Summary

Stocks posted another gain last quarter as measured by the two major indices (the S&P 500 and the Dow Jones Industrial Average, see Figure 1), but it really didn’t feel like a good quarter, did it?  With the small stock Russell 2000 Index falling -7.4% and the MSCI World ex-US Index off -5.7%<1>, diversified portfolios did not have much of a chance to finish in the black.  See Figure 2.

Figure 1

Source: Stockcharts.com Figure 2

Source: Stockcharts.com

The proximate cause of the overall weak stock market was the global economic slowdown.  First, the economic malaise in Europe appeared to spread to Germany, leaving that region with no remaining growth engine.  Mario Draghi, president of the European Central Bank, who famously started the European recovery in 2012 by saying “we will do whatever it takes” to ensure that no EC member state would default, seems to have no solution for the recent slump.  This has led to a steep decline in the Euro against the dollar.  Measured in Euros, European stocks lost only -24 basis points (-0.24%) last quarter, but translated to US dollars that loss ballooned to -7%.<2>  By and large, as unease about global growth spread, investors turned to the strongest and deepest world market (the U.S stock market), and bought those sectors they felt would be most immune to a cyclical slowdown (health care and technology).  Energy stocks were by far the worst performers (-8.6%)<3> as not even significant unrest in the Middle East could offset the twin negatives of falling global energy demand and rising supply out of North America.

Risk aversion also spilled over into the bond market, which rose just 0.2%.<4>  Despite all the warnings we’ve been getting about rising inflation, the best areas of the bond market to be in last quarter were interest-rate sensitive – long term municipal and government bonds.  Foreign bonds had to contend with the strong dollar, which more than wiped out the interest rate-related gains (currency-hedged foreign bond funds performed well).  High yield corporate bonds declined due to economic and liquidity concerns; investors grew concerned that bidders wouldn’t be there if the economy continued to slip.

Activity

The performance difference between large company stocks (up 8.3%) and small company stocks (down -4.7%) this year has been staggering.<5>  We made some good decisions at the margin.  We trimmed small company stock exposure in favor of larger cap funds.  We bought municipal bonds in taxable portfolios.  We sold out of high yield corporate bond positions such as Ivy High Yield.  That said, some of our “good” decisions did not work out as well as we would have hoped.  We selected Aston Independent Value for its willingness to go to cash if valuations got too extreme (the manager had skillfully navigated through the down markets of 2008 and 2011). Unfortunately, it declined more than -4% last quarter despite having over 70% of its portfolio in cash.  First Eagle Global, a global fund with a stellar down market track record, failed to lose less on the down side this time.  Past performance really is no indication of future performance, unfortunately.

Outlook

Last quarter we suggested that we were in a kind of best-of-all-worlds where the economy is growing enough to ensure profit growth but not strong enough to put upward pressure on interest rates, and that this allowed for modestly favorable stock and bond market performance.  Recently this equilibrium was upset as world economic growth turned meaningfully lower.  A weaker global economy is positive for bonds but not so for most stocks.  We have been dealing with those global market dynamics since the fourth week of September.   Once again the markets seem to be asking central bankers for a solution, but it appears their quivers are out of arrows.  Perhaps there are limits to the power of the world’s central banks.  Maybe if debt burdens are too high people simply can’t buy as much no matter how low interest rates are.  Perhaps the world went on such a buying binge between 2003 and 2008 that flooding the capital markets with liquidity – as the Federal Reserve, European Central Bank, Bank of Japan, and others have done since 2009 – only delayed the inevitable.  It looks like our luck might not hold after all.

That said, one good thing to come out of a weaker global economy is lower energy prices.  Traditionally this helps the economy because consumers have more money left to spend after accounting for their energy needs.  If we get a recovery in stocks over the next several weeks, it will likely be in the consumer discretionary sector as investors begin to bet on a stronger holiday shopping season.

Commentary – Is it the Golden Age of the Index?

I alluded earlier to two funds where we have done quite well in the past having failed to perform well during this market downturn.  The list of funds meeting that description is unfortunately much greater than two.  Some we owned and some we did not.  The common denominator is that each of these funds has a high “active share” which is money manager speak for the degree to which the fund deviates from its benchmark.  Over time, studies have shown that funds with a high active share add value.<6>   That said, they do not always and at all times add value.  We have been going through a period, obviously, where they by and large have not.  The question then becomes, is this approach still valid?  Should portfolios be run much more like market benchmarks?

We are always asking ourselves how we can make portfolios better.  Can we squeeze out more return for a given amount of volatility?  Could we actually get better returns taking less risk?  According to an academic theory called Modern Portfolio Theory, the answer is no (because return and volatility are positively correlated).  And yet in the real world the answer has been yes.  Researchers have documented what is called the Low Volatility Anomaly which shows that low volatility stocks have actually outperformed the market.<7>  Many funds have been created over the last couple of years to try to capitalize on this anomaly and have thus far done fairly well.  I have to wonder, however, if we are not witnessing an over-reaction to a previous investing fad.

I remember managing money in the late 1990s.  Academic literature and the success of Warren Buffett had long since established the supremacy of value investing (again, for the non-practitioner, the idea that one could earn superior returns by investing in statistically cheaper companies as measured by price-to-book-value, price-to-earnings, and/or price-to-cash flow).  From 1993 through 1999, however, value investing most emphatically did not work!  A portion of the underperformance during that time period could be attributed to the fact that many investors got caught up in technology mania.  That said, I suspect another part of the underperformance problem may have been that value investing’s advantage was well known and by 1993 too many people were pursuing that investment style at the expense of faster growing but more expensive industries like technology which were poised for takeoff.

The point I’m trying to make is that good ideas can be taken too far, creating (temporary) anomalies in the opposite direction.  Maybe some very good fund managers allowed themselves to venture too far from the benchmarks on the idea that the more “active” you were the better.  I just find it hard to believe that so many great fund managers have lost their “touch” at the same time.  Perhaps another explanation is possible.

We are going through another golden age of the index.  By this I mean a time period where the major indices are very difficult to beat.  Part of the reason is obvious – with very low expenses (including miniscule trading fees), they have a built-in advantage.  That said, are markets really so efficient that no active manager can hope to outperform them over the long term?   Increasingly index proponents are saying so.  I just have a hard time believing that for two primary reasons.  One, I know that almost all indexes are capitalization-weighted, which means that the more a component of the index (Apple, for instance) goes up in price the more of it the index has to own.  The reverse is true with falling stocks.  Therefore, at the margin every day the index buys high and sells low.  That just cannot be a successful strategy over the long term.  The other reason is that active foreign managers have done well over time relative to foreign indices.  This is largely the result of Japanese stock having ballooned to a huge percentage of the MSCI EAFE<8> index by 1990 and then gradually fizzling lower ever since.  Just about every active international manager was underweight Japan over the last two decades which helped them beat the EAFE.  The same thing on a much smaller basis happened in the U.S. from 2000 through 2005.  Microsoft and General Electric were valued at $586.2<9> billion and $475 billion respectively at the end of 1999.  By the end of 2005 they had shed a combined $384 billion, and this contributed to the average active fund having beaten the S&P over those six years.

Since 2008 the S&P 500 looks exceptionally strong relative to the average stock fund.  Much of this, I contend, is due to the superior performance of Apple, Inc., the S&P’s largest stock.  Apple, with a market cap of $84.5 billion<10>, wasn’t even in the top ten at the close of 2008.  Today it’s market capitalization is north of $600 billion.  The S&P 500, therefore boosted its relative Apple stake sevenfold.  Any fund manager not buying Apple with both hands over the last five years was at a significant disadvantage.  I’m happy for Apple (and by extension the S&P 500), but I remember how Japan worked out for the EAFE.

The point is, no approach to portfolio management, be it active or passive, value or low volatility or otherwise, gives you an advantage that can be counted on at all times.  There are factors that over the long sweep of time do appear to offer a modest advantage.  However, at any given time the popularity of one or more of these factors may cause mispricing to the extent the advantage is negated or even temporarily reversed.  Apple will not be the most valuable company in the world forever, and when it inevitably regresses towards the mean the S&P 500 will suffer on a relative basis.  Active managers whose long term track record suggests some level of skill may once again prosper.  Meanwhile, we will continue to do our best to combine those managers who have historically added value with indexes in areas where efficiency and low cost offset manager expertise.  Sometimes it will be obvious that this approach adds value, and other times it will seem like we should have just indexed the whole thing.  That’s just how it goes.

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.

<1> Per Morningstar (Benchmark Universe)

<2> Per Morningstar, MSCI Europe net return in dollars (-7.00%) and in local currency (-0.24%)

<3> JP Morgan Guide to the Markets, Third Quarter 2014

<4> Per Morningstar, Barclays US Aggregate Bond index, net return in US dollars

<5> The large company is the S&P 500 Index; the small company proxy is the Russell 2000 Index

<6> Antti Petajisto, Financial Analysts Journal, Vole 69 (2013)

<7> Nardin Baker and Robert Haugen, Social Science Research Network (2012)

<8> Morgan Stanley Capital’s Europe, Asia, and Far East Index

<9> Wikipedia, List of public corporations by market capitalization

<10> Wikinvest, Apple market cap 2008

Summary

The stock market rally continued through the second quarter of 2014.  There was a brief -4% “correction” in early April but stocks quickly recovered and continued to make modest new highs throughout the rest of the quarter.  The market has risen steadily without as much as a 10% pullback since June 2012.  Obviously, this can’t last forever.  That said, there are few signs that it is about to end.

Figure 1: S&P 500

Source: Stockcharts.com

Overall, the U.S. stock market gained 4.9%<1> in the second quarter (see Figure 1).  Large company stocks performed quite a bit better than small caps, with the S&P 500 rising 5.2% and the Russell 2000 ahead only 2.1%.  The April correction was much harder on smaller stocks, though they had a very nice recovery in June.  Energy stocks soared 12.1% last quarter to lead the way, while financial stocks gained just 2.3%<2>.  Stock market performance this year cannot be explained neatly by risk appetite, growth potential, or interest rate sensitivity.  Sector specific factors have been the most significant component of returns; for example merger activity has positively impacted the health care sector, while consumer weakness has hurt retailing stocks.

Foreign stocks gained 4.6%last quarter while emerging markets bounced back 6.6% from their first quarter decline<3>.  Latin America and Asia performed well for a change, while Europe’s 3.3% gain brought up the rear.  Investors seem to have shrugged off earlier concerns about the Ukraine, China, and Iraq, but of course one never knows when they will resurface.

In the bond market, the positive investment climate from the first quarter largely carried over.   The Barclays Aggregate Bond Index gained 2.0%, and riskier classes of bonds (emerging market debt and high yield corporate and municipal bonds) performed even better.  Short term bonds rose just 0.3%<4>.  Bonds investors have been paid well over the last five years by taking extra risk.  I am increasingly concerned that investors are looking at non-government bonds as a kind of “free lunch” since their yields are higher.  That would be a mistake.

Activity

When things are going well our primary job is to look for funds that are underperforming their benchmark and then to determine whether or not that underperformance is likely to be temporary, and thus recoverable.  If not, we replace it with a fund with similar objectives whose managers are navigating the current market environment more skillfully.  We made a couple of exchanges in the international and small company stock areas for this reason.  We also trimmed the Sequoia Fund.  In general, we sought to increase average market capitalization (move from small to large) and from growth-oriented to value-oriented.  Both of these moves made our portfolios a little more conservative.

Outlook

At this point, there are two concerns I believe could end the current bull market in the next few months.  One is a return of the European sovereign debt crisis and the other is a negative market response to Federal Reserve policy.  To be clear, at any given time there are many other things that may negatively affect the market but I believe those two to be the most pressing.

I worry about the European situation because those governments believe the implicit guarantee by the European Central Bank (ECB) to back their debt against default makes it ‘safe’. This strikes me as not too different from believing U.S. mortgage debt was ultra-safe a decade ago because all of the rating agencies said it was.  At some point, the ECB’s policy will be a significant problem.  However, predicting just when that will occur is extremely difficult.

With regards to the Federal Reserve, the Board of Governors is doing intellectual contortions to justify the continued low interest rate policy.  The national Unemployment Rate is now within their stated target range and inflation measures have begun to moderately rise (another policy goal).  Thus far, the Fed’s remarkable credibility has been a major determinant in the success of Quantitative Easing (QE).  Credibility, however, is a fragile thing and just because QE hasn’t caused a spike in interest rates doesn’t mean it won’t do so in the future.  If they lose it and bond investors demand higher rates to protect them from inflation, bond and stock prices will both tumble.

All of that said, however, we remain in a ‘best-of-all-worlds’ environment in which the economy is growing but not too strongly.  With such a favorable backdrop both stock and bond investors may continue to make money well beyond the rest of this quarter.   Our luck could hold.

Commentary

Those of you that have read past commentaries know that I am interested in the concept of odds.  Two quarters ago I wrote about stock valuations (Come On Stocky!) with the idea being that cheap markets put the odds of good returns in your favor and expensive markets stack the odds against you.  I qualified this message by stating that valuation does not move markets in the short term (expensive markets can, and usually do, get even more so before they top out), but it is always important in the long term.  If it were known, however, that the Federal Reserve was actively trying to manage investor expectations so as to engineer favorable market performance (believing that strong markets will improve the employment situation) then how much attention should one give to stock valuations?  Regardless of how cheap or expensive the market might be, in the absence of some major external shock, stocks are going to go up until the Fed changes this policy.

As money managers, we do a lot of research on past market cycles with the belief that such information will be useful in predicting future market cycles.  We want to know if there are factors that signal that the market is cresting or about to peak, because that would theoretically be an excellent time to reduce risk.  In the past, rising measures of economic performance (capacity utilization, industrial production, raw material prices paid, etc.) were signs that the Federal Reserve would have to begin raising interest rates to prevent a surge in inflation.  So too was a flattening yield curve.  Today, however, the Federal Reserve seems to want to create an investment climate that is perpetually favorable with its very low interest rate policy and refusal to incorporate any data suggesting the business cycle is actually fairly advanced (rising food and energy prices).  Additionally by manipulating the bond market through the purchase of treasuries and mortgages (QE), the Fed achieves an upward-sloping yield curve that suggests a mid-business cycle environment, which is favorable for investors.

You might be thinking; “wouldn’t it be perfect if the Fed could maintain a favorable investment climate forever?” Perpetual growth, no recession, no sustained stock market declines – what’s not to like?  The problem is that favorable business and market conditions create economic excesses.  Unlimited liquidity (as much cheap credit as a business needs) means poorly run companies don’t go out of business, they just limp along and negatively impact the profitability of their competitors.  It means there is no competition for limited credit, so savers earn extremely low rates of interest.  It means that leverage is cheap, so the best investment returns go to the most financially reckless.

So manipulating the credit markets is undesirable because it fosters bad financial behavior.  Is that the only drawback?  Actually, no.  The other is that it ultimately fails.  Economic and market cycles can be altered but not eliminated.  Ultimately the dam bursts.  The Fed will ultimately be forced to begin restricting credit, and markets will then lurch from risk-on to risk-off.  Valuation will suddenly matter again.  When the pain of bad economic decisions finally arrives it’s much more acute because many people didn’t understand the gravity of their past economic behavior. They “just did what everybody else was doing” (think of all those who re-financed into adjustable rate mortgages last decade).

One last idea; I noted on the first page of this commentary that stocks have not had a -10% correction in over two years, which is quite unusual.  That may not be a good thing.  Small losses enforce the idea of prudence, and prudence helps us avoid large losses.

We are doing our best to navigate this environment.  We really don’t see a great deal of near term economic risk, but in an artificially low interest rate environment that may not be the critical factor.  We know valuation is not an effective timing tool; rather it is more like a guidepost on a very complicated trail.  At the bottom of the market in March 2009 prices were so cheap that success was almost assured if one had a time horizon of more than, say, six months.  It was the financial equivalent of needing to roll anything except a “1” on a six-sided die.  Today valuations are in the upper 10% of their historical range, which suggests we need to roll a five or a six.  Despite the seemingly bad odds, the stock market keeps rising because everybody knows that world central banks have supplied the markets with the equivalent of loaded dice.  But as I have stated, they can’t do this forever.

To be clear, I don’t dislike the Fed.  In fact I believe their actions in 2008 kept things from becoming a whole lot worse.  My concern is simply that by expanding their balance sheet (QE) and keeping interest rates artificially low they may have created a situation where they can’t back away from these policies without creating a lot of turmoil in the markets.  Stocks have had a great run since 2009 and are clearly on the expensive end of their historical range.  Although the internal market measures we monitor look good right now, this ‘best of all worlds’ environment may present a situation in which we don’t want to wait until the last note played.  The race to the exits, when it comes, might be especially rough this time.

Remember, we update our blog periodically with my latest thoughts on the market.  (www.trademarkfinancial.us/blog)  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at cynthia@trademarkfinancial.us or 952-358-3395.

We appreciate your continued trust in our management program,

Mark A. 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.

<1> Wilshire 5000

<2> JP Morgan Asset Management, 3Q2014 Guide to the Market (both sectors)

<3> All foreign market returns cited are from MSCI (All-World ex-US, EAFE, EM, and Europe).  All measured in USD.

<4> Barclays 1-3 year Gov’t/Corporate Index

Summary

After a very strong 2013 it was reasonable to expect there would be some period of consolidation in 2014.  Stocks gave back about 5.7% through February 3rd before rallying to new highs by the end of that month.  March saw choppy sideways trading for the most part, but at quarter’s end the S&P 500 was standing 1.8% higher.  This gain occurred despite a looming crisis in Ukraine, much cooler than expected weather here in the United States, and economic disappointment in both China and Japan.  The silver lining for investors was that despite the fact that the Federal Reserve did begin to taper bond purchases, the bond market performed very well.  In fact, bonds slightly out-performed stocks over the quarter.

Until the very end of the February, it seemed like the same market sectors that drove the market in 2013 would continue to do so in 2014.  Biotechnology stocks rocketed up close to 30% in the first eight weeks of the year, on top of a 50% gain in 2013.  At some point, however, all speculative rallies end.  Almost all of that 30% gain was gone by the end of the quarter, and as this is being written the sector is down 6% year-to-date.  Many social media stocks could tell a similar story, as could market darlings like Tesla.  As the high fliers began to falter, however, income-oriented sectors came back into favor.  Real estate and utilities, two sectors that really struggled when the Fed announced tapering back in May 2013, posted gains of more than 9% last quarter.  Other higher yielding sectors – telecommunications, financial services, and energy – also benefited in March from the rotation out of high momentum growth stocks.

International stocks struggled early in the quarter, and that trend got even worse when Russia grabbed the Crimean peninsula.  In March, however, emerging market stocks reversed to the upside as very cheap valuations drew in money leaving hot sectors in the United States.  Brazil and India were some of the bigger countries that got a boost, but the Middle East, Indonesia, and Vietnam also scored double-digit gains.  On the whole international markets gained a little over half a percent on the quarter, but the performance varied greatly<1>.  Japan, which seemed poised to end its two-decade-plus economic slide, lost 5.4% last quarter.  Russia, for obvious reasons, was the worst performing market (-15%).

All categories of bonds gained last quarter, with the average being about 1.8%<2>.  That said, the dynamics of the bond market swung wildly.  The first two months were a continuation of 2013 for high yield corporate bonds, which tend to do well when stocks do.  This sector cooled off by quarters end.  Longer maturity, investment grade debt (both taxable and municipal) rebounded sharply from a horrendous 2013.  Emerging market debt surged in March just like emerging market equities.  Overall, interest rate sensitivity was a good thing as rates declined during the quarter.

Activity

A very strong trend is a wonderful and dangerous thing.  The long term outlook for health care seems very bright with average ages in the developed world continuing to rise.  Early in the quarter the concern was whether we were capturing enough of that trend.  We added funds like PRIMECAP to more aggressive portfolios to get more exposure to healthcare than we would get from T. Rowe Price alone.  By the end of the quarter the correction in that sector was in full swing, and we looked to trim positions in the T. Rowe Price fund that had grown from say 4% to 6% or more.

We also saw the chance to add to our existing international bond positions, as that neglected sector finally began to show some life in March.  Lastly, we built up our international stock positions by increasing our holdings in VEU, a low cost foreign stock ETF that includes emerging markets.

Outlook

At the risk of extending the zebras and lions metaphor past its “best if used by” date, it would seem that the lions are back.<3>  We have moved into a higher risk environment now, because we have had a taste of the factors that are likely to eventually end this bull market:

1. The tapering has begun.  The Fed is still friendly, but it is gradually becoming less friendly;

2. China is slowing.  The biggest global engine of demand is sputtering;

3. Geo-political strife.  The upside of reducing our commitments in Iraq and Afghanistan is an improvement in our national balance sheet.  The downside appears to be emboldened adversaries (Syria, Russia).
   It would seem that investors are taking the classic zebra approach, namely moving to less economically sensitive areas such as utilities, real estate, gold, and treasury bonds.   Last year’s leaders have fallen from grace recently, leaving markets more volatile.  At this moment, it remains to be seen whether investors will be content to rotate (move money from one area of the market to another) as opposed to selling outright.  It should be noted, however, that the market “traffic signals” very frequently go from green to yellow and then back to green.  Red lights are thankfully uncommon.

   Last quarter’s Commentary, entitled “Come On Stocky”, tried to convey that stocks had risen to a level where even if everything was to go right in 2014 it still would be very unlikely to see another 30% gain.  Obviously, everything isn’t going right and stocks are struggling a bit.  I am not too concerned because most of the current activity should be seen as volatility.  Stocks fluctuate.   Every investor who contemplates a stock investment should be aware of this.  Risk, on the other hand, is the possibility you will buy something at a price that once lost will never be recovered.  In the parlance of finance we call that phenomenon a permanent impairment of capital.   In a diversified, un-levered mutual fund or ETF, you are almost always dealing with volatility rather than risk.  Risk comes in when you buy into a situation where valuation and expectations reach a level that economic reality cannot justify (like technology stocks in 1999 or real estate in 2006).  Social media and biotech stocks were beginning to look that way back in late February.  We always try to limit exposure in any area of the market where the risk of permanent impairment of capital is present.

   Commentary – Party Time!

   One of the keys to understanding stock market movements is that sentiment changes drive prices.  Let me explain.  If I polled all stock market investors and discovered that 80% said they were long the stock market and 20% said they were short, you might assume that stock prices were heading higher.  You are probably going to be wrong.  In fact, given those results, there are vastly more potential sellers than potential buyers.  Put another way, the expectation of higher prices is too great.  Stocks will only go higher if the ratio gets more lopsided.  The fact is, markets cannot accommodate everybody being right.  They can accommodate a majority but not a consensus.  Once confidence levels in any market event get above 70%, the risk of reversal becomes statistically greater than the potential for further profit. This is why experienced professionals become very uncomfortable when their position becomes the consensus.

   Perhaps the best analogy is to think of investors as party goers.  Every party has a “cover charge”, or a cost to get in, but in return you get a little piece of the cover charge that every subsequent party goer pays.  Therefore the cover charge rises for every new party goer.   If you get there early the cover charge is low but it may turn out that very few party goers show up.  In that case, you don’t recover the cost of entry and you miss out on a better party.  At least when the party ends (as all parties invariable do) the cost of the cleanup will be minor.

   As you can see, investors do well when they get to a big party before a substantial amount of other investors.  If you are the last to arrive, you will pay a lot to get in, collect nothing from those that come after you, and bear a huge cleanup cost.  This is where strategy and nerve enter in.  Do you have enough confidence to be the first person to show up?  Most people don’t.  They fear no one else will show up, and they don’t want to miss out on a big party somewhere else.  Ultimately, every asset class is going to host a party.  The difference is, some of these parties get a lot bigger and some parties last a lot longer than others.

   The Biotechnology “party” has really taken off since mid-2012.  Figure 1 shows the Biotech sector’s performance since that time.  New product introductions had soared, and earnings exceeded expectations. By this past January it became a blow-out.  Everybody wanted in.  It was just too hard for the investors over in financial services or home construction or emerging markets to see that big party across the street.  At first they resisted because they didn’t want to pay the cover and they feared maybe that party was about to end and the party goers just might come over here.  But you can only watch other people have a great time for so long – “They sound like they are having so much fun.  More people keep showing up – I’m sure that more will come after I get there”.  When sentiment gets that strong, you know the end is near.

   Figure 1

Source: Stockcharts.com

What makes a great party is a narrative, or a reason why the party should last a long time.  That is how you get people to leave other parties to come to yours.   Growth investors have an ear for narrative.  They seek to determine which parties are going to turn into all-night bashes.  Value investors will only go to parties if they can get there early and pay a low cover.  That way they can still come out ahead if only some of the parties turn out to be big successes.  Indexers try to attend every party for at least a little while.   It is more important to them to avoid having the worst results than it is to try to have the best results.

No party going strategy always works.  This just makes sense – if any one strategy always worked everyone would practice it and everyone would earn above average returns (which is impossible).   If it were possible to show up when you knew the party was already a smash but pay the same entrance fee as the first one there, everybody would try to be fashionably late (again, by definition, impossible).  That said, the strategy of going to the biggest party and paying the highest price of admission is one that almost never does.

We try to diversify all our approaches because again, no one strategy works in all environments.  We participate in the big parties to some extent, but only moderately with medium risk investors and not at all with low risk ones.  We pay a lot of attention in all portfolios to what we might lose (our cleanup costs, if you will) if the party we are at should immediately end.  To that end, we strive to determine whether our market beliefs are becoming consensus (in which case there are too few left to come to the party).  It is important to understand the trends and narratives that drive the market, but even more so to know to what extent those things are already priced in.

We appreciate your continued trust in our management program,

Mark A. 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. 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.

<1> MSCI EAFE Index, net return in dollars

<2> Barclays Aggregate Bond Index

<3> See our 3Q13 Quarterly Commentary for a detailed discussion of the lion and zebra metaphor.  Feel free to contact us for a copy.

Summary

Stocks continued their rally in the third quarter.  The adage, “Sell in May and Go Away” has gained favor in recent years, in spite of the fact that the past two years have seen a very nice summer rally.  In 2013 it was driven by a surprise improvement in the European economy and a general sense that the global economic recovery, though disappointing by past standards, is for real.  The market is finally being led by economically sensitive sectors like industrials and consumer discretionary (think autos and washing machines).  Previously (2009-10) it was led by interest rate-sensitive sectors like housing and financial services (because the Federal Reserve was driving down interest rates to stimulate the housing sector) and defensive sectors (utilities, health care and consumer staples<1>) because investors preferred current income to future earnings growth.  That income-oriented securities are out of favor now is a telling sign of confidence in the global economy.

It should come as no surprise, therefore, that foreign stocks performed better than domestic stocks last quarter.  Foreign stocks were priced for recession, so there was more room to run when their outlook improved.  There are two benefits to a positive foreign economic surprise – the stock AND the currency rise together.  Foreign stocks rose 7.5% (versus 5.2% for the U.S.<2>) in local currency terms, and because the Euro had a very strong quarter, that gain rose to 11.6%<3> for U.S.  dollar-based investors.  This, my friends, is why you diversify.  You don’t know exactly when the benefits of diversification are going to kick in (they’d been largely absent in recent years) but it is sure nice when they do.  Small company stocks performed significantly better than larger companies (10.2% to 5.2%<4>), further evidence of the power of diversification.

Figure 1

Source: JP Morgan 4Q2013 Guide to the Markets

One diversifier that certainly did not help last quarter was real estate.  This sector fell -3.3%<5> last quarter as investors continued to shun interest sensitive sectors.

Bonds leveled off last quarter after a terrible second quarter.  The Barclays Government/Credit Composite was up 0.4%<6>.   Interest rates are off their July highs as the Federal Reserve sought to reassure bond investors that their tapering would be gradual at best.  Investors have finally embraced the fact that the risk reward trade-off in bonds is not favorable.  The pendulum is swinging back toward stocks after more than four years where bonds had net inflows and stocks net outflows.  Again, more reason as to why Trademark runs balanced, well diversified, portfolios.

Activity

International stocks and small cap stocks led the way this quarter, so the key was making sure we weren’t underweight in either category.  Often that meant replacing conservative funds that tread lightly in those areas with ones that will more fully participate on the upside.  We added index funds to many portfolios last quarter, replacing very conservative small cap funds like Aston Independent Value and global funds like First Eagle.   (We will not hesitate to use those two funds again if market conditions warrant.)  On the bond side we lowered interest rate risk by replacing funds like Payden GNMA with shorter duration alternatives such as Met West Intermediate Bond.  We also modestly reduced the cash weighting in most portfolios.

Outlook

Stocks have been doing very well lately.  Even the U.S. government shutdown fiasco did not derail the rally for very long, and with its “resolution” we are back to all-time highs in the stock market.  This is not hard to understand in that bonds have done poorly this year and many investors feel they have missed out on the post-2008 equity recovery.  With the Federal Reserve seemingly afraid to reduce their liquidity providing efforts by even a tiny amount, it seems as though stocks have nowhere to go but up<7>.  It should be recognized, however, that at the very least stocks are ahead of economic fundamentals.  It is worth noting that although the economy and stocks have been advancing higher since 2009, stocks are now outpacing economic growth as measured by Real (after inflation) Gross Domestic Product.  See Figure 2.

Figure 2

Retrieved from: : www.seekingalpha.com, Stocks and QE: All Things Must Pass

While it can be argued that the stock market leading the economy is the normal state of affairs, the degree to which this is the case is unusually large at the present time.  Market “corrections” happen when investors begin to fear that earnings won’t live up to projections.  Stocks certainly have a head of steam right now, but my concern is that gains from here will only make the eventual correction more painful.

Bond yields have stabilized at higher levels.  A new Fed Chairman (Janet Yellen) has been named.  It is unlikely any policy change will take place at least until she officially takes over for Bernanke in January.

Commentary – Life on the Savannah (The Wise Zebra)

I sometimes think investing is like being in a herd of zebras.  In the middle of the herd there isn’t much grass, it having either been eaten or trampled.  Around the outside of the herd, where only the bravest zebras venture, the grass is thick and plentiful.  Unfortunately, there are also lions.  Lions are stealthy; you know they are out there, but you usually don’t actually see them until it is too late.  If you stay in the middle of the herd you are safe from lions, but you will eventually become lean and sickly from lack of nourishment.  In this case you have to worry about cheetahs (smaller predators that can only take down weaker zebras) or, at some point, starvation.  So as a zebra, there is always risk of one kind or another.  To thrive, you must develop a sense of when to venture into the thicker grass and when not to.  Investors are similar to zebras in that they also have to take some risk if they want to prosper, but too much risk or ill-timed risk can be dangerous.

Every savannah is different.  In 2009 we encountered a situation where surviving zebras found grass everywhere.  The lions were exceedingly well-fed and were therefore nowhere to be found.  Even in the middle of the herd there was some grass, so being cautious didn’t hurt.  As time wore on, however, there was less and less grass for those who wanted to play it safe.  By 2013, the savannah we call the capital market was well trampled.  Those who stayed in the center (money markets) starved.  In May cheetahs came in the form of rising interest rates.  Healthy zebras (those investors that had stocks in their portfolios) had little to fear.   Under-nourished zebras (those that only owned bonds) ultimately became cheetah food.

Behavioral science has shown that humans tend to fear things that best approximate our most recent source of trauma more than things that present a higher probability of future danger.  This phenomenon has a name: recency bias.  Because portfolios were cut down by economic risk in 2008, many investors sought to minimize economic risk exposure.  Thus, they sold stocks and bought bonds in record numbers between late 2008 and early 2013 (See Figure 3).  However, this is not the risk that presented itself in 2013.  Investor intuition regarding their biggest source of risk turned out to be completely wrong!

Figure 3

Source: JP Morgan 4Q2013 Guide to the Markets

This is not to argue that one shouldn’t worry about the economy or that stocks are less risky than bonds going forward.  I’m arguing that following the herd does not necessarily keep you safe.  The investing herd often reacts in a panicky fashion to current trends, while having poor foresight with regard to future risks.  The wise zebra, on the other hand, understands the nature of life on the savannah.  He knows that from time to time predators attack.  He knows he has to be healthy to survive the cheetahs, but if he is reckless he will fall prey to lions.  A handful of zebras venturing into the tall grass might not attract lions, but a whole herd of risk taking zebras almost certainly will.  The year-to-date return on stocks is 20.4% as I write this, while the year-to-date return on bonds is -2.1%<8>.  It isn’t hard to imagine what the herd has been doing lately.    Money is now pouring out of bonds and into stocks. The wise zebra was in the tall grass months if not years ago.  Today he is starting to look out for lions.

Remember, we update our blog periodically with my latest thoughts on the market.  (www.trademarkfinancial.us/blog)  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at Cynthia@trademarkfinancial.us or 952-358-3395.

We appreciate your continued trust in our management program,

Mark A. 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. 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.

<1> 2012 through April of this year

<2> S&P 500 Index

<3> MSCI EAFE, per Morningstar

<4> Russell 2000 (small caps), S&P 500 (large caps), per Morningstar

<5> MSCI REIT Index

<6> Morningstar

<7> Think of quantitative easing as 5 Hour Energy or Red Bull for the stock market.  After a several shots it begins to lose its effectiveness, and the resulting “hangover” is that much worse.

<8> S&P 500 and Barclay’s Aggregate bond, midday October 14th, via Morningstar

Summary

The positive performance of the financial markets continued from the first quarter until the fourth week of May, when things changed dramatically.  On May 22nd, Federal Reserve Chairman Bernanke allowed that since the economy was improving, at some point they would begin reducing the amount of monthly bond purchases.  This may have seemed obvious, but the reaction in the markets was anything but.  Bond speculators in hedge funds and on proprietary trading desks decided they better get out of bonds before everyone else did.  Leverage will make you do that.  Bonds experienced three weeks of frantic selling followed by a week of stabilization on the hope that Bernanke would say on June 19th that he was kidding or misquoted or something.  When that reassurance wasn’t offered, phase two of the bond panic commenced.  Stocks were temporarily caught in the bond market’s undertow, but they had mostly recovered by the end of the quarter.

When it was all said and done, U.S. stocks had climbed almost 3% on the quarter<1>.  Sector leadership changed; the best performing sectors were financial services and consumer discretionary, which indicates growing confidence in the economy.  The defensive sectors that led in the first quarter, utilities, real estate, and consumer staples, significantly lagged the market this time around.  Smaller stocks performed better than larger stocks for the most part.  They tend to be more sensitive to the domestic economy, as opposed to the global economy.

Source: JP Morgan 3Q13 Guide to the Market

Overseas the picture was much different.  Emerging markets continue to struggle as the Chinese economy began to lose steam and Brazil (one of China’s main suppliers of raw materials) dealt with rising inflation and declining growth.  In dollar terms emerging markets lost -8.1% last quarter.  Latin America performed the worst, falling a frightening -15.5%.  The more developed markets did better.  Europe dropped just -0.5%.  Japan was the best performer (+4.4%) as steps to stimulate the economy appear to be working<2>.

That said, when people think back on the second quarter of 2013, it will be the performance of bonds and gold they’ll remember.  High quality bonds had their worst quarter since 1994.  Inflation protected bonds declined the worst, off over -7%.  When interest rates soar but inflation doesn’t budge, TIPs offer no protection.  In other sectors, emerging market debt fell more than -5%, municipal and investment grade corporate bonds dropped close to -3%, mortgage bonds were off -2%, and high yield corporates gave back -1.4%<3>.  For four years certain market pundits warned about the risks in bonds, and this past quarter their warnings finally came true.  They may have saved themselves 3% last quarter, but they left 20% on the table over the preceding four years.

Gold plunged -23.4% last quarter and stands -27.2%<4> lower for the year.  It is off by more than a third since its peak in August 2011.  Investors bought gold when they believed that global monetary authorities had lost control and that their policies would lead to hyperinflation.  Today investors have a lot more faith that Ben Bernanke, Mario Draghi, and other global central bankers can engineer the economic outcomes they want without creating a monetary crisis.  Time will tell if that faith is just.  Moreover, paper (bonds & stocks) pays interest, gold does not.

Activity

Before May 22nd our activity centered around making sure the funds we were using were performing as well as the benchmark for their category.  This is typical of any quarter.  We also replaced some international funds with a higher emerging market weighting with ones with a lower weighting, as emerging markets were drastically underperforming more developed markets.  Once interest rates began to climb, we made fund exchanges to reduce bond duration so we wouldn’t be affected as much.  This was especially true in conservative portfolios.  We continued our efforts to replace mutual funds with exchange traded funds (ETFs) where appropriate in order to reduce annual expenses.

Outlook

As stated so many times in this section previously, central bank activity is driving prices in the short run.  When they are accommodative, markets do well for an extended period of time before finally collapsing under the weight of speculation.  When central banks are restrictive, on the other hand, markets tend to do poorly.  The best time to invest is after a long period of restrictive policy when valuations are low and there is very little speculative activity.  The worst time to invest is after a long period of low rates when speculative activity has pushed valuations to extended levels.  Bonds are vulnerable right now because they have been sold furiously over the past seven weeks and holders are nervous.  They may be a buy later in the year if the economy does not strengthen enough to justify Federal Reserve tapering.

Commentary – The Diversification Question

We are often asked, “How did the market do?”   When people ask that question, they are usually referring to the Dow Jones Industrial Average or the Standard & Poors 500 stock index (both of which measure the return of the largest U.S. companies).   In reality, the “market” is much larger and more complex.  Over 8000 stocks trade on U.S. stock averages.  Many more than that trade on overseas stock exchanges.   And that is just stocks; worldwide bond markets dwarf stocks markets in size.  In addition there are the commodities markets, where “hard” assets like gold, oil, and wheat are traded.  There is also private equity and hedge funds.  To a degree not possible just a decade ago, these markets are available to investors of more modest means.  But they are not for just anyone.  Each has a unique risk and return profile.  Some are not investable due to the risk constraints of the investor.  Some are investable but best avoided because the return potential is not worth the risk<5> involved.

Every investor, from the biggest endowment to the smallest individual retirement account, is concerned with how to get the highest return for the level of volatility they can tolerate.  Large institutions diversify their assets broadly in order to limit the amount they can lose in any given scenario.  Smaller investors tend to be a lot less systematic in their approach.  They don’t have access to all of the tools that institutions have – private equity, hedge funds, etc. – so they are more exposed to the stock and bond markets which are more volatile because they re-price more frequently.  The idea behind diversification is live to play another day<6>.  You may not make as much money as you would have if you picked the right asset class and put all of your money there, but neither should you experience a loss from which you cannot recover.   When you have the responsibility to manage money for others, you absolutely want to know what that loss threshold is.  No one number fits everyone.  Your loss threshold is determined by many things, but these are the big two:

1. Time Horizon – How long until you need the money?  In other words, how long would we have to make up any drawdown<7> in your portfolio?  Because it is much harder to make up ground when you are taking distributions.

2. Psychological Tolerance – Everybody has their own panic threshold (be it 3% or 50%), where you psychologically just have to cut your losses.  It is important to know what this is so that you can structure your portfolio to avoid it, because selling at the bottom is financially devastating.
   Statistically, the more asset classes I use (provided none of those assets are not perfectly correlated with another) the lower my potential drawdown.  On the other hand, the more classes I use the less money I will have in the best performing asset class.  Let’s look at how this applies to the first half of 2013:

   *Click on the chart for a larger version

Source: JP Morgan 3Q13 Guide to the Market

As you can see, U.S. stocks have outperformed their competition so far this year.  Small stocks (Russell 2000) have done a little better than large stocks (S&P 500), but both are miles ahead of bonds (Barclay’s Aggregate) and foreign stocks, either developed (EAFE) or emerging (EME).  A diversified portfolio (shown as Asset Allocation) would have lagged considerably.   If we look at this on a ten year basis, however, U.S stocks are not that impressive.  The S&P 500 trails both international categories and real estate.  More significantly, it also underperforms the asset allocation portfolio.   And this chart even omits 2000 through 2002, all of which were down years!

Diversification reduced the loss in 2008 from -37% to approximately -25%.  That meant you only had to grow the portfolio 34% to make up what you lost (which would have taken you two years).  With a -37% loss you would have had to earn 59% to be in the black (which took about three and a half years).  If you are taking regular withdrawals, the math gets even worse.     Statistically, large loss mitigation more than makes up for what you give up during good stock market years.   This is why all the major institutions and foundations diversify their portfolios.  Though they all have highly educated people working for them and they pay a lot of money for research, none of them believe they can put all of their “eggs” in one basket and prosper over the long term.

At Trademark we agree that diversification is a superior way to invest and as such have always invested your portfolios that way.  We have decided, therefore, to start using diversified benchmarks based on client risk tolerances in our quarterly performance reports.  We feel that this provides a better frame of reference for evaluating account performance than simply listing several pure asset indices and let you figure out which are the most relevant.  Your statements benchmark page looks a little different this quarter.  All of the new benchmarks are explained in detail on the Disclosure page and feel free to give us a call if you have any questions.

In order to maximize performance for any given risk tolerance, multiple imperfectly correlated asset classes are required.  Happily, there are multiple imperfectly correlated asset classes available to investors.  The purpose of this commentary is to illustrate why managers diversify portfolios even when it sometimes seems like it doesn’t work.   Stocks have been a great asset class over the past 4 years, especially here in the U.S.   On the other hand, they did very poorly compared to almost any other asset class from 2000 through 2008.  Every asset class – stocks, bonds, real estate, gold, etc. – will go on a run from time to time.   Unfortunately, they don’t ring a bell at the top or at the bottom.  We can tell you why we believe markets went up or down, but neither we nor anyone else knows what they are going to do next.   So we diversify, we make modest adjustments when fear or greed provide attractive entry or exit points, and we stay patient and allow time to be our friend.  For as George-Louis De Buffon once said, “Genius is only a greater aptitude for patience”.

Remember, we update our periodically with my latest thoughts on the market.  (www.trademarkfinancial.us/blog)  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at Cynthia@trademarkfinancial.us or 952-358-3395.

We appreciate your continued trust in our management program,

Mark A 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. 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.

<1> As measured by the S&P 500.

<2> All international indices cited are from MSCI, in US dollars with dividend included.

<3> All bond indices cited are from Barclay’s, again in US dollars with dividends included.

<4> Gold performance data is from Morningstar and reflects the commodity not any fund or stock.

<5>  As always, the word “risk” refers to the potential for permanent loss of capital.  It is different than volatility, which is the temporary loss of capital based upon price fluctuation.

<6>  From Investopedia: “Diversification is a risk management technique that mixes a wide variety of investments within a portfolio.  The rationale behind this technique contends that a portfolio of different investments will, on average, yield higher returns and pose a lower risk than any individual investment founding within the portfolio.”

<7>  The term drawdown refers to the difference between the highest value of a portfolio and any subsequent low.

Summary

Stock prices surged in the first quarter of 2013, much as they did in the first quarter of 2012.  The similarities end there, however.  The stocks that led in early 2012 were largely those that would benefit from an expanding economy – technology, retailing, homebuilding, etc.  In 2013, investors favor more defensive industries like health care, consumer staples and utilities.  A possible explanation is that investors realize they can’t earn the returns they want in bonds anymore, so they are moving to the most bond-like of stocks.  Considering all of the potential pitfalls out there, perhaps they can’t be blamed.  After all, just when you think you know all of the risk factors out there, a Cyprus or a North Korea pops up.  Happily, those issues have not had a significant impact so far.  It appears that with world central banks increasing liquidity at an unprecedented pace, it will take something far more serious to end this bull market.

U.S. Stocks rose 10.9% on the whole last quarter.  Large stocks, as measured by the S&P 500 index, rose 10.6%.  Small cap stocks gained 12.4%.  As mentioned, the market was led by the most conservative sectors of the market while the traditional high return sectors lagged.   Tech stocks were hurt by the negative 16.3% return from Apple Inc., the largest company in that sector.  Materials were impacted by slowing growth in China.  Gold stocks fell because the feeling of crisis that pervaded markets for much of the past several years has lessened.  The deficit situation has not improved nor has the crisis in Europe been solved, but investors can’t live in a state of fear permanently.

Source: JP Morgan 2Q13 Guide to the Markets

International markets were not nearly as generous to dollar-based investors, as most foreign currencies slumped against the dollar.   As a whole, foreign markets rose 5.3% last quarter.  Japan soared 11.8% on Prime Minister Abe’s radical plan to stimulate the Japanese economy, but the countries in the region that compete with Japan (South Korea, Taiwan, and China especially) saw their markets decline.  National resources-oriented economies like Russia and Brazil also declined.  Europe was up 2.9%, as European stocks were able to gain mildly from the decline in the Euro.

Bonds lost ground on the quarter (-0.12%).  Interest rates rose sharply in January on the belief that the economy had turned the corner.  Those assumptions have been seriously called into question by quarter end, but bonds did not climb into the black until the first week of April.  High yield corporate bonds rose 2.9% to pace the sector, but the second place bond sector, municipal bonds, rose just 0.3%.  International bonds and emerging market debt fell 2.1% and 1.5% respectively.

Activity

We didn’t make any significant asset allocation decisions this quarter because market conditions remained largely favorable.  We did start to implement a modest tactical change.  We have increased the percentage of exchange-traded funds (ETFs) in our portfolios.   ETFs tend to have much lower annual expense ratios than mutual funds, but there is a small cost to buy and sell ETFs as opposed to the vast majority of the funds we use at TD Ameritrade (which have no transaction fees if they are held for ninety days).  ETFs also have the advantage of being easier to use to make quick asset allocation decisions, because they can be bought or sold any time of the market day.

Outlook

Three months ago we wrote that as long as world central banks remained accommodative, we did not expect to see a meaningful decline.  We still feel this way, though we don’t expect stocks to gain anywhere near 10% in the second quarter.  Seasonal patterns are not as favorable (May and June are among the weakest months historically).  It should be noted that stock prices are now some ten percent or so higher than they were at the start of the year, while corporate profits are only slightly higher.  In essence, stocks have become 10% more expensive.   In the short run, liquidity is more important than valuation.  Investors usually respond immediately to changes in the amount and availability of credit in the system, but they seldom make changes based on valuation alone.  There is no hard and fast rule about how expensive is too expensive.

We are in a sweet spot right now.  The economy is weak enough that the Federal Reserve is maintaining a very easy credit position.  If the economy were stronger, this policy would be seen as inflationary and interest rates would rise.  If the economy were much weaker, this policy would be seen as ineffective, and consumers and businesses would likely adopt cash conservation strategies that could lead to recession.  At some point, however, things will change.   If the excess liquidity is removed (either because it has been too effective or not effective enough), asset prices (especially stocks) may be in for some tough sledding.

Commentary – Avoiding the Elevator

There is an old saying, “the market takes the stairs up and the elevator down”.  This alludes to the fact that people tend to become optimistic gradually but they get fearful in a hurry.  Having endured the crash of 1987 and the financial crisis of 2008-09, one cannot help but have a healthy respect for how fast and how hard markets can move against you without justification.  In 1987 neither the financial system nor the economy was in peril, but the market plunged 22.3% in one day because a new computer-based system designed to protect portfolios instead caused waves of selling.  It took several weeks to realize that this did not herald a new Depression.  In 2008, financial stocks had a well-deserved sell-off, but other perfectly sound assets sold off as well because with banks fighting for their lives, credit was just not available to potential buyers.  Those who were fortunate enough to have money didn’t want to part with it.

We bring this up because today’s markets are very different in comparison to when I started in the investment industry in the 1980s.  Economic analysis was so much more important then, because stock prices traded largely on the prospects for profit growth, and bond prices on either interest rates or the prospects of a change in their credit rating.  The Federal Reserve was a semi-uninterested bystander.  It increased or decreased credit (interest rates) in response to the prospects for inflation.  It observed employment rates and asset prices, but did not consider it part of its job to manage them.  That idea is completely out the window now.  Central banks seem to believe not only that they can but also that they should act to manage asset prices in order to both increase employment and protect the financial sector from its own blunders.   Typically, the greater a person’s investment portfolio has grown the more they feel like spending – a phenomenon known as the wealth effect.  Such consumption can push up asset prices and have unfortunate unintended consequences.   Critics have said that the belief that the Fed is supporting asset prices gives investors a feeling of invincibility that leads to over-investment (asset price “bubbles”).  Because these bubbles often deflate with ruinous consequences (think of the real estate market over the last decade), easy credit may ultimately do more harm than good.   At the very least, they distort the normal economic signals financial analysts get from measures such as the shape of the yield curve.

I don’t want to make it seem like everything that happens (good or bad) is the Federal Reserve’s fault.  Far from it.  What I am saying is that because they can (when they choose to) have a large effect on both the bond and the stock markets, and because they are more willing than ever to use that power, financial analysis now has to concern itself like never before with the question of what the Fed is going to do.  And this creates perverse behavior – like investors cheering weak economic news because they believe it will bring more Federal Reserve stimulus.

Ordinarily, one would respond to a situation where valuations were high and economic predictability was low by being extra defensive.  If interest rates were normal, we’d be very tempted to put 20% of portfolios in cash and earn 4% or so while we see if the Fed’s efforts work and if Europe can keep from imploding.  Of course, cash doesn’t yield 4% today – it yields less than 0.1%.  So you have to decide to accept lower portfolio returns or take greater risks in order to reap the same level of returns.  Many investors have already chosen to take risks they wouldn’t otherwise take if yields were closer to normal.   And when you push people into taking more risk than they are comfortable with, they won’t hold on when prices start to fall.  On the plus side, bull markets typically don’t end until they have drawn in much more substantial participation from smaller investors.   The fact that there is still a lot of fear and skepticism even though (domestic) stock indices have made new all-time highs suggests we still have a little ways to go on the upside.  Or so I hope.

Hopefully we have articulated the challenges investors face today and why many professional securities analysts are uncomfortable at this point.   We don’t know how the Federal Reserve will ultimately withdraw liquidity and restore a reasonable interest rate to savers without causing considerable turmoil in the financial markets, because such a thing has never been tried before.  Having experienced the proverbial elevator ride five years ago, we feel compelled for our investors not to let that happen to them again.  If we give up some upside in the process (and let’s be honest, we have) that is a trade-off we believe most of you are willing to make.

Trademark News

Our Android app is now available.  Search: TFM or Trademark Financial Management in the Android store and look for our logo.  Remember, we update our blog once or twice a month with my latest thoughts on the market.  (www.trademarkfinancial.us/blog)  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at Cynthia@trademarkfinancial.us or 952-358-3395.

Thanks you for your continued trust in our management program.

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. 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.

Wilshire 5000 per Morningstar

Source: Morningstar

Russell 2000 per Morningstar

MSCI EAFE ($) per Morningstar

MSCI Japan($) per Morningstar

MSCI Europe ($) per Morningstar

Barclay’s Aggregate Bond per Morningstar

Barclay’s High Yield and Global Aggregate Bond Indices, per Morningstar

For those that would have preferred to have taken greater risk and captured more upside, we are using more ETFs now to ensure a higher level of market participation.

Summary

Asset prices improved in the 4th quarter for the most part, but the list of winners and losers changed quite a bit from earlier in the year.  As risk appetites grew and fears about a European collapse waned, investors gravitated to smaller companies and international ones.  The Federal Reserve made more explicit its desire to help the economy by making risk assets such as stocks and real estate more attractive<1>.   Their theory being that a richer populace is a more economically active one.  One can debate whether these moves will create unintended consequences in the long run that will more than offset the short term benefits, but in the here and now they are creating a favorable environment for risk taking.

The bellwether S&P 500 stock index actually declined 0.4%<2> last quarter, reducing its full year return to 16%.  The chief culprit was Apple Inc., the world’s most valuable company.  Apple gained 32.7% in 2012, but lost 19.8% in the last three months.  The broadest measure of the U.S. stock market showed a 0.3%<3> fourth quarter gain.  Mid and small cap U.S. stocks gained 3.6% and 2.2% respectively.  Financial Services was the leading industry last quarter as investors gained comfort that the world’s central banks had effectively re-liquefied the industry such that no defaults were imminent.  Utilities, the sector investors tend to go to for safety, posted a modest decline.  Safety is not presently in fashion.

S&P 500 Return for 4Q12 and 2012

Source: 1Q13 JP Morgan Guide to the Markets.  All calculations are cumulative total return including dividends reinvested for the stated period.

One of the ways investors obtained higher returns last quarter was in foreign stocks.  A resurgent Euro coupled with a decline in risk perception led to a strong quarter for European stocks (7.0%)<4>.  Emerging markets rose 5.6% and even Japan joined the rally (5.8%).  The latter benefited from the belief the Japan’s new Prime Minister could at long last get his economy stimulated by pursuing more inflationary policies.  Such is the state of the global economy that the market cheers inflation.

Bonds usually don’t do too well as a whole when economic growth is accelerating, and last quarter was no exception.  The Barclays Aggregate gained 0.2% on the quarter, lifting the full year bond return to 4.2%<5>.  Bond investors did much better in those bonds that have some equity-like properties, as those do much better in a “risk-on” environment.  High yield corporate bonds and emerging market debt each gained over 3% last quarter and more than 15% in 2012.  They are both profiting from investors’ frantic search for yield.  One should remember that with higher yields also comes the loss of diversification benefits.  In other words, in a falling stock market those types of bonds will probably behave like stocks.

Activity

We continued to increase the foreign stock exposure in our portfolios.  Global growth is generally associated with a falling dollar, while world economic crises tend to cause the dollar to rise.  Emerging markets seem the most likely to gain from superior economic growth and currency appreciation, so that is where new purchases were targeted.  We did not change the bond component of our portfolios much.  The Fed’s policies are generally bond favorable (at least in the short term), but the valuations of most bonds are not attractive.

Outlook

We continue to feel that stock prices have done better than their underlying earnings warrant.  No doubt a great deal of this is due to Federal Reserve policy – if you want to make more than around 3% per year right now you have to take equity-type risk .  The climate of fear that pervaded the market in the wake of the 2008 market debacle enabled investors to buy stocks and riskier bonds at what proved to be a discount, since the risk of another market collapse was over-priced.  That is no longer the case.  In other words, there are still apples on the tree, but the ones on the easy to reach lower branches have all been picked.

That said, I believe the wind is still at our backs.  Market liquidity is very high.  I can’t see a meaningful decline as long as world central banks are this accommodative.  While I’m sympathetic to concerns that this easy money policy ultimately will produce a devastating crash somewhere, I do not see that time being in the first quarter of 2013.

Commentary – Risk Management

The stock market<6> has been rising for most of the past four years and is nearing the levels it reached at the previous market peak in 2007. However, as the chart below shows, if dividends were re-invested the market is up 2.3% since 2007.  Investors could be forgiven for not realizing how far we’ve come, given that all we hear about today is the soaring national debt, the debt ceiling debate, and the mess in Europe.  So what should we make of this?  Should we be looking to sell, or can this rally go a lot further.  This is a critical question because it is not enough to know that there will at some point be a day of reckoning; it is critical that you get the timing approximately right.  To get out too early is to be wrong, for you may miss more on the upside that you would have lost later on the down side.   So, how do we invest to earn as much as possible within our risk tolerance, yet not be over exposed when the inevitable comes to pass?

Source: 1Q13 JP Morgan Guide to the Markets.  All calculations are cumulative total return including dividends reinvested for the stated period.

First of all, there is always something to fear – inflation, recession, political crisis, etc. – such that to move to the sideline whenever you perceive risk is to not to be an investor at all.  On any given day, the top of the market may be years and dozens of percentage points away.  The markets will eat your lunch if you can only stomach the best of times, because you will sell into fear (low) and buy into greed (high).  Too often I have seen investors ruled by their emotions, with less than stellar results.  The typical emotion-based investing pattern goes like this:  right after a market crisis investors are nervous.   They therefore over-estimate risk and as such are under-weight risky assets like stocks.  They are suspicious of the market recovery when it comes, and with every minor market retreat they think “here we go again.”  They under-perform the rallies, but initially they are happy just to be making money again.  Because the occasional pullbacks are continually modest, they stop being a source of terror.  As the markets’ advance continues, investors begin to get more aggressive.   As the advance matures, aggressive areas of the market crowd out conservative ones, because that is where the performance is.  Fear has given way to greed.  Eventually, of course, the next crisis hits, the market falls and investor portfolios (now aggressively positioned) are significantly impacted.  They try to preserve their remaining assets by getting more conservative, starting the cycle over again.

In many cases, investors’ poor performance didn’t result so much from whether they traded or how often they traded but instead on when and what kind of trades they made.  So what constitutes a good trade versus a bad trade?  If we sell a rising asset and it turns out that it was “too early” (the asset continues to appreciate) did we make a bad decision?  Not necessarily.  It depends on the reason for the sale.  A good sale is one that reduces your LONG TERM<7> potential loss more than it reduces your LONG TERM potential gain.  A good buy, it follows, is one that increases your long term potential gain more than it increases your risk.

From time to time we have taken defensive measures in our portfolios because we felt the risk of loss was high relative to the potential for future appreciation.   There are better and worse times to get defensive, just as property insurance may vary dramatically in price based on the insurance company’s assessment of its risk.  If there is a devastating hurricane, for example, insurance companies may experience very large losses.  They will raise their rates for two reasons – they need to replenish their reserves from the past loss and they know demand for insurance will be higher<8>.   The insurance company doesn’t wish for there to be no storms (for if there were no storms nobody would buy insurance).  They just hope that they have collected sufficient premiums to cover the claims of the next storm (and make a nice profit, of course).

In a similar vein, the smart investor doesn’t wish that the market would never decline, only that they not be over exposed.  Successful long term investors try to protect against large losses, because trying to protect against all losses is so expensive it wipes out almost all return.  Defensive measure we have used in the past include a higher cash position, an exchange to a less volatile fund, taking short position as a hedge, or perhaps a modest gold position.  Employing some or all of these defensive strategies may be warranted if market liquidity is threatened or stock valuations are too high.  These are the two conditions that lead to the vast majority of significant market declines.  That said, most of the scary headlines we read today do not directly affect either of these conditions.  Losses are always possible, but large losses seem unlikely.  Therefore, we believe defensive measures are not called for at this time.

We are always trying to assess whether the return potential in the market is worth the risk at the current price.  If prices go too high or liquidity conditions begin to deteriorate, we may employ some defensive measures – holding extra cash or using lower volatility stock funds, for example.  This helps our clients better resist the normal emotional pulls (the urge to sell after a decline or buy after a big rally) that come with being in the market, because emotion is a wealth killer.  Just as big storms and occasional losses are part and parcel of being an insurance company, market volatility and negative headlines are things you just have to learn to live with if you are going to be a successful investor.

Trademark News

Last quarter we told you that we were are developing an iPad, iPhone and Android app.  We hoped it would be ready in December but it was delayed.  With any luck it will be available in the next few months.  We’ll let you know more on our blog (www.trademarkfinancial.us/blog) and in next quarter’s newsletter.  Additionally, we update the blog once or twice a month with my latest thoughts on the market.  If you’d like to be added to the blog update distribution email list or to begin receiving your statement electronically please contact Cynthia Gates at Cynthia@trademarkfinancial.us or 952-358-3395.

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. 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.

<1> By purchasing certain bonds in order to keep their yields low and therefore less attractive to investors.

<2> S&P 500 information from Morningstar.  The same is true of the performance data on Apple Inc.

<3> The Wilshire 500 is the proxy for the broad U.S. stock market.  The S&P 400 is used for midcap stocks and the S&P   600 for smallcap stocks.  Again, the performance data is from Morningstar.

<4> MSCI is the source for all international stock performance cited here.

<5> Barclays is the source for bond performance information.

<6> As measured by the S&P 500

<7> Notice the importance of long term here.  In the short term a rising stock will probably continue to rise and a falling stock will probably continue to fall.  If you bought tech stocks in 1999, you still made money for several months before they crashed.

<8> At least for a while.  If we go five years without another hurricane some people will drop their coverage because they feel less fearful.

Summary

Markets were surprisingly strong last quarter as fairly lackluster economic numbers brought about global central bank intervention.  We have been in an unusual situation where “good is good” (meaning that good economic news leads to higher stock prices) and “bad is good” (bad economic news leads to the belief that the European Central Bank, U.S. Federal Reserve, and the Bank of China will add billions of dollars of stimulus to keep the rally going).  As it happened, the bad was good enough to prompt an influx of central bank liquidity.  This lifted both financial assets (stocks and bonds) and “real” assets (gold and real estate).  While that also increases the likelihood of future inflation, investors are generally more focused on the shorter term.  With the European debt crisis apparently pushed off for a few months and the U.S. budget situation on hold until 2013, the very short term appeared less dicey.  This had investors in a buying mood.

Overall, U.S. stocks rose 6.3% last quarter.  That brings the market’s gain to 16.3%<1> for the year.  Larger company stock generally performed better, with the S&P 500 (up 6.4% in 3Q12, 16.4% for the year) easily surpassing the midcap and small cap indices (both 5.4% in 3Q12 and 13.8% for the year, respectively).  I tend to think that graphs help put things in perspective so I inserted two charts from J.P. Morgan that illustrate the performance of the S&P 500 over several time periods.  Energy<2> was the leading sector with a 10.1% gain, followed by telecommunications and consumer discretionary (think cars and TVs).  Utilities and REITS were the worst performers.  These are seen as more defensive industries and often don’t perform well when investors are seeking to increase risk.

Source: Russell Investment Group, Standard and Poor’s, J.P. Morgan Asset Management as of 9/30/12

Source: Russell Investment Group, Standard and Poor’s, J.P. Morgan Asset Management as of 9/30/12

The actions by world central banks were even more beneficial for foreign stock investors.  The U.S. held up considerably better than Europe or Asia in the first half of 2012 because the U.S. was, as Bill Gross of PIMCO famously put it, “The cleanest dirty shirt in the hamper”.  Thus Europe and Asia had more to gain from the “cleansing” action of billions of dollars of credit.  Asian stocks rose 9.3%<3> on the quarter while European stocks tacked on 8.8%.  Once again, Japan was the place you really wanted to avoid.  Japanese shares gave up 0.8% last quarter.

The bond market rally continued.  Federal Reserve bond buying and investor demand for yield pushed bond prices up despite the increased risk of rising inflation.  Here too, the riskiest classes of debt instruments performed the best.  Emerging market debt soared 6.8% and high yield corporate debt rose 4.5%.  Bonds in whole, as measured by the Barclay’s Aggregate Bond Index, were up 1.6%<4>.  That gives them a year-to-date return of 4.0%.  International bonds were helped by central bank activity, because it reversed the “flight-to-quality” buying of the U.S. dollar that had characterized the first half of the year.

Activity

When the central banks are actively easing, the only asset you really don’t want to have is cash (because the price of everything tends to be inflated).  We reduced our overall cash positions carefully where they were on the high side.  Most of the purchases were in global stocks (primarily the Artisan Global Value Investor fund) and large company stocks (BBH Core Select among others).  We did not do any major rebalancing because the overall investment environment (expansionary; risk-favoring within a context of below-average growth and an above-average risk of negative external shocks) did not change.

Outlook

The 16% year-to-date gain in stock prices is nice, but it is not justified given the lackluster growth in the economy.  In fact, in the absence of considerable central bank effort, the global economy would probably be contracting.  There is too much debt in developed nations (so their consumers cannot buy as much, and developing nations cannot export to them as much).  There is an excess world supply of labor, so wage growth is stagnant at best.  In “real” or inflation-adjusted terms, wages are falling.  There is no quick or easy solution.  Central banks are actively using monetary policy to fight deflation, but they cannot lift “real” growth.  As long as they continue to try, asset prices will perform better than they deserve to.  Which begs the question . . . . . . how long can this go on?  In another words, where would stock and bond prices be if governments were not indirectly supporting them?  The reason we have to ask this is that at some point in the future indirect government support will cease.  If we forget that today’s price levels are to some extent “artificial”, we are setting ourselves up for disappointment down the road.  The challenge for investors is to determine at what point (and how rapidly) the artificial prices and the true (unaided) prices begin to converge.  An aggressive investor would choose to be fully invested in order to take advantage of the price appreciation fueled by the excess liquidity.  A conservative investor would recognize the current market environment as a financial game of musical chairs, since political factors may force central banks to stop the music (in other words, end quantitative easing/outright monetary transactions) at any time.  Doing so would certainly hurt asset prices, so they probably elect to stay out of the market.   For most investors, pursuing a “middle of the road” strategy make the most sense.

Commentary – Valuation

If there is one thing that investors need to have a good sense of, it is valuation.  History has shown that when you invest at times when valuations are low, the probability of earning above long term average returns is high.  On the other hand, invest at the highest valuation points and long term below average returns are very likely.  The most common measure of market valuation is the price earnings ratio (P/E).  Stocks are said to be cheap when the price of a dollar of corporate earnings costs less than $12, and expensive when it cost more than $18.  Of course, there are other factors that influence this measure.  During periods of high inflation, for example, a dollar of future earnings is worth a lot less than a dollar of current earnings.  P/E ratios will typically be lower during those periods.  During periods when economic growth is especially strong (perhaps due to innovation or declining raw material costs) P/E ratios are often at the highest end of the range.  So where do we stand today?

That depends on how you look at it.  For example, much of the investment industry sees valuation today as being cheap.  Recently JP Morgan calculated the market’s current level is just 12.1 times “adjusted after-tax corporate profits”<5>, placing it firmly in the lower end of its historical range.

Other market bulls cite the fact that the yield on the S&P 500 (2.24%) is lower than the yield on the 10-year Treasury (1.67%), a rare phenomenon over the last 60 years that has in each case been followed by strong stock performance.  See the inserted chart S&P 500 Earnings Yield vs. Baa Bond Yields.

Source: Standard & Poor’s, Moody’s, FactSet, J.P. Morgan Asset Management. As of 9/30/12

On the other hand, more than a few advisors (especially those without equity funds to promote) find the market rather expensive.  John Hussman, using Yale professor Robert Shiller’s price-to-last-10-years-average-earnings metric, says stock valuations are in the highest 1% of history<6>.  See the inserted chart S&P 500 Shiller Cyclically Adjusted P/E.  His stats show that every time stocks are this expensive a significant decline is less than a year away.  Institutional money manager GMO isn’t that pessimistic, but they agree that future returns will be below average because after-tax profit margins are at record highs and must regress toward the mean.  At least one side is going to be very wrong.  But objectively, how do these arguments stack up?

Source: Russell Investment Group, Standard and Poor’s, J.P. Morgan Asset Management as of 9/30/12

First of all, since the S&P 500 is currently about 1440, a P/E of 12.1 implies earnings of $119 per share in 2013.  Past 12 month earnings are $101, so either future earnings are about to surge (not likely given recent CEO commentary) or JP Morgan is going by operating earnings (versus the more historically consistent reported earnings).  If we take a middle of the road estimate of 2013 reported earnings ($105), we get a P/E of 13.7.  Still modestly on the cheap side.

As for the argument that stocks are cheap relative to bonds, I wholeheartedly agree.  However, that discrepancy can just as easily be resolved by poor performance on the part of bonds as by strong stock returns.  The argument that P/Es should be higher today because inflation is low should also be rejected.  Historically, this relationship holds up during periods where inflation is stable but it works poorly when inflation is either volatile or negative (de-flation).  If the price of gold is any indication, the outlook for inflation is highly uncertain.  In any event, we do not afford Japanese stocks the highest P/Es today even though their inflation rate is clearly the lowest (-1%).  P/E ratios are more sensitive to the expectation of future growth – that’s why they were so high in the late 1990s.  With much of the globe expecting a prolonged period of sub-par growth, P/Es should be on the low side of average.

Now let’s look at the bearish arguments.  First of all, the Shiller P/E is not going to yield a useful result unless we factor out 2008, when earnings were essentially zero.  If we reduce the Shiller P/E by 10% (to adjust for the 2008 anomaly), we get a high P/E of 20.0.   The median historical Shiller P/E is about 19, so this is only modestly above average.  The GMO argument, that corporate profit margins have been unusually high at over 9% and will fall back toward the historical average of around 6.3%, also troubles me.<7> I don’t believe this will happen.

Source: Montier, James.  What Goes Up Must Come Down! www.GMO.com as of 9.30.11

There is plenty of surplus labor in the world, so labor costs won’t crimp margins.  Moreover, the political power of capital relative to that of labor is at its highest point since the 1920s.  Raw materials prices are set to fall.  They had surged in recent years because of the tremendous infrastructure growth of China as the Chinese built huge stocks of copper, aluminum, iron ore, timber, cement, etc.   Now China is slowing down just as raw material producers are adding capacity.  Moreover, the exploitation of vast natural gas reserves in the United States will also put downward pressure on production costs.  Finally, corporate taxes will either stay the same or be lowered, depending on the outcome of the election.  Rather than this (profit margin compression) being a negative for stocks, I foresee margins remaining elevated for a long time to come.

My conclusion is this – the path for the stock investor is neither decidedly uphill nor downhill.  In the end, neither the “boom” nor the “doom” arguments persuade me.  I expect that the relative difference in valuation between bonds (fairly expensive and over-owned by retail investors) and stocks (reasonably valued and under-owed by most people) will prove a long-term tailwind for stock investors.  Most of this will probably be realized beyond the next year or two.  By that time, bond investors will probably have become as dissatisfied with low returns as CD investors are today.

Trademark News

We are pleased to announce several new technology initiatives.  First, we are in the early stages of developing an iPhone, iPad and Android app that will allow you to review account valuation, performance and reporting information for your Trademark managed accounts.  The app should be available by the end of the year but we’ll let you know in our next newsletter.  Second, we now have the ability to email you your quarterly statement rather than mailing a paper copy.  Lastly, I want to remind everyone that I maintain a blog at www.trademarkfinancial.us/blog that I update once or twice a month.  It’s a good place for you to keep up with my current view of the market.  If you’re interested in either e-statement or being added to the blog update distribution email list please contact us.

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. 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.

<1> Russell 3000 used for overall market return, S&P 400 for midcap stocks and S&P 600 for small cap stocks.

<2> Sector data courtesy of JP Morgan Asset Management

<3> Global stock data taken from MSCI via Morningstar

<4> Bond data from Barclays Global via Morningstar

<5> J.P Morgan Asset Management, October 9, 2012

<6> John Hussman, “Low Water Mark” September 17, 2012

<7> Source: Montier, James.  What Goes Up Must Come Down! GMO White Paper. March 2012

Summary

The stock market pulled back during the second quarter but the decline was modest (3.1%).   More than 100% of the decline was in May, as a disappointing jobs report threw cold water on hopes of an economic recovery.  Stocks staged a modest rally in June on the hopes that the Federal Reserve would soon move to stimulate the economy (as it has done the previous two summers).  While a slow growing economy does not necessarily imply a weak stock market, investors do need to believe that the economy’s trajectory is upward.  Right now that confidence is fragile.  Bulls are basing their case on the fact that corporate earnings continue to grow and profit margins are very high.  The bear case is that we are slipping back into recession and when we do, neither earnings nor margins will hold up.

Because once again bonds outperformed stocks, I’m going to discuss their performance first.  As the economy faltered, interest rates declined.  This sparked a 2.1% gain in bonds for the quarter.  In contrast to the first quarter, higher quality bonds outperformed more risk areas of the bond market.  High yield bonds gained only 1.8% and emerging market debt 1.4%.  The best performance came from those areas where duration is typically longer, such as TIPs and municipal bonds.

It was a disappointing quarter for those who believe inflation is a near and present danger.  As interest rates fell, everything associated with the notion of inflation hedge (other than TIPs) declined as well.  Precious metals and energy were the worst performing sectors of the market.  Other sectors that depend on economic strength (materials, financials, technology, industrials, and consumer durables) also declined.  The winners were the defensive sectors (utilities, health care, and consumer staples).  Larger companies (-2.8%) managed to lose a little less than smaller companies (-3.6%); oddly enough mid-size firms did worse than either (-4.9%).

Not surprisingly, international stocks fared worse.  For the most part, foreign economies slowed faster and their currencies depreciated against the dollar.  The major foreign stock index, EAFE, declined -7.1%.  Latin America fell the most (-13.2%).  Asian stocks (ex-Japan) lost only -6.2%.  Emerging markets stocks as a whole lost -8.9%.

Activity

We did not have to do much during the quarter because the portfolios had already been positioned for a weaker investment scenario.  As a result, our risk-adjusted relative returns were very competitive.  We have tried to be careful about owning volatile funds, even those with good track records, because we regard the chance of a 20% decline in stocks being greater in the short term than a 20% gain.  We pride ourselves on being stubborn about giving back gains.

Outlook

We believe that economic growth during this economic cycle is going to be considerably less than in previous cycles for a variety of reasons.  This would suggest that stocks do not offer exciting return potential.  That said, in an environment where bond yields are below 2% (for the most part) and inflation (outside of health care and college tuition) is barely above 1%, even mid-single digit stock returns would be attractive.  This is driving the current mania for income- oriented sectors such as utilities, REITs, pipeline MLPs, and preferred stocks (they yield 4% or more, so they would beat most bonds without any change in price).

Bonds, on the other hand, often do quite well in the middle of the year.  If there is less economic activity, for whatever reason, high quality bonds are probably going to benefit.  High quality bonds have outperformed stocks over the last five years by an average of 6.74% per year!  As a result, bond valuations are beginning to appear excessive in some areas.  Many bonds are now priced above 100, which is the par value at which they will mature.  In a time of market stress safe assets often get overvalued and risk assets get undervalued.  At some point, however, the whole notion that bonds = safe, stocks = risky may have to be re-examined.

Commentary – The Event Uncertainty Principal

Last quarter I wrote about the three ways an advisor can add value.  Two involved essentially timing decisions (buying when stocks were out of favor and consequently priced low; selling when stocks were in favor and consequently priced high), and one involved security selection.   The problem with these value adding strategies is that at any given time there may not be anything you can do to implement them.  For example, right now it is not clear whether or not stocks are particularly cheap or expensive.   From a cyclical standpoint, most economists believe that the current economic expansion started in 2009.  It seemed to stall in both 2010 and 2011, only to recover modestly with help from the Federal Reserve.  It seems to be stalling again.  Does that mean we have yet to see the cyclical peak, or has it already occurred?

In the absence of truly great buying or selling opportunities, and assuming we can’t identify the next Apple Computer (circa 2003), or the next buy-and-hold-for-the-next-decade sector like gold in 2001, what should we be doing?  My close-to- three-decades in this industry have taught me that some of the best investment decisions are the ones where you elect to stand pat.  Opportunities will present themselves if you are patient.

Perhaps human beings are tinkerers by nature – I certainly think most investment managers are.  It is our nature to want to make each portfolio just a little bit better.  We scrutinize a variety of measures to enhance the probability that we have the best fund or the best portfolio for a given scenario, but we know that it is just an educated guess – there will always have been something better we could have owned.  It takes a certain amount of hubris for a manager to believe he or she can put together an “optimum” portfolio.  That leads one to false confidence or endless tinkering – either of which, statistically, do not improve results.

During bull markets, it is usually a profitable strategy to identify the strongest stocks and/or strongest industry sectors and overweight them while owning little or nothing in the weakest areas of the market.  This works because during bull markets trends tend to be long-lived (hence the cliché, “the trend is your friend”).  However, during bear markets (and this current period is most likely a bear market despite the occasional strong rally), chasing trends usually does not pay off.  There is no solid sector leadership, so by the time an outperforming sector is identified, it falters.  This has really affected mutual funds that depend on momentum strategies, as well as most alternative strategies.  When a strategy that had been working stops being effective (and this happens to EVERY strategy at some point) rather than reflexively chasing what is currently working, the wise advisor steps back and assesses  why the strategy is no longer effective and what that tells him about the current environment.

The Event Uncertainty Principle is based on the premise that NOBODY knows what the market is going to do in the short run.  There are two kinds of mistakes that investors make – being wrong and being early.  If you absolutely knew what was going to happen and precisely when (and everybody else did not have this information), you could make a very large amount of money.  Even the biggest and most well-connected don’t know what is going to happen and when. Otherwise J.P. Morgan would not have lost several billion dollars on one trade recently, and Bear Stearns and Lehman Brothers would still be with us.

When something happens we have a tendency to say “of course that happened.  It was obvious that was going to happen”.   When we think about the sub-prime debacle, for instance, it seems obvious now that those mortgages should not have been rated AAA.  At the time, however, that was a radical notion.  Even those who knew there was a problem did not necessarily get the timing right.  It is just human nature to try and make sense of things, and in doing so establish the world as a more stable, orderly, and predictable place than it really is.  The randomness of life can be unsettling.

The bottom line for us is to deliver the best investment results we can.  The point of this Commentary was to establish that it isn’t always clear what will produce the best results in the short term because even widely-predicted events tend to unfold in an unpredictable manner.  While the future is always uncertain (no matter what people tell you) that doesn’t mean that very good opportunities don’t arise from time to time.  We just don’t believe we are in such a time right now.  Valuations do not scream either buy or sell.  The economy is not obviously growing nor is it clearly contracting.  The macro environment may seem scary, but that did not stop stocks from gaining more than 9% in the first half of the year.  In this environment, we aren’t inclined to be very active because we are skeptical that doing so would add much value.  Be assured, however, that should any of these conditions change, we are ready to pounce on the opportunities they create.
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. 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.

Wilshire 5000, per Morningstar

Barclay’s Capital Aggregate Bond, per Morningstar

Barclay’s Capital High Yield Corporate Bond and Barclay’s Capital Emerging Market Debt, respectively

Standard & Poors 500 (Large Cap), 600 (Small Cap), and 400 (Mid Cap) Averages, respectively

MSCI EAFE, Latin America, Asia ex-Japan, and Emerging Markets, respectively, net return in dollars

As of July 20, 2012 Vanguard Total Bond Index has a 5 year annualized return of 6.89%.  Vanguard Total Stock Index is up 0.15% over the same time frame (per Morningstar).

Summary

Once again, most of what could go wrong for the global economy did not go wrong.  Investors began to accept the idea of a U.S. led expansion and pushed stocks to levels not seen since early 2008.  What began last October as a relief rally based on the premise that the global economy was not about to crash has turned into genuine optimism. Unemployment continued to decline (though not as fast as we’d like), bond yields remained low, the Federal Reserve remained accommodative, and the European Central Bank kept the Eurozone from collapsing.  I’m not sure this merited a second consecutive 12% quarterly increase in stock prices, but I will gladly take it.

Unlike last year when stock performance varied wildly (U.S. stocks averaged a slight gain while foreign stocks plunged over 12%), this past quarter saw fairly uniform gains.  The S&P 500 index gained 12.6% while small stocks, as measured by the Russell 2000, rose 12.4%.  The real difference in performance came from the industry group.  Financial services stocks rebounded strongly last quarter (22.3%) after being the worst performing sector last year and over the previous 5 and 10 year periods.  Technology also performed well (21.7%) led by a 48% gain in Apple, Inc.  Given the spike in gasoline prices, Energy was a surprising laggard (4.9%).  Natural gas prices have plunged as improved drilling techniques and an unusually warm winter have resulted in a supply glut.  Utilities (-1.5%) was the only losing sector during the quarter.  They had been bid to overly lofty levels last year by defensive and yield-hungry investors.  For the quarter, growth stocks gained 16.7% while value stocks rose only 9.2%.  This shows the preference investors now have for opportunity over relative safety.

Despite a fairly dicey global economic outlook, foreign stocks rose 10.9%.  Emerging markets gained 14.1%.  One might have expected Europe to have been a laggard, but they still jumped 10.7%.  Latin America was up 14.6% and the Asia-Pacific region 11.7%.  Foreign stocks have performed much worse as a whole since 2008 and unlike U.S. averages are nowhere near their late 2007 peaks.

The best that can be said for the bond market is that yields did not spike as some predicted.  Bonds recovered from two waves of interest rate jitters to finish with a slight gain on a benchmark basis (0.3%).  Fortunately, most traded bond funds are shorter in maturity and lower in credit quality than the benchmark, which allowed them to gain an average of 0.9%.  High grade corporate bonds rose over 1%, while high yield corporates made more than 5% and emerging market bonds tacked on 5.5%.  Global bond funds fell close to 1%.

Activity

As this quarter saw mostly a continuation of the dynamics of the previous quarter, we did not make many changes.  Where we did, it tended to be to make sure the securities in aggressive portfolios were keeping up with the surge in financial services and technology.  We increased the use of Touchstone Sands (PTSGX), a momentum-oriented large cap growth fund.  The addition of Apple stock to aggressive portfolios last year has worked out very well.   In more conservative portfolios we reduced both cash and global bond weightings in favor of U.S. corporate bonds.  Global government bonds slumped in dollar terms as U.S. economic growth was much better than that of Europe or Japan.  Our overall philosophy, which was to err on the side of caution by employing less aggressive, more dividend-oriented stock funds, remained in place for most investors.

Outlook

There is much uncertainty out there.  Political uncertainty in the U.S. driven by the Presidential election, economic uncertainty in Europe driven by the fact that many countries have debt burdens they cannot meet through growth or currency depreciation, and uncertainty in China driven both by political changes (a new group of leaders are elected by the Party this year) and economic challenges (how to rein in inflation without hurting the economy too much).   There are very few potential upside catalysts on a six month basis.  What we’ve achieved over the past few years has largely occurred through aggressive central bank (Federal Reserve and ECB) manipulation of credit and the bond market. That can’t continue forever.

The bottom line is this:  Stocks are no longer cheap. Over the past three years stocks have been available at a discount.  That seemed appropriate, as circumstances (a collapsed U.S. real estate market, high debt relative to GDP in most of the industrialized world, a potentially shrinking government sector) suggested that economic growth would be lower than average this economic cycle.  Investors did not want to pay the average market multiple for stocks if profit growth was going to be below average.  As it turned out, profit growth thus far has NOT been below average.  There are a variety of explanations for this, but the bottom line is that corporate earnings have done better than expected, and investors have finally given in and re-priced stocks (upward).  Today many stocks trade at prices that assume this robust profit growth will continue.  When expectations are low, “risk” (the chance that the expectations are wrong) tends to be to the upside.  Now that expectations are fairly high, in many areas there is more downside risk than upside.  Take homebuilders, for example.  After a 65% six month gain the industry now trades at prices that assume a multi-year housing recovery.  If that happens, those stocks have fairly modest further upside potential.  If the recovery falters, they have double digit downside potential.

Commentary – How to Add Value

There are two basic ways an advisor adds value.  One of them is to earn the client a greater return than the market provides at their level of risk tolerance.  The other is to protect them from making decisions they will regret later. I’m well into my third decade as a money manager, and I can tell you with certainty that the latter is far more important.

There are three ways an advisor can improve investor return over the course of a market cycle:

1. They can increase stock exposure when markets are near cyclical lows (buy low)

2. They can decrease stock exposure when markets are near cyclical highs (sell high)

3. They can own superior funds that either make more when the markets go up, lose less when markets go down, or a combination of both (security selection)
   We have always paid special attention to security selection.  We carefully examine past performance and attempt to determine what the factors were that led to superior results.  More importantly, we want to know if those factors are still in place.  Is the manager still there?  Is the fund able to deal with the influx of new money?  Are market conditions reasonably similar to those the manager has successfully navigated in the past?

   We also try to buy low and sell high, but this is a lot more difficult.  Markets are rarely at extremes.  Most of the time valuation doesn’t provide much short-term guidance.  Since you can never know exactly where the cyclical low is (until you have passed it), buying low requires a certain intestinal fortitude.  It is fair to say that most people do not have it.  Selling high is only modestly less difficult.  Far fewer people call you in a buying panic in up markets, but occasionally they move their money.  When the stock market really took off at the end of the 1990s, it was very difficult for anyone managing a diversified portfolio to keep up.  Put simply, every dollar that you had in stocks that wasn’t in the technology sector cost you in performance, and it might get you fired.  Nobody wanted small stocks, foreign stocks, or gold or energy or manufacturing stocks (unless they made computers).  Most managers rode the tide, posting great numbers before the crash.  Local money manager Lee Kopp had two years in the 1990s with returns of greater than 100%.  Some managers resisted, and a few didn’t survive long enough to be proven right (anyone remember George Vanderheiden or Robert Sanborn?).  As you know, the technology sector eventually crashed and the NASDAQ is still to this day more than 25% below its 2000 peak (while the non-technology sectors all made new all-time highs by the end of 2007).  Kopp’s mutual fund lost so much money he closed it.

   The point is that earning a greater return than the market for a while turned out to be far less significant for the client than keeping his portfolio diversified.

   That said, in order for an advisor to add value for you there needs to be mutual trust The client has to trust that the advisor knows what he is doing when he’s not selling on down days (or God forbid if he’s buying!) or if he’s raising cash when  markets are strong.  The advisor has to trust that the client will not pull the plug on the strategy before it has a chance to work (because it will never work at first; you will never start buying on the very lowest day nor will you ever sell at the absolute top).  Markets tops and bottoms are not one day events they are processes.  Advisors’ strategies have to be processes as well.  This means you have to start lightening up on stocks before you believe they have peaked.  These are the times when you wish there were no benchmarks and no CNBC to make investors anxious.   When investors should be thinking, “I’ve made a bunch of money but prices are kind of high now.  I should maybe take some profits”, instead they say “How come I didn’t make as much as the Dow did?”

   With the advent of exchange traded funds, matching a benchmark is easy.  The question is whether or not matching the market’s fluctuations is the best way to reach your goals.   Hopefully you know by now that we place a high value on minimizing losses.  A quick glimpse of this chart shows why.   Note how much harder it is to make up a 25% loss than a 15% loss.  The S&P 500 plunged approximately 56% from October 9, 2007 to March 9, 2009.  Though it has more than doubled from its low, it has not yet made up that loss. If one had lost only 35% during the last bear market, and then earned just half of the market’s 112% subsequent gain (through 4/14/12), he would have more than recovered his loss.  We all want to capture 100% (or more) of the market upside, yet experience substantially less of its downside.  That is not possible without being willing to give up some upside as markets approach the top of the cycle.  Great investors do not try to maximize gains in every environment any more than great golfers always aim for the pin.  To do well, you have to calculate the risk and reward potential and decide what kind of approach the circumstances warrant.  Right now we believe the answer is “Cautious”.

   The following shows that if one were to lose -20% and then gain back +20%, one would still be short 4%.  The investor would need a 25% gain to make up for a 20% loss.  If he lost twice as much (-40%), a subsequent gain of +40% leaves him not 8% but 16% short.  He needs a 66.67% gain to get back to even.

   Loss And Recovery Table

As much as you want your advisor to out-perform every quarter, what you really need him to do is protect you from surrendering to greed or fear.  You want him to exercise judgment such that you can experience as much of the upside as your risk tolerance permits, be that 30% or 100%.  You need him to be calm in both soaring and diving markets, because that is where large sums of money are ultimately lost or made.  We are up to the challenge.  We have demonstrated the patience and the nerve to sell early and buy early.  Today, we believe we are in a “sell early” situation where it makes sense to dial back on risk before the next crisis is upon us.  We thank you for your trust in allowing us to do this for you.

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 the current notice filing requirements imposed upon registered investment advisers by those states in which Trademark. Trademark may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. 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. 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.

The S&P 500 was up 12.59% during the period 1/1/12 – 3/31/12.  It gained 11.82% from 10/1/11 through 12/31/11.

The MSCI EAFE (Europe, Asia, Far East) Index declined 12.14% in 2011.

Morningstar Financial Services Index

Morningstar Technology Index

Based on the 3/31/2012 closing price of $599.55 and the 12/31/2011 closing price of $405.00.

Morningstar Energy Index

Morningstar Utilities Index

Morningstar Growth and Value Indices

MSCI EAFE Index,  Net Return in Dollars

MSCI Emerging Market Index, Net Return in Dollars

MSCI Europe and MSCI Asia-Pacific Indices, Net Return in Dollars

Barclay’s Capital Aggregate Bond Index.  All other bond indices cited are also from Barclay’s Capital.

Per Telemet, the XHB Homebuilders ETF has gained more than 65% from its 10/3/2011 low.