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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.  (  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 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 ( 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.

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