April 2024: The BakerAvenue Prudence Indicator

BakerAvenue Prudence Indicator Says... 

Long Term: Positive  |   Short Term: Neutral

Some Spring in the Cyclical Step

"If you don't like change, you are going to like irrelevance even less."
- General Eric Shinseki

The S&P 500 posted a double-digit return in the first quarter of the year, helping the index achieve several new all-time highs. While strong performance by several of the largest mega-cap tech stocks (e.g., MSFT, NVDA, AMZN, GOOGL, META) was well-documented, less discussed was the fact that market breadth improved notably with more economically sensitive stocks leading the charge. In fact, in equally weighted terms, the energy, industrials, financials, and materials sectors all outperformed technology last quarter. If that weren’t enough to get the cyclical conversation going, breakouts in key commodity markets (e.g., copper, aluminum, oil, etc.) helped to solidify the rotational optimism.

We see three reasons to embrace the cyclicality: earnings growth, economic expansion and monetary policy. First, regarding earnings, we have championed an accelerating earnings growth view and continue to expect corporate profits to set a record this year. Encouragingly, it’s the cyclical pockets of the market that are increasingly contributing to those growth expectations. Secondarily, there are currently more signs of economic expansion than contraction. US economic growth keeps surprising to the upside with employment and manufacturing the key contributors (e.g., the well-followed ISM Manufacturing survey was above 50 last month, signaling expansion). Europe appears to be rebounding from a low level, amid easing financial conditions and an improving consumer backdrop. Even China data has started picking up. Finally, the monetary policy cycle favors pro-growth positioning. Mid-cycle rate cuts amid improving global growth have historically been positive for economically sensitive stocks. We see no reason this cycle should be any different.

We acknowledge the path will be challenged by an uneasy macro backdrop. Geopolitical uncertainties (~45% of the world population is holding an election this year) will also keep tail risks elevated. But it is important to give credit where credit is due, and the recent cyclical strength feels justified. Although strong growth and rising commodities keep the timing/pace of prospective rate cuts up for debate, we think it is more problematic for bonds than equities, so long as the earnings keep delivering.

In times like these, it is important to have an investment process in place that removes emotion from the equation. At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a balanced (neutral) position while our longer-term view is positive.

For those who have been following our market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated our expectations of slow but non-recessionary growth. There are subtle changes to consider, but our view remains the same. Ultimately, another year of economic and earnings growth should be enough to offset the higher rate backdrop and support a continued grind higher in equities. We believe it is a good time to be active and want to be thoughtful regarding portfolio construction and risk control.

The Technical Perspective

The technical backdrop remains overly concentrated, but structurally intact. We believe the markets are in better technical shape relative to last month, with several indices holding steadily above key moving averages. Price momentum is strong, and internal metrics (e.g., market breadth, new highs vs. new lows, etc.) are moving off depressed levels. Small cap and equally weighted indices have lagged significantly over the past year and remain at multi-year relative lows but are showing signs of life. Despite the narrowness, leadership has remained within the pro-growth pockets of the market and defensives have lagged. We are intently focused here as we consider portfolio tilts.

We do expect the market to broaden out and leadership to continue to adjust as the year progresses. Healthier markets tend to have strong participation rates, so we are on the lookout for improvement here. We are also encouraged by the higher performance dispersion within sectors and industries, as it supports more active oversight. We expect the lower correlations backdrop will continue into 2024, an environment we welcome.

Investor sentiment is now more balanced (e.g., bull-bear surveys have moved higher), but positioning remains light (e.g., investors have poured over $6 trillion into money market funds) and should act as a catalyst. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher or lower). While there is certainly a high bar for allocations given elevated risk-free rates, our view is that investors have room to increase equity exposure as the lack of inflows already reflect considerable unease.

The Macro Perspective

The macro discussion must start with a view of the global economy. Incoming economic data continue to support our slow but not recessionary growth narrative. GDP growth has surprised on the upside here in the US for the last several quarters and estimates for the current quarter remain positive. Recent macro worries have centered on the mix of higher inflation combined with slowing growth and tighter financial conditions (i.e., restrictive monetary policy). We understand the concerns but continue to see peaking Fed policy as a sustained catalyst. We expect growth metrics to carry more influence (relative to inflation or rates) as we move deeper into the new year.

Interest rates will continue to carry significance, just less so. We don't think the lagged effects of prior policy tightening has been fully digested, thus our focus on growth. Yield curves have been inverted for well over a year as the front end of the curve has moved higher with Fed rate hikes. Curve inversion should be respected, as it has a very strong track record in signaling recessions over the past 40+ years. What they cannot predict accurately is the timing of the recession nor its depth and magnitude. One of the most pressing questions for investors is: Can the Fed get control over inflation without causing a deep recession? So far, so good.

Macro themes will remain important, no doubt, but we anticipate markets to sharpen their focus on specific security characteristics as the year progresses (e.g., company fundamentals, asset class relative strength, etc.). Security selection, identification of investable themes, and traditional bottom-up analysis will play an expanding role and help portfolios ride out the lingering macro-induced market gyrations. Geopolitical and political events will represent increasingly material considerations for investors. While particularly difficult to position for, we have several market- and non-market-based factors to lean on that help assess materiality and support positioning.

The Fundamental Perspective

Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Headwinds, such as higher financing and input cost pressure, have been more than offset by consumer spending resiliency and solid demand trends. Estimates for revenues and profits have been revised higher over the past few months and remain a stalwart defense against any recession forecast.

Valuations are in line with long-term averages. However, valuation dispersion within sectors and industries remains high with a historically sizable gap between the highest and lowest priced assets. We see opportunities in both groups (continued leadership in one, reversion to the mean in the other). Several of the secular growers are commanding high multiples, but also market-leading profitability. Value-oriented pockets offer opportunity, but investors will need to be selective.

The credit backdrop will be important to monitor as growth concerns persist. So far, the credit backdrop has supported the move in equities. One of the defining criteria between recessions and slowdowns has been the behavior of the credit markets. Both investment-grade and high-yield spreads vs. Treasuries have moved lower and remain at non-recessionary levels. Corporate cash flows remain healthy with dividend reinstatements (or increases) running well ahead of dividend cuts.

Concluding Thoughts

We welcome the market’s repositioning (into cyclicals) and share the optimism. The recent move higher certainly raises consolidation odds, but history suggests forward returns are promising, particularly after the long spell between new highs. We have championed an active approach of investing with secular winners, while simultaneously allocating capital toward assets that will benefit most in a sustained recovery. We see no reason to alter that view. Our forecast for a maturing but sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all.

Our investment philosophy is based on a dual mandate of growing and protecting client assets. We are staying active, using any volatility to harvest losses while opportunistically deploying capital where appropriate. Our cash weightings remain residual in nature and are focusing on strategy positioning vs. our respective benchmarks to control risk. Of course, should the backdrop destabilize, we will take a more defensive stance.

Should you have any questions or comments, please contact BakerAvenue. We are happy to share our thoughts in greater detail, and we welcome the opportunity to speak with you.