BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
Down the Stretch with Hints of Shifting Narratives
"People calculate too much and think too little."
- Charlie Munger
We use our monthly publications as a time to reflect, to step back from the market’s day-to-day news flow, and to see what stands out amid the noise. As we round out the year, many of the defining characteristics of 2023 are showing subtle signs of changing, or, at the very least, becoming less influential. We leverage insights from our technical, macro, and fundamental research to guide our investment approach. We scrub a litany of factors that influence our take on each discipline, and each has a storyline that is showing signs of shifting.
To begin, we wrote last month about the overly concentrated nature of the market and how price trends were good and internals had room for improvement. The overly concentrated nature of the market made us a bit uneasy, and we were hopeful breadth would improve. The recent push higher has included a broadening set of participants (e.g., November was the first time small caps outperformed large caps in six months). We expect the shifting participation narrative to continue.
Tighter financial conditions, expressed via the Fed’s rate hikes and higher interest rates, have been a key investor consideration throughout the year. Due to disinflation, we wrote recently that much of the hard work is done and investors should expect a lower, but not low, interest rate backdrop to become the modus operandi. Hiking cycles are likely close to finished (e.g., there are now more central banks cutting rates than raising rates) and we sense a trend change in regard to the influence of rates on the markets. To us, that means less rate volatility and economic growth can now take over as the fulcrum by which investors gauge their outlooks.
Finally, while subtle, we see calls for a profit recession slowly fading into the background. For much of the year, many (not us) expected corporate profits to be dragged down by sluggish economic growth and the impact of higher interest rates. Instead, earnings have been buoyed by the economy (the US in particular) doing better than expected, coupled with expectations of an AI-driven surge in revenue. An added tailwind has been the resurgence in corporate margins. Input costs have come down (e.g., improved supply chains, less inflation, etc.) and revenues have remained stable. We see the recent revisions to corporate profits (higher) as justified, sustainable and supportive of more sanguine outlooks.
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 volatile, but structurally intact. We believe the market is in better technical shape relative to last month, with several indices holding steadily above key moving averages. As mentioned earlier, 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 we move into the new year. 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., cash balances, flows into stocks vs. cash or bonds, etc.) 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 this year 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 (e.g., unemployment is close to a fifty-year low). GDP growth has surprised on the upside here in the US for the last several quarters and estimates for the current quarter remain positive (although slower than the previous quarter). Recent macro worries have centered on the mix of higher inflation combined with slowing growth and tighter financial conditions (e.g., restrictive monetary policy). As noted, we see changing narratives here and expect growth metrics to carry more influence (relative to inflation or rates) as we close out the 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, so we are focused on growth. Yield curves have been inverted for 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? We think the Fed is likely finished hiking for this cycle.
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 see subtle shifts changing a few long-standing storylines as we close out the year. 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.
Disclosure: Past performance is not indicative of future performance.