Quarterly Market Perspective for 1Q21
The stock market’s recovery continued in the first quarter of 2021 as all major categories of stocks made new highs. For the quarter, U.S. stocks gained 6.17% (as measured by the S&P 500). That said, the quarter was anything but a continuation of 2020’s themes. This year’s market rally strongly favored smaller and more speculative companies. Why? Because larger, safer companies do not tend to decline as much when the economy slides into recession, and they tend to begin their recovery sooner. As investors gained confidence post-vaccine roll-out late last year, the worst hit stocks of 2020 began rebounding with a vengeance. Cyclical industries (industrials, financials, transportation, chemicals, metals & mining, for example) performed extremely well, while those companies that soared in 2020 because of their leverage to the “stay at home” theme (largely technology and consumer durables) sold off heavily starting in February. This necessitated an unusual amount of trading activity in order to adjust to the new trends.
International stock markets also gained, though they once again lagged the U.S. considerably. Despite a net gain of 3.48%[i] overall, conditions significantly varied between regions. Europe outperformed other foreign regions as its recovery seemed to be on the same trajectory as America’s. Japan, heavily dependent on exports, was negatively impacted by the rising value of the yen. After a strong start, China lost over -4% on the quarter when the authorities began cracking down on Chinese internet companies. Factoring China and Japan out, however, Asia would have had the best performance. Latin America (-5.32%) was devastated by its collectively awful response to Covid.
Expectations for stronger economic growth pushed up interest rates, leading bonds to a -3.37% loss. This was the worst quarter for bonds in many years. High yield bonds were able to eke out a 0.85% gain as yields of over 4% offset mild interest rate-related capital depreciation. For lower yielding investment grade bonds, there was no such reprieve. Long term (10 year+) bonds lost over -10%, global bonds shed -4.46%, and mortgages were off -2.90%. Just a tough quarter all around. Fortunately, bond have rallied in April.
Where to begin? For starters, we had to shift stock exposure from an overweight to growth sectors like technology to cyclical value sectors like financial services and industrials. We also increased the weighting in smaller company stocks as the economic recovery is broadening out. The international part of portfolios also had to change; if cyclical stocks are moving in the U.S., they will soon be moving in Europe and Asia as well. That said, the aforementioned crackdown in China has put an important part of the emerging market story on hold for the time being. This has necessitated a rethink in what kind of emerging market funds you want to own. Bond duration had to be shortened during the quarter because of rising interest rates. During periods of recovery, we tend to lower bond credit quality to benefit from higher yields. Lastly, for more aggressive investors we have carved out a small niche for emerging technologies such as digital assets.
“It’s tough to make predictions, especially about the future” – Yogi Berra
At any given time, an experienced investment analyst can tell you what the markets expects. For example, currently when interest rates rise, it is generally an expression of confidence in the economy. This means economically sensitive areas of the market, like smaller capitalization and cyclical stocks, are expected to outperform. On the other hand, if interest rates decline, it is probably due to concern about the economy, which means investors will prefer large, non-economically sensitive stocks that can thrive in a recessionary environment.
I can also tell you that investors expect that the economy will take off once the Covid crisis is truly behind us. Pent-up demand for travel and leisure is expected to be off the charts. Reflecting this, hotel company Marriott recently exceeded its previous price peak of $151.50 set in December 2019, and online travel giant Booking Holdings just hit an all-time high almost $300 higher than its pre-pandemic peak. I am not saying either stock couldn’t go higher, but they appear to have already priced in the economic recovery. At the same time, the consensus holds that inflation will surge during the first half of 2021 as production tries to catch up to surging demand. By the fourth quarter, however, supply and demand are expected to come into equilibrium such that the near-term upward pressure on interest rates will dissipate. In other words, the market is being driven forward almost relentlessly by the expectation of strong future growth but very modest interest rate increases. Again, this might happen, but it makes me nervous when the market prices in the best-case scenario because I hate having more to lose from things going wrong than I have to gain from things going right.
This “goldilocks” narrative could be threatened by either weakness (Covid doesn’t fully go away and service-related businesses only partially recover) or by strength (the recovery drives up demand for everything from lumber to gasoline to plumbing services, and this results in sharply rising inflation). Stocks tend to perform best in the early stages of an economic recovery, but you cannot stay in the early stages indefinitely.
Recently, we have fielded a lot of questions about bitcoin and other cryptocurrencies. Investors should know that financial professionals are under two limitations when discussing anything from an investment standpoint (be it Dogecoin, non-fungable tokens, or Hummel figurines). The first is that as professionals we must have a reasonable basis for our opinion and are liable for that opinion (not unlike a doctor or an accountant would have if they gave general advice without understanding the client’s specific situation). We are not free to just have an opinion. The second is that our specific knowledge- that which we study and are tested on- has to do with matters that are quantifiable, such as “If a bond yields 5 percent and has 4 years remaining until maturity and inflation is steady at 3%, assuming no default risk, what should the price of the bond be?” The equilibrium price of novel assets like Ethereum does not fall into that category because the price is purely a function of investor sentiment and supply/demand dynamics. Thus, we struggle to formulate a reasonable opinion.
Valuation questions that are purely matters of supply and demand are much harder to give good answers to, because it is difficult to forecast demand for something that has existed for a very short time. When it comes to gold, a metal that has been a storehouse of value for close to 5,000 years, some of us may be willing to hazard an educated guess because there is some historical basis to work with. We know it tends to correlate negatively to real (inflation-adjusted) yields, but beyond that the price of gold tends to venture into political/sociological territory (i.e. how do you feel about the near term prospects for your country?). Therefore, when you ask us about Bitcoin, a cryptocurrency with a lifespan far, far shorter than that of gold, we tend to think “not only do I have no idea where it is going, but I am taking a certain risk having ANY opinion on it”. Regulatory agencies have given us no guidance in terms of what we can say, but we know they are monitoring this area closely[i].
Determining the intrinsic value of any asset is difficult. Securities analysis training emphasizes cash flow valuation techniques and teaches analytical processes that when applied correctly, should help improve decision making. It does not promise to always be right. When it comes to determining what an asset’s underlying value is, I can use my training as a CFA to determine what I believe to be a reasonable estimate. It may or may not agree with the market’s price for the asset, just as a gambler might advise you not to hit on 17 at the blackjack table only to see you draw a 4. Statistically correct but [iii]specifically wrong.
To be clear, price and value are often used interchangeably but they are in fact two very different things. Value, assuming you have the correct information, is a matter of expected future cash flow and mathematics. Price, on the other hand, is a function of the dominant market narrative and supply/demand curves. It probably belongs in the realm of soft sciences like psychology and economics, where people may behave rationally but are under no requirement to do so. Case in point: Gamestop, the mall-based software retailer, had a market capitalization of $1.2 billion on January 8th, 2021 and $11.1 billion on April 19th[iv]. I cannot justify the more than 9-fold increase in the price of that stock based on the cash flow prospects for the company, so I confidently believe that the current price ($164) does not represent good value. I have no idea what the actual price will do. Thirty, fifteen, or even five years ago I might have said that I expected that the price would decline. Today, with rock bottom borrowing costs, essentially free trading, and easy access to information about what everybody else is doing (especially in the options market), all bets are off[v]. I can tell clients what I believe to be the prudent thing to do in the sense of risk versus reward because having spent thirty-five years in this business I understand how many ways the market can move against you. Sometimes, however, people will take crazy risks anyway and they will pay off.
 MSCI EAFE in US dollars
 On the other hand, if you ask about blockchain or distributed ledger technology, you ARE asking us a securities question. It would be similar to asking us about cybersecurity or genomics in the sense of “what do you think about these areas in terms of growth or investability?”, and we can feel more comfortable giving you an answer because we have researched these areas and can meet the standard of “reasonable basis”.
 Source: YCharts.com
 There is a delicatessen in New Jersey that does less than $50,000 in annual revenue that the stock market values at $101 million as of April 19, 2021.
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