has understandably become quite poor.  This might actually create a bit of a buying opportunity.

Chart 3

Source:YCharts.com

Activity

It is hard to overstate the change in the market that occurred after the election.  Prior to the election the market was defensive, favoring larger companies and defensive industries.  After the election, risk was suddenly vigorously embraced.  Smaller companies and economically sensitive industries performed much better.  A great deal of our activity, therefore, was making sure portfolio were not overly exposed to less volatile, high dividend stocks, which had been so successful in 2015 and early 2016.  We bought more small caps and sold some positions that were too defensive to succeed in the new environment, including USMV.    We also made several transactions in non-qualified portfolios to reduce realized capital gains or in a few cases to more effectively use a capital loss.

We have been gradually decreasing cash levels in portfolios.   All of this has had the impact of making portfolios modestly more aggressive. That said, we are most comfortable owning larger, dividend-paying companies and industries that are a little less economically sensitive because statistically that cuts down on volatility.  For that reason, we weren’t predisposed to sell funds that had done very well for years – both in absolute terms and relative to their peers – just because the fad was to bet on a huge recovery.

What surprised us the most when we looked at November’s performance was how different returns were among funds that we didn’t really believe had much of a cyclical or defensive bias.  Principal Midcap (PEMGX), for example, is a 5-star Morningstar rated, middle capitalization, fund with a top decile 3, 5, and 10-year ranking in its category.  It gained only 0.85% last quarter.  T. Rowe Price Capital Appreciation is in the very top 1% in its peer group over the trailing 3, 5, and 10 years and it could only scratch out a meager 0.15%.  On the foreign side, MFS International Value is another 5-star, top decline 3, 5, and 10 year fund that had a surprisingly rough (-5.76%) fourth quarter.  We did not fully appreciate the extent to which our portfolios expressed a preference for consistent growth over opportunistic growth. We are not going to abandon great funds because they went out of favor for a few months.  Everybody underperforms from time to time.  We obviously want to know why, and if we know the answer and are satisfied by it, we don’t make a change.  If over the next several quarters it becomes apparent that this is truly the dawn of a new economic era then we will make more changes.

Outlook

I’m going to refrain from making any predictions, because I believe the outlook has never been more uncertain.  We have spent the last eight years in a policy regime that emphasized low interest rates as a means of forcing investors to use their cash balances to invest.  Investors were generally rewarded, but savers were unquestionably punished.  The financial economy (stocks & bonds) did well even as financial services companies themselves were hamstrung by regulation.  Main Street (the net worth of the average person) did not do nearly as well, though employment improved dramatically.  In any event, the market is predicting that all of this going to change with the new administration and congress.  Fiscal policy will replace monetary policy as the main economic lever as Congress in theory now has a President it is willing to work with.  Global trading relationships seem certain to change.  How this will impact the dollar is uncertain but critical.  It is widely expected that corporate tax rates will be slashed.  This should improve corporate balance sheets as well as provide more fuel for stock buybacks.  Almost certainly, however, the federal budget deficit and debt beyond 2017 will increase.

Until we get more clarity on how all of this will play out, our instinct is to run fairly neutral portfolios, with very little sector exposure and no major interest rate bets.  The markets, both stock and bond, have probably overstated the degree to which one individual can change the larger economic forces shaping the globe at this time – the deflationary implications of an aging world population, high and growing government debt burdens, and the increasing use of technology to improve productivity by replacing human workers.  Politically, however, one individual can do quite a lot.

Commentary

The market traded at all-time highs in December.  Many clients we spoke with conjured up a mental picture of a rising ocean tide; the idea that all stocks were higher. In reality, you should picture coffee in a mug in a car travelling down a bumpy road.  Upon hitting a bump and the level of coffee surged in some areas and plunged in others.  Over the five week period between November 4th and December 9th a very large amount of money “sloshed” from bonds and foreign stocks to U.S. stocks.  The actual volume of coffee in the mug did not change very much.  So if you had a well-diversified globally invested portfolio, then last quarter was entirely unspectacular. Chart 4 highlights the difference in the U.S. stock market (ticker: VTI), the developed economies stock markets (ticker: VEA) and the emerging economies stock markets (ticker: VWO).

Chart 4

Source: YCharts.com

Diversification is a play on the notion that not everything can have its worst performance simultaneously, because money that comes out of one asset class may go to another.  For example, in 2008 almost every asset declined, some quite sharply.  However, U.S. Treasury bonds increased 11.34% as investors fled from the risky to the safe.  While diversification is good at helping you avoid the large loss, it will sometimes produce small losses where is might have been possible to avoid them.  In a mediocre year like 2015, due to modest weakness in emerging markets and commodities, it actually subtracted from returns.

Diversification is also a hedge on the notion that the asset class we think is going to perform best often doesn’t.  In recent years the most popular assets, U.S. stocks and bonds, really have performed well.  It is easy at this point to believe that the American economic system is so superior that U.S. securities will always outperform the rest of the world.  Experience tells me the outperformance cannot continue in perpetuity.  I’ve seen long impressive runs by Japanese stocks (1980’s) and Chinese stocks (2000’s).  It seemed at the time that those markets were unstoppable forces.  Of course, as we all know those markets because wildly overvalued and eventually re-priced.  I often need to remind myself that markets are driven by humans who are subject greed, fear, enthusiasm and despondency. Ultimately all market movements, be they bullish or bearish, are susceptible to those emotions and thus the animal spirit become unsustainable.  Keeping some of your eggs in other baskets helps ensure you lose less when the inevitable re-pricing happens.  The hardest things to do as a money manager is to remain disciplined and committed to one’s investment strategy, in our case global diversification, after periods of relative underperformance.  It is precisely at those times when maximum opportunity is created but it is also the most difficult time to invest.

For our part, we observed the surge in stocks and in the dollar in the days following the election and identified the pockets of greatest strength (small and mid-size stocks, and the industrial, materials, and financial services industries) and greatest weakness (large “blue chip” stocks, and the utility and consumer staples industries).  We analyzed our exposure to these asset classes and made changes we felt we were warranted based on relative under or over weights.    We believe that markets overreacted in terms of expected 2017 economic growth and that investors will return to less cyclical industries at some point.  So far in 2017 bond yields are falling once again and more growth-oriented industries (think info tech and biotech) are performing the best.  Regardless, we remain committed to our process of disciplined, globally based investing.

The intent here is to give you an insight into how markets moved over a particular period of time and how diversification plays an important part in our portfolios.  Investment decisions always seem easier in retrospect and we are not inclined to chase after sharp market moves.  Last quarter the market reacted strongly to the environment it believes will be in place shortly after Inauguration Day, but right now that is all speculation.  Those moves might not look good six months from now.  You have placed your trust in us to act prudently with your money and we take that trust very seriously.  Much like our country’s largest endowments, Trademark pursues a globally diversified portfolio approach because it is the highest standard of practice in the investment management industry.

Please Note – Fee Reduction

We have reduced the fees our clients are charged in several of our asset management programs.  The changes are summarized on our Form ADV.  Copies of our ADV can be found on our website at www.trademarkfinancial.us/current-disclosures.

Thanks for your continued trust in our management,

Mark Carlton, CFA

Index Return Source: Morningstar Adviser Workstation

Russell 2000 as measured by iShares Russell 2000 ETF (Ticker: IWM), NASDAQ 100 as measured by PowerShares QQQ ETF (Ticker: QQQ), S&P 500 as measured by iShares Core S&P 500 (Ticker: IVV).  Source: YCharts.com.  Tracking error, or small differences in the return of the ETF and index, are normal and the result of share creation and redemption, and dividend payments.

Russell 3000 Index, through 12/31/2016, according to Frank Russell & Associates.

MSCI EAFE Index, through 12/31/2016, according to Morgan Stanley.

Total returns as measured by iShares Russell 3000 (Ticker: IWV) and iShares MSCI EAFE (Ticker: EFA).  Source: YCharts.com

Total return as measured by iShares Core U.S. Aggregate Bond (Ticker: AGG), SPDR Nuveen Bloomberg Barclay’s Municipal Bond ETF (Ticker: TFI), and iShares iBoxx High Yield Corporate Bond ETF (Ticker: HYG)

Total return as measured by Vanguard Total Stock Market ETF (ticker: VTI), Vanguard FTSE Developed Markets ETF (VEA) and Vanguard FTSE Emerging Markets ETF (VWO).

Diversification is a risk management technique that mixes a wide variety of investment within a portfolio. (Hat tip to Investopedia) The idea is that by spreading ones assets among a number of different investments not all will move in the same direction at the same time.

Total return as measured by Bloomberg Barclay’s Intermediate Term Treasury ETF (ticker: ITE).  Source: Morningstar Adviser Workstation

Disclosure

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

Summary

It was a tale of two half quarters. The first six weeks saw equities sell off on fears that the Federal Reserve would continue hiking interest rates in 2016 and the result would be a global recession led by the emerging markets.  The last seven weeks of the quarter produced a spectacular rally as the Fed backed away from its planned rate hikes and risky assets began to recover.   As the dollar fell, the pressure on global currencies was reduced considerably.  Emerging markets (particularly Latin America) soared.  Oil prices began to recover.  Such is the power that monetary authorities wield today.

Putting the two pieces of the quarter together, stocks put in a mixed performance overall.  The S&P 500 rose 1.42% for the quarter, while the Russell 2000 small cap stock index was off -1.47%.   The technology-heavy NASDAQ Composite fell -2.09% as “growth” stocks under-performed “value” stocks for the first time in two years.<1>  See Figure 1. The strong decline early in the quarter caused investors to prefer high dividend paying stocks to rapidly growing companies, and that bias persisted even as stock recovered.  The utility and precious metals sectors performed the best last quarter, which makes little sense if you consider gold an inflation hedge.  Financial stocks did the worst once again, as investors remain wary of a sector so sensitive to government interference.

Figure 1

Latin America finally posted a sharp rally after five years of absolutely hideous performance.  A modest recovery in commodity prices and the possible impeachment of the Brazilian president was behind the surge.  Despite the 6.40% gain from emerging market, international stocks as a whole posted another quarterly decline (-0.33%).  Japan was the leading culprit as even negative interest rates don’t seem to be able to spark inflation or depress the Yen.  Europe was down -2.75%.<2>  See Figure 2.

Figure 2

The aggressive use of monetary policy to combat weak global growth was again positive for bonds, especially high quality bonds.  The interest rate sensitive Barclays Aggregate Index gained 3.03%, its best quarterly performance in several years.  Anyone who has warned investors over the last five years not to invest in bonds has done them a great disservice; yields have gone lower (not necessary in a straight line of course) and prices have gone higher.  Even sectors that struggled mightily in 2015 – high yield corporate bonds, emerging market debt, and inflation protected bonds – each posted solid returns.<3> Activity

Our trend-sensitive indicators led us to reduce stock exposure in January and begin to build it back up in March.  Since we bought at a higher price than we sold, this hurt performance modestly.  Our key objective is to make sure we are on the right side of the big moves.  Had the -11% decline early in the quarter persisted or turned into a 20% or 30% decline, we would have lost quite a bit less.  When the market began to recover we had to become buyers to make sure we didn’t fail to participate if stocks rallied 20% or 30%.  The process of selling and later buying, even if the buys turn out to be at higher levels, has the benefit of allowing us to sell weak relative performers (in January this was mid- and small cap growth stock funds and certain international funds) and eventually buy into areas with better relative strength (dividend payers and low volatility stocks).

Outlook

The market clearly likes the idea the Federal Reserve is not going to increase interest rates for at least the next two months.   Many strategists think the Fed is on hold for the rest of the year.  It may be hard to justify current U.S. stock prices based on earnings or cash flow growth, but there is no questioning the fact that Fed induced momentum is currently positive.  Moreover, many people who sold stocks late last year or early this year have missed the rally and are hoping for a pullback in order to buy.  This is what has kept stocks from declining more than a percent or two over the last nine weeks.  That said, bears are counting on the following factors to ultimately push stocks lower:

1. Weak corporate earnings and falling future earnings expectations;

2. Seasonally, late spring and summer are weak periods for stocks (especially in an election year);

3. None of the remaining four U.S. presidential candidates is viewed as market friendly;

4. Central bank policies to stimulate the various economies have shown little results other than to transfer money from savers to investors/speculators. Political developments in the U.S. and Europe strongly suggest that the public has lost patience with these policies.
   The upshot is that in the very short term, technical and seasonal factors suggest that the upward trend continues.  Looking toward the rest of this year, however, if people in the U.S. and Europe don’t start to see tangible signs of their economies picking up (i.e. higher wages, more interest on savings), they may force political changes that would not be market friendly.

   Commentary – Let’s Play Twister!

   We prepared for the worst three months ago as U.S. corporate earnings were set to fall for the fourth consecutive quarter and the rising dollar made the global market scenario even worse.   In February action by the European Central Bank and non-action by the Federal Reserve completely changed the tone of the market.  Whether or not this should have produced such a rally is beside the point – for the last six years investors have been rewarded for dancing to the central banks’ tune, regardless of what they think of the underlying economy.  More than a few veteran market participants are concerned that this is not the way that investment markets ought to work and at some point central bank activities will lose their effectiveness.

   U.S. stocks, as measured by the S&P 500, have done quite well over the last several years.  In fact, they have more than doubled (counting dividends) since the summer of 2010.<4>  See Figure 3. The pattern is familiar.  We rally for a few months in anticipation of an economic recovery but the recovery comes up short of expectations and stocks sell off.  Each time, in the face of a slumping market and lackluster economy, the Federal Reserve has stepped in.  As nice as this is for investors, one has to question whether this is the proper role of the Fed.  There are some very sharp minds out there – John Hussman, Ben Hunt, Vitaly Katzenelson, and John Mauldin come to mind – who warn that central bank actions are not sustainable.  At some point a market driven by price discovery and fundamental analysis, rather than central bank liquidity, needs to be restored.  If not, investors have to allow for the possibility that there will be a time when the central bankers make a move and it doesn’t work.  At that point, faced with dependence on an institution that has no arrows left in its proverbial quiver, we could be in for a significant decline.   This is the basis for most of the dire warnings you see on the right margins of your internet browsing.

   Figure 3

Until that day comes, however, if we want to keep up with the market we have to play what amounts to be financial Twister<5>.  Investment strategist David Zervos has been the most successful market strategist over the past several years by repeatedly telling us to forget the fundamentals and watch the central banks.  The ECB is pushing rates further into negative territory?  Left hand blue!  Buy gold and global equities, sell the Euro and European bank stocks.  The Fed has put interest rate hikes back on the table as early as June?  Right leg yellow!  Sell domestic and emerging market bonds, buy defensive stocks.  It doesn’t matter what any individual security might be worth.  Stocks, bonds, and currencies are all asset classes to be bought or sold as a play on what any particular central bank is doing.  And incidentally, this is killing active value managers.  You found a small cap auto parts company growing at 12% annually and trading at 10.5 times earnings?  Nobody cares, unless the stock can get itself into an index that will rise on the “risk-on” trade the next time Janet Yellen says the Fed remains “on hold”.

It has always been our preference to have good fundamental support (either reasonable stock valuations or the expectation of higher earnings) when we buy stocks – as opposed to low interest rates and the promise of a friendly Fed, which is what we have now.  U.S. stock prices, at over 20 times trailing earnings, are fairly expensive by historical standards.   Investors really need to see a sharp earnings recovery to justify current prices, but so far companies are not indicating that this is likely.  That encourages us to build in a little extra margin of safety in the form of a higher than normal cash position.  We aren’t doing it because we think we know when the next market decline is coming – I can assure you that we don’t.  We are doing so because the scope for investor disappointment seems unusually high.  It’s a long way from here to normal valuations.

In the end it comes down to what you believe your role as an investment professional to be.  If it is to squeeze every dollar of potential return from markets, then we certainly should follow Zervos and fully embrace the central bank following game.  However, we tend to agree with Hussman, Hunt, Katzenelson and Mauldin that central bank policies are ultimately destabilizing and cannot last.  Therefore, we believe caution is warranted.  We have to take seriously each market decline (in other words, we sell stocks to raise cash at the margin – as we’ve stated in the past we’ll never move to 100% cash) on the thought that this time maybe Janet Yellen or Mario Dragi and the other central bankers have nothing left up their sleeves.  If they do engineer the turn-around, then we’ll buy stocks back and suffer only modestly for our caution.  That’s okay if its helps us avoid fully participating in a 2008 style loss.  I believe this is what our clients are really looking for us to do.

Thanks for your continued trust in our management program,

Mark Carlton, CFA

<1> Total return as measured by the following ETF proxies: iShares Core S&P 500 (IVV), iShares Russell 2000 (IWM), PowerShares Nasdaq QQQ (QQQ).  Source: YCharts.com

<2> Total return as measured by the following ETF proxies: iShares MSCI Emerging Markets (EEM), iShares MSCI ACWI ex US Index (ACWX), iShares Core MSCI Europe (IEUR)  Source:YCharts.com

<3> Source: Morningstar Adviser Workstation

<4> Source: YCharts.com as measured by iShares Core S&P 500 ETF

<5> A game popular in the 1960s and 1970s in which players placed arms and legs on the colored dots as specified by a spinner.  If you could not contort yourself in such a way as to touch the right dots, you were out.

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

In a way, 2015 was a lot like 2011.  Markets muddled through the first half of the year, then plummeted in the third quarter before staging a modest recovery in the fourth quarter.  Like four years ago, large stocks rallied enough to close the year with a gain while mid and small cap stocks had a much smaller bounce and finished with losses.  The difference was that in 2011 the dividend paying blue chips were the winners, while this time around it was a handful of technology and consumer names that led the market.  And handful really is the correct word.  Factoring out just Amazon.com, Netflix, Facebook, and Alphabet (Google), the S&P 500 would have been negative on the year.

With the S&P 500 stock index gaining 1.28% in 2015 and the Barclays US Aggregate Bond Index up 0.48%, simple diversification would’ve resulted in a return somewhere around 1%.  If, however, you diversified by size, geography, credit quality, and asset class, your returns in 2015 would have been quite a bit worse.  Small cap U.S. stocks lost -1.84%.  International developed market stocks as measured by the MSCI EAFE (think Europe and Japan) fell -0.99%.  Emerging market stocks plunged -16.20% as measured by the MSCI Emerging Markets index.  Commodities crashed -27.6%.  Gold dropped -10.7%.  High yield U.S. bonds were down -5.02%.<1>  See Figure 1. As you can see, last year was very difficult, even if you were underweight all of those diversifiers.  In fact, economist Zachary Karabell noted that 2015 was the hardest year to generate returns since 1937, since it was the first time in 78 years that no asset class gained 10% or more.<2> Figure 1: 2015 Annual Returns by Asset Class

Source: YCharts.com

There was just one way to make money last year in foreign markets, and that was to own European or Japanese stocks on a currency hedged basis.  Every region declined in U.S. dollar terms, but as noted above, one was a lot better off in developed markets than emerging markets.  China continues to be the biggest driver of the global economy, and unfortunately they are not currently driving in a helpful way as their economy slows.

On the bonds side there were basically two ways to come out ahead – municipal bonds and mortgage securities.  To be sure, returns were modest – muni bonds were up 3.30% and mortgages 1.13%.<3>  Taking any kind of risk to try to earn a higher yield was in most cases punished last year, as investors become nervous about a slowing economy and rising defaults.

Activity

We were more active than usual in the fourth quarter of 2015.  We made use of new exchange traded funds (ETFs) that sorted the universe of stocks for factors that were currently in favor.  The three that we used most frequently were low volatility (choosing stocks with lower than average daily fluctuation), momentum (stocks whose prices had been showing relative strength when compared to the market as a whole) and quality (stocks of companies whose financial strength was superior when measured in several different ways).  As investors grew more defensive, it was the low volatility strategies that performed the best relative to their respective categories.  We used them both domestically and internationally.  Also, given the tough sledding the market encountered in the second half of the year, we had a larger amount of capital losses to harvest for tax purposes in taxable portfolios.

Outlook

Three months ago, amidst a rebound in October after a very rough third quarter, we wrote that we didn’t expect that rally to lead to new highs.  The first quarter of 2016 is obviously off to a poor start, perhaps confirming that the May 2015 all-time high was the peak for this cycle.  Oaktree’s Howard Marks likes to talk about asset prices being more a function of psychology than any kind of hard science.<4>  Investors tend to overlook negatives for a long time, then suddenly over-react to them.  We have expressed our concerns about high stock valuations relative to modest economic growth for quite some time, but only recently have those concerns been borne out.  Market leadership has been narrowing – health care is clearly no longer a leading sector, and there just aren’t enough consumer growth stocks to carry the market by themselves.  Even some of those companies – Apple and Disney, for example – are now 15% or more off their 2015 highs.

The combination of a weak global economy and a Federal Reserve in credit tightening mode is probably too great a headwind to allow the market do much more than tread water at best over the next few months.  As a result, we expect to maintain higher than normal cash positions and to continue to rebalance portfolios so as to reduce volatility.

Commentary – And Again…

“Wait a minute, Mark.  If you are concerned about the stock market, why don’t you just sell everything and go to cash?”  I hear this every time the market declines, and I have answered it before, but since it is topical I want go over it again.  There are three reasons we don’t sell everything when the stock market starts to fall:

One: Because we don’t know if the current decline is temporary or whether it will last for a long time.

There is certainly fear out there, but nobody knows how long it will last and what the magnitude of the current decline will ultimately be.  I do know that the stock market decline in 2016 has been pretty much in lock step with the price of oil.  Falling oil prices hurt certain entities – oil producing firms and countries and the companies that supply them and anybody invested in them – in a very real way.  It does not, however, hurt everybody.  The average U.S. consumer is getting a dividend in the form of a lower gasoline bill and lower heating bills.  At some point the market may focus on this. Right now, however, we are doing the equivalent of seeing the house across the street on fire and worrying that our house is going to be next.  At some point, oi prices will bottom.  That may or may not coincide with an overall market bottom.

Worry is something, unlike cash flow or return on equity, for example, that we as investment analysts can’t forecast.  It grips the market for a time and then it goes away, sometimes gradually and sometime not.  Historically, most 10% declines in the market do not turn into 20% declines and most 20% declines don’t turn into 40% declines.  And yet some do.  It is the lack of certainty about markets that creates volatility, but it is volatility that creates opportunity.

Two: Because there are many assets that do not necessarily decline when stocks do.

The first two weeks of 2016 have certainly been rough on stocks all over the world.  Would it surprise you to know that most bonds are up this year?  Government and municipal bonds more often than not rise in value when stock prices fall sharply.  This is what is called negative correlation.  There are other asset classes that often have negative correlations with stocks.  Gold, for instance.   Gold is up a little over 2% year-to-date.  There are also certain type of funds that that will invest on trends in asset classes or commodities.  These are called managed futures funds.  They have the ability to profit from a decline in stocks, or oil, or copper, etc.  As a whole, these types of funds are ahead in 2016 as well.  The point is, one should not assume that just because stocks are down that everything in one’s portfolio is also declining.

Three: Because moving in and out of the stock market has a poor track record.

We know that psychologically the most comfortable place to be when the market is going down is out of stocks.  That said, from an investing standpoint what is psychologically easy is seldom profitable.  The herd does not get rich.   It is often said that stock climb a wall of worry, because while there are always reasons to fear that stock prices will fall, most of the time they don’t.   Just looking back over the past several years – a time period in which the S&P 500 more than doubled – there were plenty of reasons to have bailed out of stocks.  The Federal Reserve embarked on an unprecedented expansion of its balance sheet (2009).  The U.S. credit rating was downgraded from AAA to AA+ by Standard and Poors (2011).  Greece has a credit crisis (2011) and ultimately defaulted (2015).  Commodity prices began a sharp fall as China began to re-orient its economy away from massive capital spending (2012 to the present).  Syria disintegrated into a war zone, throwing the Middle East into chaos (2013 to the present) and creating a refugee crisis in Europe (2015).  The list goes on.  And yet, General Mills still sells cereal and yogurt and Amazon still sends you nearly any material thing you could want in a day or two.  Profits are still being earned all over the world.

More often than not, selling stocks on the basis of fear leads to buying them back later at higher prices.  Vanguard, Morningstar, Dalbar and JP Morgan have all done studies showing that people’s actual returns are much worse than that of the mutual funds in which they invest because investors have a strong tendency to buy into rising markets and sell into falling markets.  Wall Street even has a saying “bear markets are when stocks return to their rightful owners” that refers to the fact that any idiot can buy a rising market but only the savvy investor buys when prices are low. See Figure 2; the yellow bar represents the average investor return between 1995 and 2014 as calculated by J.P. Morgan Asset Management.

Figure 2: 20 Years Annualized Return by Asset Class (1995-2014)

Source: JP Morgan 1Q16 Guide to the Market

If we thought we could be more effective jumping in and out of the market we would.  We’ve been doing this long enough that we remember the names of those who got one major market call right and never did it again.  We don’t know of anybody that has consistently made that work.

The point is, we believe that all market conditions require intelligent, experienced management.  Nobody rings a bell at the top or at the bottom.  Market movements constantly confound expectations.  One has to continuously evaluate one’s holdings in light of the current circumstances and be ready to make changes if necessary.  The investment world is fortunately very diverse, so alternatives exist for just about any type of market condition.  Going to 100% cash is not the only way to protect a portfolio; in fact it tends to reduce one’s returns over time due to the difficulty of timing one’s re-entry.  All we really care about is being effective on your behalf; that is why we spend a considerable amount of time on research, analysis, and portfolio monitoring.

Thanks for your continued trust in our management program.

-Mark Carlton, CFA

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.  <1> Source: YCharts.com.  As measured by the total return of the ETFs tracking those indices from 12/31/2014 – 12/31/15: S&P 500: IVV, Barclay’s US Agg: AGG, S&P 600: SLY, MSCI EAFE: EFA, MSCI Emerging Markets: EEM, DB Commodity Index: DBC, Gold: GLD, High Yield Bonds: HYG.  We’ve listed ETF returns because they represent an investible way to access the referenced index.

<2> Source: A Most Challenging Year, Zachary Karabell, Investpmc.com

<3> As measured by the Barclay’s Municipal Bond Index and the Barclay’s U.S. Mortgage Backed Securities Index.  Source: Morningstar Adviser Workstation

<4> Latest memo from Howard Marks: On the Couch, January 2016, oaktreecapital.com

Summary

Financial assets had a tough second quarter.  Interest rates rose while corporate profits dipped.  Greece was once again in the headlines, this time joined by Puerto Rico and China.  Those negatives were offset by continued growth and rising employment in the U.S. economy combined with economic improvement in Japan and Europe.  It seems like we have been on the verge of a Greek default since 2012 and an interest rate hike since the summer of 2013.  At some point, investors got tired of the “crying wolf” aspect of these two crises, lifting stocks up over 60% since the summer of 2012.  Now, however, those situations are too pressing to ignore, and that is proving to be an increasingly strong headwind for both bonds and stocks.

The major U.S. stock index, the S&P 500, did eke out a slight gain (0.28%)<1>. (See Figure 1)  Increasingly, however, the market is being driven by a handful of larger consumer names like Disney, Nike, Facebook, and Apple.  On an equal-weighted basis, the market would have declined -1.09%<2>.  Health care was the top sector once again with a gain of 2.8%, while the biggest loser was real estate (-10.69%)<3>.  With the Dow Transportation Index off -7.12% and the Dow Jones Utilities Index down -6.26%, it felt like the losers lost more than the winners gained. (See Figure 2)

Figure 1

Source: YCharts.com

Figure 2

Source: YCharts.com

Foreign stocks were a very mixed bag.  Overall they gained 0.62% in U.S. dollar terms.  Japan and Latin America each rose more than 3%.<4>  For Japan it was the continuation of gains made over the past three years as the yen has declined, whereas for Latin America it was a bounce off deeply oversold levels.  Latin America has struggled mightily since commodity prices peaked in 2011.  China is probably the most interesting market.  It shot up more than 42% from March 11th to June 12, only to give almost all of it back by the second week of July. China’s economy is slowing, and the volatility associated with this is playing havoc with countries whose economies have become somewhat dependent on supplying it raw materials, such as Australia, Chile, South Korea, and Canada.

As for fixed income, this was the quarter that the bond bears had warned us about for the last six years.  The Barclays Capital Aggregate Bond Index sank -2.11%. (See Figure 3)  Bonds had their worst three months since the second quarter of 2013.  Interest rates rose across the board and credit concerns increased as well.  This meant that neither Treasuries, nor municipal bonds, nor corporate bonds (whether investment grade or high yield), nor international bonds posted a gain.  Obviously, shorter duration bonds had less interest rate sensitivity so they performed better.

Figure 3

Source: YCharts.com Activity

The most important thing to do this past quarter was to monitor exposure to interest rates.  Interest rate exposure will hurt you when rates rise, of course, but long duration bonds are usually the best possible asset during periods of economic or political instability.  For most investors, we trimmed existing bond positions because their upside is limited in most scenarios.  For more aggressive investors, however, we actually bought long bonds in order to offset some of the risk of our foreign stock positions. We also reduced our weighting in interest rate sensitive equities like REITs and utilities and in global bonds.  Some of the proceeds went into mid cap stock funds that emphasized health care, but in most cases we held on to the cash to await better entry points.  We are increasing cash levels because our concerns are growing and we want to have money on the “sideline” to invest if and when prices fall.

Outlook

We have written about the U.S. stock market being overvalued for several years now. With the Federal Reserve maintaining very low interest rates and the economy continuing to expand modestly however, there has been little to indicate that stock prices were about to fall toward fair value anytime soon.  Bear markets tend to need a catalyst.  Greece has danced in and out of the headlines since 2011, but it does not seem likely that its troubles (in and of themselves) could cause more than a modest correction unless the rest of the European Union really screws things up.  A crash in the Chinese stock market, on the other hand, could be the catalyst to a broader global decline because it is not priced in.  China is experiencing at least a partial unwind of a speculative mania which started last summer and then went parabolic in March.  The plunge since June 12th has been frightful, and the authorities have had only modest success in halting it.  Because we are concerned about China we are raising a little more cash.  That said, it is not our policy to sell everything when market conditions deteriorate.  We’d like to explain our reasons below.

Commentary – Nobody Has a Crystal Ball

We do not go “all in” or “all out”.  There are several reasons for this:

1. Conditions may change very rapidly.

2. Almost nothing happens in the market that doesn’t benefit at least somebody.

3. Frequent trading isn’t tax efficient.

4. Frequent trading increases costs.

5. Frequent trading has never been shown to be effective over the long term.
   Let’s discuss each of these points in detail.

   Conditions may change very rapidly.

   We are in an age of extremely interventionist central banks.  Whether here, in Europe, in Japan, or in China, market troubles seem to be met with aggressive measures to halt the slide.  Each of our “quantitative easings” has come as a result of stock market weakness and been quite effective (at least in the short run).  The same can be said of European interventions in 2012 and earlier this year.  Recently the Chinese government brought a stop to its stock plunge by banning short selling and buying stocks.  Even if you believe that all of these measures are ultimately doomed to fail, they can and have been very successful at delaying any potential day of reckoning.  Selling into a market correction has been a very unprofitable strategy over the past six years. Almost nothing happens in the market that doesn’t benefit at least somebody.

   It is extremely rare that everything in the stock or bond market goes up or down at the same time.  Typically, markets go back and forth between a “risk on” mode and a “risk off” mode.  The risk in question may be economic, interest rate, liquidity, or something else.  For example, when the Greek crisis hit, there were elements of economic and liquidity risk involved, so investors sold European stocks aggressively and to a lesser extent U.S. stocks and Asian stocks.  They were hardest on stocks that benefitted from global growth and Euro-denominated securities.  On the other hand, they bought Yen and Dollar denominated government bonds, and they bought higher yielding domestically focused stocks in both the U.S. and Japan, such as utilities and real estate.

   Money is constantly flowing, seeking the best payoff for a given level of risk.  These calculations are made and remade with every new piece of information that comes out.  When we calculate capture ratios, we are basically looking at how each security does when the tide is rolling in versus how it performs when the tide is rolling out. <5>  Volatility gives active strategies more of a chance to shine.  If we can find a mutual fund or ETF that tends to consistently make a little more or give back a little less, we get interested in looking more closely at the strategy.

   Frequent trading isn’t tax efficient.

   If you trade frequently, all of your profits will be taxed at the higher short term tax rates.  For taxable investors in higher tax brackets, the savings could be as much as 19.6%.

   Frequent trading increases costs.

   Frequent trading can be expensive.  Most brokerages will not let you trade for free and those that do will not let you do it frequently.  At TD Ameritrade, for example, the vast majority of trades we make do not carry a transaction fee.  The fund or ETF we purchase, however, may have a restriction that allows them to retroactively charge a fee if we don’t hold it for a certain period of time.  In addition, TD itself will charge us a separate fee if we do not hold a fund at least 90 days.  Mutual fund and variable annuity companies typically allow free trading within their family, but they generally limit the number of trades you can make in a twelve month period.

   Frequent trading has never been shown to be effective over the long term.

   The most important reason we don’t make large “in or out” market calls is that they usually don’t work.  I’ve been in the securities industry since the mid-1980s and I remember exactly two professionals getting the 1987 crash right and neither ever had a timely call like that again.  Several people were right about the tech crash in 2000 but they were not the same people who were right about the sub-prime crash in 2007 and in each case the people that were right were early enough to have to endure some real pain first.  But oh, there were so many more people over my nearly thirty years that were disastrously wrong!  I remember the gold bugs who were wrong for 16 years and missed a stock market run from Dow 1500 to over 10000 before their ship finally came in in 2001.  I remember for years hearing that bond yields had nowhere to go but up while bond yields were busy falling to 5%, 4%, 3%, and lower (greatly enriching bond investors).  Inflation didn’t come back when the Federal Reserve started quantitative easing back in 2010 and the stock market didn’t crash either, though both were widely predicted by the folks who run scary advertisements on CNBC.

   Jumping in and out of the market requires being right not only about the “what” but the “when”.  The best investors in the world do not try to do this.  They focus on getting the “what” and the “how much” right, because the “when” is notoriously unpredictable. Financial writer John Mauldin has often used an avalanche metaphor to indicate that imbalances in markets are relatively easy to spot, but knowing what will finally set them off and what kind of collateral damage they will do is the hard part.  It is impossible to react to breaking news faster than the market; the only possible advantage we can create is to react more thoughtfully.

   So what do we do instead?  It is Trademark’s practice to carefully decide what to buy, and then modestly add to or subtract from those positions as conditions warrant.  From time to time we have to replace securities either because something happened at the fund (manager change, deviation from the stated investment process, etc.) that causes us to believe the fund’s track record cannot be maintained, or because the fund’s particular approach is less suited to the current environment as one of its competitors.  We may under or overweight sectors or regions because of economic fundamentals, but we don’t put all of our eggs in one basket.  For us, it is not about making the biggest profits when we are right; it is about being in the right asset class and the right funds as often as we can while trying to limit the consequences when we are wrong.  Nobody has a crystal ball.  The biggest investing mistakes are made by those that think they know what is going to happen and therefore don’t have a strategy when things inevitably move against them.

   <1> S&P 500 Index per Morningstar

   <2> S&P 500 Equal Weight Index per Morningstar

   <3> Sector returns courtesy of FactSet and Russell per JP Morgan’s quarterly report

   <4> Foreign stock returns from MSCI per Morningstar

   <5> Upside/downside capture ratio show you whether a given fund has outperformed–gained more or lost less than–a broad market benchmark during periods of market strength and weakness, and if so, by how much

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.

Summary

The U.S. economy improved modestly in the first quarter of 2015.  The bigger story, however, was how well the rest of the world’s developed markets responded to financial stimulus.  In the U.S. quantitative easing has been a fact of life since 2009 and the stock market is up over 200% from the March 2009 lows.  In fact, “QE” has been so successful in stimulating financial activity that the Federal Reserve has signaled it is prepared to raise rates later this year.  By contrast, Japan and the European Union started their stimulus programs much later and have not seen anywhere near the market recovery the U.S. has.  That said, U.S. economic growth has been so gradual over the past several years that bond yields have continued to decline, providing another surprisingly good quarter for bond investors.

After two years in which large company U.S. stocks handily outperformed every other asset class, the benefits of diversification were quite evident in the first quarter.  The S&P 500 index gained less than half a percent (0.47%) on the quarter, as the strong dollar hurt many multinational companies.  Small and mid-size firms, which tend to do more of their business domestically, were up 4.35% and 5.01%, respectively. See Figure 1. Health care was the best performing industry group as investors continued to be attracted to their strong earnings growth.  The worst sectors were utilities and transportation stocks – each gave back more than -4%.  Both sectors gained more than 25% in 2014.

Japanese stocks posted a 10.2% quarterly gain.  The sharp decline in the yen in 2014 paved the way for the export sector to do exceptionally well.  The rest of Asia was up 4.9% led by India which was up 9.9%.  Europe has also been trying to push its currency lower, and that effort is finally starting to bear fruit.  Europe rose 3.5% in dollar terms, but more than 10% in local currencies.  The worst region was once again Latin America (off -9.5%) as Brazil is reeling from rising inflation and a corruption scandal.

Bond yields continue to confound the experts by staying low.  Every time we think the interest rate cycle has decisively bottomed we get a surprisingly weak economic report and the next interest rate increase gets pushed a few more months into the future.  The Barclays Aggregate Bond Index rose 1.6% last quarter.  Inflation protected bonds rose 1.4%, and municipal bonds tacked on 1.0%.  As one might expect in a strong dollar environment, foreign bonds posted a loss on the quarter.  The best bond sector was high yield corporate debt, which shook off a fairly awful second half of 2014 to end the quarter 2.5% higher.

Activity

Seeing that the depreciation of the euro and the yen were stealing growth from the dollar, the move to make this past quarter was to increase one’s foreign stock weighting, especially on a currency-hedged basis.  There are ETFs and mutual funds that enable us to do this, and where available and risk-appropriate we took advantage.  The second performance enhancing step this quarter was favoring growth-oriented funds at the expense of value-oriented funds.  See Figure 2  In the later stages of a cyclical market rally, investors tend to get more aggressive and are willing to pay up for companies they feel would not be hurt if the Federal Reserve raised rates.  Slower growing large companies with strong balance sheets tend to do well during most phases of the market cycle, but not this one.

Outlook

We wrote last quarter that we really need to see economic growth pick up elsewhere in the world, because the U.S. couldn’t remain the one and only economic engine indefinitely.  Happily, we have seen growth pick up overseas (admittedly from pretty low levels) and that gives us hope that the cycle can continue even longer.   There are some headwinds, however, that suggest the going will get tougher:

1. The Federal Reserve is almost certainly going to raise rates in the next few months. Given the massive amount of borrowing over the past several years, this is a concern that nobody seems to be able to accurately quantify.  Higher rates don’t guarantee a decline in the stock market, but equities do perform much better historically when interest rates are falling.

2. The U.S. manufacturing sector had an advantage when the dollar traded at $1.45 to the Euro and at 85 yen two years ago, but now we are at $1.08 and 121 yen. This is going to cost U.S. exporters.  Iron ore mines in northern Minnesota have recently been idled because they are no longer competitive.

3. According to Goldman Sachs’ David Kostin the S&P 500 Index trades at a forward P/E of 17.2x, the highest level in the past 40 years outside of the Tech Bubble. The median stock trades above 18x, ranking in the 99th historical percentile since 1976. Sure, we could go higher on a 1999 style blow-off top, but do you really want to bet on that?
   Headwinds notwithstanding, as long as we remain in economic “Goldilocks” territory – weak enough to keep interest rates well behaved but strong enough to permit gently rising employment – stocks are probably going to remain the asset of choice.

   Commentary – Extra Innings

   Every quarter I attempt to come up with an analogy to describe the type of market environment we are in.  This quarter I’m going to present two analogies. The big takeaway should be that we are in a favorable but fragile environment where any type of change will be viewed skeptically by market participants.

   The Wheel of Fortune Analogy: Imagine you are watching the well-known television game show Wheel of Fortune.  One of the contestants has been successful this round and has piled up $6,000 and a trip.  There are only three consonants left and you are sure she must know the answer to the puzzle.  You yell at the TV “Solve the puzzle now!” but she has noticed that each spin lands her in the same section of the wheel with only money spaces.  So, despite the fact that each new spin offers only incrementally more money while risking all her winnings, she spins again.

   The Baseball Analogy: It has always been fashionable for market pundits to describe the market cycle in baseball terms.  For example, “Stocks have done very well over the past several years, but the Federal Reserve hasn’t even begun raising rates, so we think we are only in the seventh inning of the rally”.  Maybe so.  On the other hand, a better baseball analogy may be that the rally that began in the Spring of 2009 wasn’t the first inning of a new game but instead the top of the tenth in the old game.  Let me explain.

   The Federal Reserve, through its bailouts and liquidity programs, succeeded in making sure the fallout from the previous game, the real estate and financial crisis, did not result in a general deflation (which had historically always been the result of a debt crisis).  The effects of this are mixed – the economy is unable to hit a home run, but it doesn’t strike out either.  Though it is theoretically possible that one good hit could end the game, the Federal Reserve (umpire) is acting like the referee in those Buffalo Wild Wings commercials by pulling out all the stops to make sure that doesn’t happen.

   The Federal Reserve and other world central bankers are working to create an environment that rewards risk taking on the belief that taking risks leads to economic growth and more jobs.  But for some of the key players in the global financial system, the central banks won’t let them fail – even when they make bad decisions.  China for example is struggling under the weight of overinvestment in infrastructure to the extent that many of their projects will never earn a return that justifies the cost of the capital provided.  Similar if smaller inefficiencies are promoted by central banks all over the world (including our own).  The concern here is that if you keep bailing out small missteps then  bad behavior continues until it reaches a critical mass that becomes uncontainable (ala 2008).  In market terms, we are in an investment environment where we no longer have frequent modest declines of 10-15%, which serve to remind us that market risk is always with us but can be overcome with patience and prudence.  Instead, we have long rallies without significant pullbacks such that risk is forgotten.  Ultimately these end in devastating routs that wipe out a significant chunk of the market’s value and leave individuals with a profound sense of distrust.

   The upshot is that investors are playing a game where the odds of success in the short term are very favorable but the negative consequences of a sudden end to this “not too hot, not too cold” environment are so much greater than the upside should it continue.  Put another way, the risk reward tradeoff is skewed.  All things being equal, we would prefer not to be market timers since it is extremely difficult to call a market top.  That said, the market is approaching a point where raising some cash might be prudent, despite the odds.   We are not afraid to be early.  After all, if you don’t have an eye on the exit, you risk getting trampled when the game ends.

   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. Per JP Morgan Guide to the Markets, 4Q14

   All of the international market  indices cited in this paragraph are from MSCI via Morningstar

   All of the bond market indices cited are from Barclays via Morningstar

   Source: GSAM Short Stories in 3 Chapters, April 13th, 2005