Quarterly Perspective Archives | Page 6 of 6 | Trademark Financial Management

Summary

As is so often the case with stocks, a very bad quarter was followed by a very good one. Last quarter the stock market rose close to +12%, not quite erasing the previous quarter’s -15% loss but putting U.S. stocks ever so slightly into positive territory for the full year. The biggest reason for the strong stock performance last quarter was that last August and September investors discounted stocks to factor in the risk of a European economic collapse and a slide back into recession here in the U.S., but when neither occurred investors re-priced stocks higher. The bears apparently did not count on the ability of world bankers to once again find a way to put off the day of financial reckoning. It is not as if the situation in Greece or Portugal has gotten any better; markets have just stopped worrying about it for the time being. Call it “gloom fatigue”.

Almost every asset class gained. Stocks gained because the global economy managed to muddle along despite investors fearing much worse. Bonds rose because economic performance was weak enough to allow interest rates to fall further. Only gold managed an outright decline (-3.84%). Transportation stocks did the best (+20.37%) as the economy rebounded somewhat while fuel prices declined. Small company shares surged +17.17%, but like large caps they failed to fully recover from their huge (-19.83%) third quarter decline. Investors tended to favor utility, health care, and consumer staples companies for their ability to withstand an economic downturn. Financial and materials stocks performed the worst.

International stocks rose, but very modestly. While U.S. stocks were able to erase more than 80% of their 3Q11 losses, overseas companies only recovered about 20% in dollar terms. Bond guru Bill Gross coined the phrase “cleanest dirty shirt” to illustrate the fact that while the U.S. financial struggles are considerable, everyone else’s seem worse. Overall, foreign stocks gained just +3.33% last quarter to finish the year down -12.14%. India and Latin America performed even worse than Europe last year.

Bonds (+1.12%) recovered from a fear induced sell-off in the third quarter that saw only highly rated bonds post gains. World central banks’ efforts to boost liquidity especially helped riskier sovereign debt and high yield corporate bonds. Municipal bonds continued their strong recovery from the panic selling that followed Meredith Whitney’s December 2010 appearance on CBS’ 60 Minutes program. Their +10.7% gain for the year was second only to long term Treasury Bonds. Playing it safe was not the way to go as money market yields were essentially zero.

Activity

It was not a very active quarter compared to other recent quarters. Funds that favored more defensive industries tended to perform better from the beginning of May to the end of the year. We had already made those changes over the summer. The international component of portfolios was a bigger challenge. The best performers for most of the year were those that owned some gold as a hedge, but that changed dramatically in the fourth quarter. At that point we moved to foreign funds that hedged currency exposure, favored defensive industries, or had some U.S. exposure. On the bond side, we had to replace funds where the fund managers had shortened duration too much, because we wanted more interest rate exposure in order to benefit from falling rates.

Outlook

I would like to be able to say that the rally last quarter proves the naysayers are wrong and that we no longer have to fear an economic slowdown or a crisis triggered by Europe or China, but I can’t. Those risks are still there. While some of the weakest sectors from last year (financial services, materials) are having a nice bounce in 2012, I am not ready to change our portfolios. For most investors we are going to continue to err on the side of caution.

If you recall, last quarter I wrote that at some point stocks get so cheap that you just have to “hold your nose and buy”. Three months and +15 percent later, we are closer to the other end of the spectrum. We are not at valuations that suggest that a 2008-style 50%+ decline is in the offing, but if the crisis in Europe leads to a global recession, a 2002-type 20-30% sell-off would not be a great shock. That said, I don’t believe a decline is imminent. In the short term, things look fairly good. The economy is growing and corporate profits continue to rise. We can’t run our financial lives worrying about the bad things that might happen, but we do have keep the risks in mind. In our case, this means being on the more conservative side of our asset class ranges, and using alternative strategies to substitute for stocks, bonds, and cash where appropriate.

Commentary – The Trouble with Benchmarks

One of the things all advisors tend to struggle with is benchmarks. In other words, how do we help a client evaluate whether or not we’ve done a good job? For a long time we used a market benchmark like the S&P 500 or the Dow Jones Industrial Average, because we knew these were indices that could be easily obtained and that our clients were familiar with them. For many moderate risk investors these indices never made sense, however, because our clients were not 100% invested in large U.S. companies like those indices are. We have diversified our clients’ portfolios with small companies, foreign stocks, bonds, money market funds, and maybe even a little gold. Therefore it made more sense to use blended benchmarks, which combine most or all of those asset classes. This is an improvement, but there are still certain shortcomings that are present no matter what kind of benchmark one uses. One, fear of underperforming a benchmark can lead advisors to think short term and make decisions that ultimately cost investors; and two, any benchmark is only as good as its components.

Let’s look at how good our benchmarks are. Is the Dow Jones Industrial Average a good benchmark for the stock market? It’s a price-weighted index, meaning that the highest priced stock (IBM) has a much greater impact than does Exxon Mobil, despite the fact that the latter is nearly twice as large by market capitalization (number of shares outstanding multiplied by the price per share). If price-weighting was the best measure of value, Bank of America could do a 30-1 reverse split and go from 30th in importance in the Dow to first, even though the split wouldn’t have made its shareholders a single penny. While the market cap-weighted S&P 500 has done a pretty good job reflecting the value of the average stock over time, its performance can be skewed by erratic investor behavior. The incredible rise and fall of technology stocks from 1997 through 2002 led benchmark investors on quite a wild ride. Because of this, other firms (most notably Research Affiliates) have come up with alternative benchmarks which employ such strategies as equal-weighting or fundamental weighting (weighting companies based on metrics such as revenue or book value).

Other asset classes also have problems with benchmarks. The most popular bond index (Barclay’s Aggregate Bond Index) has a much longer maturity and high credit quality than the average bond fund, making it incredibly hard to beat when interest rates fall and surprisingly easy to beat during economic recoveries. The most popular international index (Morgan Stanley’s Europe, Asia and Far East Index or MSCI EAFE) has been an easy bogey for most of the top foreign fund managers due to its high relative weighting in Japanese stocks. So the question is, should advisors follow benchmarks whose composition is arbitrary or which might cause investor portfolios to be unnecessarily volatile?

A better question might be whether advisors should follow benchmarks at all. One study concluded that the less a fund manager clung to his benchmark the better he tended to do. This fits with what we have observed over our many years in the business. Let’s go back to 2008. The S&P 500 plunged -37%; foreign stocks dropped more than -45%. It would have been hard to underperform any stock index that year with a properly diversified portfolio, so most advisors did a good job, right? It is doubtful, however, that many of them felt good about the year. I know I didn’t. To have done well in a bad year from a client standpoint, advisors had to step outside the benchmark way of thinking.

People have finite lives. They can’t always rely on what stocks will do in the long run. They have a fixed number of earning years and then they have to live on what they have saved. Most people cannot endure another -25% or -30% year even if the market loses -60%. So to some extent advisors need to move from relative return (how did client portfolios perform relative to the appropriate benchmark) to absolute return (how much did client portfolios make or lose). We need to be able to position your portfolios to grow within the risk parameters you have given us regardless of what the market is doing, and we will only do this well if we don’t fear that we are being judged on every quarter’s performance relative to the benchmark.

The way markets move today would you even want to try to chase it? Let’s look at the last six weeks. At the beginning of December investors were feeling a little shell-shocked. The stock market had already posted 35 trading days in 2011 with gains or losses of more than +/-2% (I believe in 2006 there were zero). The prevailing sentiment was to pile into the least volatile, highest yielding stocks and hope to finish the year with any kind of a gain. Investors drove telecom stocks, utilities, health care stocks and consumer staples up another +3 to +4%. On the other hand, technology and materials extended their year-to-date losses as investors sold those stocks for tax purposes. Fast forward to the first half of January 2012 and the top sector is materials and the worst is utilities. One moment investors are motivated by fear, the next by greed. Next week it’ll probably be fear again. As a financial professional I can’t manage to a benchmark when the market’s mood shifts from ebullient to despondent and back more often than:

Lady Gaga changes outfits
The Vikings change new stadium locations
<Insert your least favorite politician> changes their mind
Kidding aside, what we are saying is that benchmarks have their uses but please do not get too hung up on them. Your financial planner has provided us with your risk tolerance and we manage your portfolio consistent with that mandate. We will continue to make buy and sell decisions in your portfolios based on our perception of each security’s risk and reward potential, as opposed to what the market is currently doing. We give you information each quarter which includes benchmarks because we want you to have an idea of what we had to work with in terms of the opportunity to grow your portfolio. Beyond that, benchmarks have some serious flaws in terms of assessing both what a client should expect to have made in a given period, and the value an advisor provided (especially in the short term).

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.

As measured by the S&P 500 all performance information in this section is taken from Morningstar.

As measured by GLD

As measured by Dow Jones Transportation Index

As measured by the S&P 600 Small Cap Index

As measured by the MSCI EAFE

As measured by the Barclay’s Aggregate Bond Index

As measured by the Barclay’s Capital Municipal Bond Index

K.J. Martin Cremers and Antti Petajisto, “How Active is Your Fund Manager A New Measure That Predicts Performance,” Yale School of Management, March 31, 2009.

Summary

No two ways about it – the third quarter of 2011 was difficult. The stock market declined all three months. July was the month of the U.S. debt ceiling struggle. Both stocks and bonds meandered most of that month as politicians tried to work things out. As we got close to the August 2nd deadline, however, public confidence plunged. Bonds soared and stocks plummeted. In August the European sovereign debt crisis returned to center stage. The Euro sold off as some speculated as to whether or not it would survive. Nervous global investors sought the relatively safer dollar and yen. Of course, this just made the alarming decline in European and emerging market stocks even greater in dollar and yen terms. Gold soared 16.6% in the first three weeks of August, only to give every bit of it back by the end of September. By September, economic reports covering August began to roll in and they showed a sharp drop in economic activity. Investors knocked stocks down even further fearing that the economy had slipped back into recession. Interestingly, the bond market began to slump late in the quarter suggesting bond investors did not believe the economy was slowing as much as stock investors seemed to think. (This feeling has been borne out through the first week of October).

The bottom line was an average decline for U.S. stocks of over -15%. Large companies fared better as the S&P 500 lost -13.9% during the quarter and is now down -8.7% on the year. Small and mid-size companies each lost close to -20%. Developed international markets lost -19% and emerging markets dropped over -22%.

Bonds performed much better–if you stuck to high credit quality. The BarCap Aggregate Bond Index rose 3.8%, but most bond funds hold shorter average maturities and as a result gained closer to 2.5%. On the other hand, high yield corporate bonds were slammed by the same economic concerns plaguing the stock market; they sank over -6%. T-Bills, the safest fixed income investment and the staple of most money market funds, rose just 0.01%.

Activity

Our focus last quarter was on replacing funds that were outliers to the downside with better performing alternatives. We also reduced international exposure, and upgraded the credit quality of the bond portfolio. Since we had started the fund replacement effort back in the second quarter, we were pretty well positioned in terms of stocks. On the other hand, the sell-off in credit sensitive bonds was greater than we expected, and given the strength of corporate balance sheets, unwarranted. High volatility favors active management, so we are making changes more frequently now.

Outlook

At some point, prices get to a level when you just have to hold your nose and buy. We still have a dysfunctional political system in the U.S. The European sovereign debt crisis is, if anything, closer to its ultimate resolution due to the fact that those still supporting Greece can’t hold on much longer. The global economy continues slowing and China doesn’t appear to have the wherewithal to flood it with money as it did three years ago. There are plenty of reasons to want to sit on the sidelines and wait things out. That said, as investors you do not get paid for doing what is easy. The question isn’t whether or not things are bad. The question is whether investors have discounted the right amount of bad news, too much, or too little. Stock prices on September 30th reflected too much fear, I believe, and present an opportunity.

Because stocks have already declined so much, I am actually more nervous about bonds. Investors have flocked to bonds because they have outperformed stocks by a large margin over the past decade. The risk-reward equation for bonds going forward is not very attractive, however. At some point investors won’t be as negative on stocks as they are right now, and at that point the prospect of earning less than 2% on their short term bond fund is going to seem awfully unappealing. We are in an environment where the Federal Reserve is manipulating the yield curve in order to stimulate the economy. If the Fed was not in the market, almost certainly long term Treasury rates would be higher. At some point, therefore, they will be.

Commentary – The Least Worst Choice

First Eagle, a well-respected value-oriented mutual fund manager, recently stated that “Equities remain the least worst choice for a long term investor.” I want to discuss what they mean and why I agree with that statement.

Last quarter I tried to illustrate the difference between losses due to market fluctuation (those that can easily be recovered) and losses that stem from a fundamental mispricing of an asset (which may never be recovered). I did that to illustrate that sometimes prices fall for reasons unrelated to the success of the issuer. There is a fundamental understanding of investment markets that you MUST understand in order to be a successful investor. The more expensive (cheaper) the asset is, the less (more) return it will provide over the long term. This is so important that I want to de-construct it so we can understand it better.

The first part of the sentence refers to how much one has to pay for the benefit (meaning yield or appreciation potential) one is getting. For example, the stocks of many medical device companies were expensively priced at over 20 times annual earnings per share a decade ago because investors believed they would rapidly grow earnings. As it happened, in almost all cases those companies did double or triple their earnings. Unfortunately, investors came to see those companies less as innovative technology companies and more as boring manufacturing firms. Many of those firms now trade at 11 times earnings or less, meaning investors made little or nothing on those stocks even though the companies performed as expected. At the wrong price, even a good company is a bad investment.

The second part of the sentence refers to time, specifically the long term. In the short term, there is very little to contain the fear and greed of investors. It seems absurd to think that investors would pay over 100 times annual earnings back in January 2000 for a semiconductor equipment company that earned just over a dollar per share, but they did. Sometimes you can buy an investment that is expensive only to see it get more expensive. However, investors cannot maintain a climate of extreme greed or extreme fear indefinitely. At multiple points in time, prices move through fair value. We can project fair value in the future by using historical median interest rates, price-earnings ratios, and earnings growth rates. There is no guarantee those figures will be correct, but we are at least removing our current bias from them. For example, today’s estimates of future economic growth tend to be conservative because we are in a weak economic environment and have been for many years. There is no guarantee, however, that this will still be the case ten years from now. Bottom line: if we only buy assets when they are in favor, our long term returns will not be very good. If, on the other hand, we can buy good assets when sentiment is bad, long terms returns can be surprisingly good.

Broadly speaking investors have four asset classes with which to work. One is cash, or money market instruments such as T-bills. They currently yield 0.01% (and if you own a money market fund inside a variable annuity, after insurance expenses their annual yield is closer to -1.6%). Since the cost of living is rising at a higher rate than 0.01%, cash is not an attractive place to invest for the long term right now. A second option is the bond market. For sake of argument we will restrict the discussion of bonds to higher quality bonds since lower quality bonds correlate much better with the stock market. The ten-year Treasury bond yields a little over 2% today. High quality corporate 10-year bonds might yield as much as 4%. These yields reflect conditions in which inflation is low and the Federal Reserve is buying long term bonds to keep interest rates down as a means to encourage mortgage refinancing and stimulate the economy. If we assume that ten years from now Fed policy is neither restrictive nor accommodative, bond yields would almost certainly be higher. Therefore, bond prices would be lower. Investors buying a long term Treasury bond fund would earn a return of less than 2% annualized. High grade corporates and municipals might do a percent or two better, but we are still looking at annual returns of less than 4% best case. A third asset class an investor might choose is commodities. This wide ranging group includes oil & gas, timber, grains & livestock, and both base and precious metals. Generalization of such a disparate class is very difficult because each commodity has its own fundamentals (some are scarce while others are plentiful). Over the long term, however, the rate of growth of most commodities tends to grow with the rate of population growth. The only way it can do better is if its scarcity or its usage increase. There is no reliable way to know how much more or less scarce or in demand gold or natural gas or cotton or soybeans or niobium will be ten years from now. That brings us to stocks.

The historical return for U.S. stocks is around 9.8% according to CNNMoney. Stock returns are comprised of appreciation (which is tied to the rate of profit growth), dividend yield, and net change in investor sentiment. The long term growth rate of profits has been surprisingly steady at around 6% over time. Dividends have fluctuated from over 6% in the late 1970s to under 1.5% in 1999; today they yield about 2.3%. It is the changes in investor sentiment that give markets the volatility we all know and love. If we estimate stock returns ten years out, we should probably adjust the 6% annual profit figure downward to allow for the fact that corporate profit margins have been at record levels recently and almost certainly will be lower in the future. Dividend yields are lower than average today as well, so the 9.8% annual return we otherwise would have expected might well be closer to 7%. That leaves us with the net change in investor sentiment. How might that change in the next ten years?

Stocks today trade at earnings multiples below their historical averages. We attribute this to the fact that investors have a lot of fears. Europe might break apart. Our politicians seem incompetent at best and corrupt at worst. Wall Street is run for the benefit of large trading firms instead of small investors. Add to this the national debt, China, oil, weather, the list is seemingly endless. To be sure, all of these fears seem very rational. But will things really be this bad or worse ten years from now or will we have addressed at least some of them? For example, in ten years Greece (and Portugal and Ireland) either will have defaulted or the Europeans will have come up with a better system to replace the current one. If we assume no improvement in price-earnings ratios, stocks would project to a 7% annual return, which would beat bonds by at least 3%. If P/Es returned to their post-war average, stock would gain double digits annually.

First Eagle was saying in its “least worst” commentary that all asset classes look bad right now but that for the long term investor, stocks are the best option. I firmly agree with that assertion. The caveat I would make is that if you cannot be a long term investor (either because you need to take withdrawals or you cannot stomach the volatility that comes with being a stock investor) then you should own primarily bonds and cash and accept the very modest returns that these investments provide. You will probably be far better off earning 3% than selling every time the stock market drops and buying every time it rises. If, however, you have the time horizon and the fortitude for stocks I believe you will be well rewarded on a ten year and longer basis. Just know that the road will continue to be bumpy as global financial markets sort through a variety of challenges. It may very well be that the first half of the decade is less profitable than the second half.

You can keep up with us on our blog at www.trademarkfinancial.us or on Twitter at TrademarkFinMgt.

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.

As measured by GLD

Wilshire 5000 per Morningstar

Source: JP Morgan 3Q11 Guide to the Markets

S&P 400 Midcap and S&P 600 Smallcap Indices

MSCI EAFE and EM Indices, dollar-based

Barcap Corporate High Yield Index

First Eagle Update, 10/7/2011

PMC-Sierra actually reached $255 per share, or 250 times earnings. It trades at less than $7 today.

Fair value being the subjective price in which all material knowledge about a company is known and fear and greed are in equilibrium.

CNNMoney.com, 1926-2010

Source: JP Morgan 3Q11 Guide to the Markets

Summary

Stocks rallied sharply in the last week of the second quarter to finish relatively flat. The quarter had started strong for stocks but gave way in May over deep concerns about the slowing U.S. economy and a potential debt crisis in Europe. There is a strong seasonal tendency for rallies to fizzle out in late April or early May and then a summer rally to lift the market again in July. It doesn’t work every year, but traders are well enough aware of it that when they saw the market decline in May they were prepared to expect the July bounce. When markets got a little bit of good news on the June 27th, the Dow rose more than 100 points. Traders wanted to make sure the ship didn’t sail without them (so to speak) so they continued to buy the rest of the week. The decline of a little over 7% (from April 29 to June 24) was all but erased by July 1.

Our warning in the last Quarterly Perspective about the energy sector getting overly optimistic proved prescient, as energy (-4.6%) was one of the two worst sectors over the past three months (along with financial services, -5.9%). Health Care and Utilities, two sectors which tend to perform best when the economy struggles, led the way with gains of 7.9% and 6.1% respectively. Overall the S&P 500 gained 0.1%. World markets were modestly better, with the overall index up 1.5%. Despite concerns about Greece, Portugal, and Ireland, European stocks (+2.4%) once again outperformed emerging markets (-2.5%). Investors have to remember to look beyond the headlines; interest rates were rising in the emerging markets on inflation concerns while they were stable in most of Europe due to sovereign debt fears. Rising interest rates tend to be harder on stocks than economic concerns.

Bonds responded very well to the slowdown in the economy. Overall bonds gained 2.3%. The best performing sector of the bond market was municipal bonds (up 3.9%). Muni bonds had a horrible fourth quarter of 2010 after a prominent analyst warned of massive defaults, but investors have come to realize that those dire forecasts were at the very least premature. The worst sector of the bond market was high yield corporate bonds (1.0%). They tend to perform more like stocks and they also declined modestly when the economy hit a rough patch in May.

Activity

We looked to add to defensive sectors opportunistically last quarter. Health care stocks tend to be a good place to be when the economy slows because health care usage is not economically sensitive. We eased back on small company stocks because they usually lose more during market downturns. Lastly, we replaced or reduced fund positions where the fund was substantially lagging. That was the case with both Fairholme and Janus Overseas. Both are past winners of Morningstar’s Fund of the Year award and Fairholme actually was Fund of the Decade for the period 2000 through 2009. As the saying goes, however, you can’t eat past performance. Both funds have underperformed similar funds this year by a wide margin and we felt the manager underperformance was large enough, even in light of their past track record, to warrant action. That is one of the advantages of having your account managed.

Outlook

The issues that have hung over the market for the past several months are not going away. It is likely that the debt ceiling will be raised before the August 2nd deadline, but Americans will still be spending more than they are taking in. Europe will probably arrange to keep Greece afloat for several more months, but ultimately its lenders will not be paid back in full. From time to time these and other issues are going to flare up, and stocks will be affected. The best thing we can do as investors is realize that if policymakers are not willing to pursue constructive, long term solutions then stocks are going to remain stuck in a range. Therefore we cannot succeed by chasing strength. On the other hand, rather than fearing market weakness, we should be using it to our advantage.

Commentary – Know Your Losses

No matter how good an investor is, he or she is going to lose money from time to time. Sometimes you over-estimate the potential of a fund or a stock, sometimes the market just takes everything down with it. Investors typically cope with the prospect of losses in one of two ways – either try to avoid losses altogether, or try to make sure all losses are small ones. Loss avoidance is psychologically preferable. The problem is that loss avoidance strategies usually don’t pay very much. We have had periods of time where investing in guaranteed bonds or certificates of deposit paid handsomely, but today yields on these type of securities pay next to nothing. For the investor who wants to earn a return greater than inflation on an after-tax basis, you have to risk principal. To be successful, you have to understand the nature of the potential losses you face.

Markets fluctuate. If you cannot grasp and be comfortable with that fact, you aren’t an investor – you’re a saver. Investors know that it is precisely the fluctuating nature of market prices (be they stocks, bonds, gold, or pork bellies) that provide the opportunity for profit. So when you are contemplating a purchase, you should ask yourself two questions; “How much might I lose?”, and “How long would it take to recover that loss?”

There are three categories of losses. The first and most common is the transitory or short-term loss. Typically, investor perception has taken a mild turn for the worse. If the investment was based upon a solid foundation (the promise and ability of the issuer to repay the bond with interest, or the profit growth of the company, for example) the loss should be small and the price should recover in the fairly short term. Savvy investors welcome these occasions as buying opportunities. The second category is significant impairment. This is a situation where the loss is sizable and the while the prospects for an eventual recovery are good, it will take a very long time. Impairments tend to occur either when a solid company turns out to be not-so-solid, or when an investment is made where a solid foundation does not exist and the investment (speculation) disappoints. The third form of loss is the permanent destruction of principal. The enterprise (gamble) failed; you have no hope of ever recovering your principal.

The mistake most investors make is to see a significant impairment when they in fact have a short-term loss. They sell a security that would certainly recover on its own. It is one thing to trade for advantage (replace one security with a similar one expected to perform better), but if you sell for cash you are taking a loss. It could be a good move if you recognize a more serious loss in the making, but all too often it is an emotional reaction that winds up costing the investor. The second most common mistake is to fail to see the possibility of an impairment or permanent loss. This occurs when an investor is so enamored with the potential of an investment that they do not see the risks. The mania for investing in internet stocks in the late 1990s and real estate in the last decade was predicated on the notion that you could make a lot of money in a relatively short period of time, and that the risk of loss was very small. There is no (legal) investment that has ever fit that description. A lottery ticket can be described as a small risk in search of a large payoff, but the risk of a complete loss is, of course, quite high. . I mention this because I believe precious metals are being thought of today the way real estate used to be thought of. Those who bought gold in 1979 or 1980 had to wait close to 25 years to break even.

This should give you an insight into why we invest the way we do. We know we are going to suffer losses from time to time, but we want to make them small ones. First, we prefer mutual funds and ETFs to individual stocks and bonds because it is a lot easier to suffer a significant or permanent loss in a particular company than on a whole industry or country. Even the worst diversified losses (85% in the U.S. in the Depression and more than 50% on several occasions thereafter) have been recovered in time, whereas stocks like Pets.com and ADC Telecom never did. We prefer stock and bond funds to other types of investments because they generate cash flow that we can value. We don’t have to guess at future demand – only at what price level the income or earnings will trade at. Second, we try to be careful not to own too much in areas that have already had a strong run up in price. Technology stocks still trade quite a bit lower than they did in 1999 not because we use less technology but because our growth assumptions back then were wildly unrealistic. We’d rather be conservative and then be surprised on the upside than be too optimistic and be disappointed.

To sum it up, then, not all risk is the same and – if one is truly an investor – not all risk should be avoided. We invest in ways that seek to reduce the chances of a principal loss that cannot be recovered reasonably quickly through the normal functioning of the financial system.

You can keep up with us on Twitter at TrademarkFinMgt too!

Standard & Poors, per J.P. Morgan Asset Management

ibid

MSCI EAFE Net Return, US Dollars, per Morningstar

MSCI Europe Net Return, US Dollars, per Morningstar

6 MSCI EAFE Net Return, US Dollars, per Morningstar

7 Barclays Aggregate Bond Index per Morningstar

Barclays Municipal Bond Index per Morningstar

Barclays High Yield Corporate Bond Index per Morningstar

Summary

Stocks posted another gain during a very volatile first quarter of 2011. The U.S. stock market surged to a gain of more than seven percent through February 18th, before concerns about inflation and an economic slowdown cut that gain in half over the next two weeks. Then, just as stocks began to recover, Japan was hit by a devastating earthquake and tsunami. This push briefly erased all the market’s year-to-date gain. Eventually investors realized that the global financial impact of the disaster in Japan would not be as bad as feared. The U.S stock market recovered to finish with a quarterly gain of 5.9%<1>. While short of the highs we hit mid-quarter, it was nonetheless very impressive given the host of challenges the market faced.

International stocks did not perform quite as well. Emerging market stocks were hit by rising food and energy prices. Europe struggled to come to terms with debt problems among some of its members. Japan obviously had a very tough quarter. The United States was (as one market pundit put it) “the best house in a bad neighborhood”. Foreign markets did recover late in March as the dollar headed south on fears of a government shutdown. For the quarter, foreign stocks rose 3.4%<2>. Emerging markets, down as much as 8% at one point, surged at quarter end to a 2% gain. European stocks were up a surprising 6.4%. As one might expect, Japanese stocks fared the worst with a loss of about five percent.

Bonds gained less than a half of one percent<3>. Low yields and rising interest rates is about the least favorable combination for most fixed income instruments. High quality, longer duration bonds provide a nice hedge against economic weakness, but other than a brief spike in March (as investors became concerned about the global effects of the Japanese tragedy) these bonds slid in the face of a recovering economy. On the other hand, lower quality corporate bonds (which are more sensitive to economic strength than interest rates) were able to post a gain of about 3.8%<4>.

Activity

We rebalanced portfolios where necessary to allow for rising interest rates and increase exposure to large cap U.S. stocks. We also added to the health care sector and replaced several underperforming funds. For example, the Fairholme Fund was Morningstar’s Fund of the Decade from 2000 through 2009. Unfortunately, its -2.3% loss in the first quarter placed it in the bottom 1% of funds with similar objectives. Our patience is obviously longer than three months, but it is not infinite (especially when some of its competitors gained seven percent of more).

Outlook

As always, it is impossible to predict what the markets are going to do. Bonds would seem to be easier to forecast since we know the economy has been growing and we expect the Federal Reserve will keep its promise to end quantitative easing at the end of June. The only way bond yields won’t rise is if the economic difficulties elsewhere in the world (Japan, Europe) spill over here. On the stock side, the path of least resistance (at least in the short run) seems higher. This is how we see the indicators right now:

Liquidity: Positive. There is a lot of cash out there, and that correlates well with strong markets.
Valuation: Neutral. On a price-to-reported earnings or price-to-cash flow basis stocks are on the expensive side; versus bonds or money market yields stocks are cheap.
Sentiment: Neutral. While slightly over-bought in the short term, we have not seen the strong, steady inflows from individual investors that is typical of market peaks. In fact, every time we get a sell-off (even the brief six percent dip this past quarter) individual investors quickly become net sellers and professional investors become net buyers.
Some sectors of the stock market, most particularly those that are involved in providing energy, raw materials, or agricultural goods to the Pacific Rim, have done very well and are pricey at this point. Other areas of the market have done comparatively little over the last two years and appear to have a fair degree of upside left.

Commentary – Cyclical Versus Secular

In order to understand how the stock market moves you first need to understand the economic (business) cycle and then you need to understand each industry’s relationship to the cycle. Here is the “Cliff’s Notes” version:

The economic cycle refers to the cycle of business and credit expansion and contraction around a general growth trend. One full cycle usually lasts from three to six years, and there are four stages. At Stage 1 of the cycle (usually thought of as the beginning) the economy is growing at a below trend rate. Interest rates are typically low because credit demand is low. As credit becomes available at low rates, businesses find it attractive to finance expansion. Economic growth picks up.   As we enter Stage 2, fears of sliding back into recession fade, but interest rates remain low. At some point, economic growth is above-trend, and with credit demand rising, the cost of credit (interest rates) rises.   This is Stage 3. In Stage 4 the cost of credit is greater to business than the expected return, so business cuts production. The economy falls into recession. The cost of credit falls. Soon we are back to Stage 1.

The market cycle is related to the economic cycle. Stocks typically move AHEAD of the overall economy. The stock market is already rising at Stage 1 because investors anticipate the benefits of low interest rates. Stocks extend their gains during Stage 2, but where smaller and consumer discretionary stocks usually lead during Stage 1, stocks in industries that are most sensitive to the economic cycle tend to do best in Stage 2 (though all sectors go up). Certain industries begin to turn lower in Stage 3 even though the economy is still growing because investors anticipate rising interest rates. Their preference turns to larger companies and stocks in industries they believe might be immune to the cyclical downturn. In Stage 4, investors want companies that have very little economic sensitivity (health care, utilities, and consumer staples). Most stocks decline in Stage 4.

Now we will discuss the term “secular,” or long term, cycle.   It refers to the concept that some industry cycles are a lot longer (15-20 years) than the typical business cycle. Industries in a secular bull market typically experience only modest declines in Stage 3 and 4, while those in secular decline may not gain much even in Stages 1 and 2. For example, the home construction industry tends to move in long waves. It is in secular decline right now, after a fifteen year bull market (1990-2005). While low interest rates have made home ownership as affordable as it has been in decades, this has had almost no impact on economic activity or the stocks in that sector. On the other hand, the mining and materials sector is in a long wave uptrend after twenty years of decline (1980-2002). This industry has experienced rapid growth this decade because expansion in emerging markets kept prices and demand high. Stock price gains in this industry have tended to be much greater than those of the overall market.

Investors tend to assume that each company and each industry will rise and fall with the economic cycle. That is not necessarily true. The great investment opportunities come from discovering secular moves that the market perceives as cyclical. One example would be buying energy and commodity stocks in early 2009 after they had plunged 50-70%. The other great opportunity is getting into industries where the trend is changing from secular bear to secular bull. Imagine buying gold mining stocks in 2000 when gold was under $270 per ounce. Unfortunately, it is far more common to see the opposite – paying a secular growth price for stock that was simply in Stage 3 of the economic cycle. Or worse, buying into a secular growth industry just as the long wave was ending. For example, think about how much more money was invested in technology in 1999 versus 1989, or real estate in 2005 versus 1995.

The reason for writing this is to put today’s market in context. Investors have a very high degree of confidence in the energy sector right now. Crude oil is currently north of $120 per barrel, approaching the 2008 all-time high of $147 yet there is (again, like 2008) no shortage. High prices lead to increased production. If some of that production is being held off the market for speculative purposes, prices can still rise short term. At some point, however, it costs too much to store that production versus the expected profit. Supply floods the market and prices plunge. We are seeing similar speculative hoarding in other commodities such as copper because many believe that Chinese demand for materials is limitless. We can’t tell you if this trend will last another three days or five years. We can say, however, that energy and materials are high return, high risk propositions right now. That is okay for some people, but it is not the way we prefer to invest.

Conversely, health care is an industry that has been in secular decline since its heyday in the late 1980s and 1990s. Declining growth rates, government regulation, patent expiration, and other factors have contributed to a sharp compression in the earnings multiple of companies in this industry. At this point however, you have cheap valuations, nice dividends, and a growing customer base as the population ages. We see this as a modest return, low risk situation. This is the kind of opportunity we look for.

It is difficult to fully do justice to the concepts of economic, market and secular cycles in just a few paragraphs. If you’re interested in learning more about this and other topics you can keep up with our thinking on our blog at www.trademarkfinancial.us/blog or follow us on Twitter at TrademarkFinMgt. Our general thesis is that the economy is in late Stage 2 of the business cycle. Interest rate pressures are already being felt in Asia, Latin America, and Europe, so Stage 3 can’t be far off.    Interest rate sensitive stocks are more vulnerable now than more economically sensitive ones, which will likely be supported by money coming out of the bond market. This makes buying into the stock market, while still generally favorable, an increasingly risky proposition right now.

Past Performance is no assurance of future results. All index data provided by Telemet Orion or Morningstar Advisor Workstation. Numbers do not reflect fees, brokerage commissions or other expenses of investing. Trademark Financial Management, LLC (“Trademark”) is an SEC 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. Please read the disclosure statement carefully before you invest or send money.

<1> S&P 500 Index per Morningstar

<2> MSCI EAFE Net Return in US Dollars per Morningstar. The foreign index performance numbers that follow are also from MSCI per Morningstar (Emerging Markets, Europe, Japan)

<3> Barcap U.S. Aggregate Bond Index per Morningstar.

<4> Barcap U.S. High Yield Corporate Bond Index, per Morningstar

Summary

The U.S. stock market posted its second consecutive double-digit quarter as more investors became convinced that the economic recovery was for real. It is well known on Wall Street that stock price movements precede those in the economy. Stocks rallied in the final three quarters of 2009 to signal that the recession was over (in the Spring of 2010 economists finally got around to declaring that the recession ended in June 2009). After a half-year of sputtering while economists debated whether we were going to fall back into recession (the dreaded “double-dip”) stocks began a meaningful surge at the end of August. Recently this has been confirmed by gains in economic performance numbers such as factory orders and industrial production. Employment is expected to pick up as well (note that employment is a lagging indicator of economic performance; typically, businesses do not start hiring until they are forced to by increasing demand). Whatever one may believe about the long term impact of quantitative easing, it is doing exactly what Fed Chairman Bernanke hoped for in the short term.

U.S. stocks gained about 11.3% last quarter, finishing the full year with a 16.4% increase. Small and mid-size companies continued to lead the way as investors looked for those companies with greater exposure to a growing economy. Sectors like mining & materials, energy, industrials, transportation, and retailing performed very well while economically defensive sectors like utilities, consumer staples, and health care under-performed. International stocks rose a little less than 8% in dollar terms last year and only 6.6% in the fourth quarter. The global economic recovery was already evident in Asia and Latin America, so stocks in those regions modestly under-performed the U.S. market. The Euro declined against the dollar in the fourth quarter, reducing the gain in European stocks to less than 5% for dollar-based investors.

Bonds finally had the bad quarter market pundits had been warning about since the middle of 2009. While inflation currently remains mostly subdued, concerns arose that today’s economic policy decisions designed to promote employment growth would be harmful in future years. Bonds fell about 1.3% overall. Municipal bonds suffered the most due to fears of rising defaults. Strategist Meredith Whitney’s dire forecast for the muni market on an episode of 60 Minutes in December helped fuel a 4.2% quarterly drop. Even previously high-flying emerging market debt slipped 1.2%. On the plus side, high yield corporates had a very good quarter (up 3.2%) and floating rate and mortgage bonds also managed modest gains. Activity

Stocks defied expectations of an October correction, rising 8% through Election Day. Thereafter they gave back 4% before beginning another 8% surge after ADP reported rising payrolls on December 1st. We felt stocks had become modestly overvalued by the end of October, so the November correction did not surprise us. We expected the traditional year-end rally to get us back to the October highs, but not further. That we are four percent above those levels now makes us reluctant to commit new money. We have trimmed stock exposure in areas that have run up excessively (emerging markets, for example). We have also reduced the interest sensitivity of the bond part of the portfolio. We have trimmed our weighting in government bonds, putting the proceeds in floating rate bonds wherever possible. The latter generally have higher yields and can benefit from a strengthening economy.

Outlook

Since certain areas of the stock market (large company stocks, especially) have not kept pace, we believe that is the area to look at in 2011. Valuations are much better there than they are in the small and midcap area. Objectively the outlook for stocks is good – interest rates are fairly low, the Federal Reserve has created plenty of credit in the financial system, key measures of orders and production are rising, and employment is starting to improve. The concern we have is that stock prices have already risen and fully reflect the positives. My best analogy is betting on a horse at 1-2 odds. You are likely to win, but since everybody else is betting on that horse you get paid a small amount if it wins and you lose a lot if something goes wrong. I would be more than happy to get more aggressive if we can knock a little of the fluff out of stock prices. Historically, you do a lot better when you buy into worried markets.

Bonds have had a tremendous run over the past decade, averaging almost 6% per year. Since investment grade bonds yield less than 4% on average, there needs to be capital appreciation in order for bonds to return 6% to investors. In other words, interest rates need to fall. With the economy clearly in recovery mode, that appears very unlikely. In fact, if interest rates rise, bonds will return less than the 4% they yield now. This is why many market strategists are very negative on bonds going into 2011. We believe the increase in bond yields will be mild this year and that we will be able to get mid-single digit returns from a combination of corporate, international and municipal bonds.

Commentary – How We Arrive At Our Market Forecast

Plain and simple, the return on stocks is equal to the growth (or contraction) in corporate earnings plus or minus the change in the multiple of earnings investors are willing to pay. The latter is historically much more volatile than the former. It follows that you can make money during periods when the economy performs poorly (without being short) as long as investor expectations improve. We have had two consecutive years of well above average stock price gains largely because the preceding year (2008) was so bad. Earnings contracted and investor expectations plunged that year, combining to drive stocks down 37%. Even with 2009’s gain of roughly 27% and last year’s 16%, the stock market is still considerably below its late 2007 peak. That makes it hard to say that the market today is expensive. And based on the levels of 2000 or 2007 it clearly isn’t. Yet if you change your frame of reference from three to thirty or a hundred years, we are clearly above the average in terms of valuation. (For an outstanding chart see: dshort.com) If you have a strong conviction that there is something about the past fifteen years that suggests that stock prices should trade above their long term averages, you will be cheered that we have a long way to go to reach previous valuation peaks. On the other hand, if you see this chart as showing that we have always had multi-decade high and low valuation periods, you may be concerned that we are in a multi-year transition process from an above-average valuation era to a below-average one.

This concerns me a great deal. As I stated before, over time corporate profit growth is fairly consistently in the 6-7% range. You can add about two percent to that for dividends. If I want to earn double-digit returns, therefore, I must either invest at a time when I believe investors are going to become more optimistic in general, or I must identify an area of the market that will enjoy a much better than average rate of profit growth and/or investor enthusiasm (like technology in the 1990s, or emerging markets in recent years). And it follows I must avoid (or at least under-weight) those sectors likely to fall out of favor in investors’ eyes.

So what are the prospects for investors to be willing to pay higher earnings multiples in the future? The chief components of P/E multiples are:

Liquidity, or the credit available in the financial system to buy stocks;
Inflation expectations (in other words, how much a dollar earned in the future is worth today);
Profit margins, or how vulnerable earnings are to changes in input costs, wages, tax rates, etc.
Cultural factors (in other words, how popular culture is supportive of or hostile to the notion of stock ownership, as opposed to investment alternatives such as bonds, real estate, gold, etc.)
Let us take them one by one. Liquidity could hardly get more favorable. Interest rates and borrowing costs are low, and the Federal Reserve is actively friendly in this regard. As long as this lasts, it is a positive for stocks. It is very hard to believe, however, that this component won’t be less favorable several years down the road. Inflation expectations are well behaved at the present time, but investors are clearly concerned about the future (as evidenced by rising gold prices and the political success of the Tea Party). Inflation might not rise much in future years, but it almost certainly won’t decline. Profit margins have been at record highs as a percentage of sales for most of the decade partly due to technological advances in inventory management and very modest wage pressures. The only short-term threats here are higher corporate tax rates (highly unlikely) and rising input costs (raw materials, transportation) that can’t be passed on. Rising oil prices may hurt on both counts, as much of our products and packaging is petroleum-based. Finally there are cultural factors. Investor willingness to hold stocks took a significant hit in 2008 and 2009. A third straight year of double-digit gains could do a lot to restore confidence. So would a sub-par bond year and a sell-off in gold. This component has the greatest chance of contributing to stock price gains. Frankly the best we can hope for out of the other three is that they don’t deteriorate.

The implication in this analysis for me is that while we have the hope of multiple expansion (and double digit returns) this year tied to improving investor psychology – it is likely that over the next five to ten years stock investors receive less than the 8-9% annual returns implied by earnings growth and dividends. Our hope has to be that none of the components gets meaningfully worse such that valuations don’t fall in to the “bad period” range. Remember, it took ten years of essentially 0% returns to bring valuations from their peak in 2000 just to average by 2009. If we are destined to see below average valuations, stock returns going forward may be closer to the 3-6% range. That said, there is reason for hope. What could render this analysis too pessimistic would be a major breakthrough, perhaps in medical science or transportation, which would bring major profit gains to a particular sector and/or cost savings across all industries. In transportation at least, we are more than overdue. Absent an unforeseen advance, however, stocks are priced for a scenario that almost certainly cannot last. Caution is warranted.

Past Performance is no assurance of future results. All index data provided by Telemet Orion or Morningstar Advisor Workstation. Numbers do not reflect fees, brokerage commissions or other expenses of investing. Trademark Financial Management, LLC (“Trademark”) is an SEC 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. Please read the disclosure statement carefully before you invest or send money.

As measured by the Wilshire 5000

As measured by the MSCI EAFE (dollar terms)

As measured by the MSCI Europe (dollar terms)

As measured by the Barclay’s U.S. Aggregate Bond

As measured by the Barclay’s Municipal Bond Index

As measured by the Barclay’s Emerging Market Debt Index

As measured by the Barclay’s High Yield Debt Index