January 2025: The BakerAvenue Prudence Indicator

BakerAvenue Prudence Indicator Says... 

Long Term: Positive  |   Short Term: Neutral

Sensible Enthusiasm

"There is nothing so stable as change."
- Bob Dylan

We see more positives than negatives as we enter the new year. Economic growth has proven to be resilient, earnings are poised to accelerate, and investor positioning looks constructive. However, following '23-'24's breakneck pace, the odds of more normalized returns have increased. The market (S&P 500) trailing two-year return ranked above the 95th percentile relative to all other periods. Following prior periods of similar strong returns, performance was still positive, just below average. We are calling it “sensible enthusiasm.”

While our optimism is bridled somewhat by policy uncertainty, the backdrop is ripe for active oversight with plenty of room for stock and sector selection. Last year ended with the fewest number of stocks outperforming the market in history. The narrowness was justified by the strong fundamental profile of the secular leaders, but recent trends point to a broadening market. Performance dispersion is increasing, valuation gaps are wide, and thematic trends (e.g., power infrastructure, increasing capital spending, improving capital markets, etc.) remain investible. We think it is a good time to be selective.

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. Given the regime changes, there are adjustments to consider, but our overarching views remain the same. Ultimately, another year of economic and earnings growth will 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 structurally intact with several indices holding steadily above key moving averages. Leadership continues to be supportive with the relative strength profile of pro-growth sectors outpacing defensives. The move off the ’22 lows is in line with historical norms, and seasonals remain a tailwind. As profit taking has increased in former leaders (e.g., technology), equally weighted indices have started to pick up and have helped to broaden the market. There is work to be done here, and it remains an opportunity for tactical repositioning as leadership shifts. We are intently focused here as we consider portfolio tilts.

While we have embraced the growth momentum (we own several of the secular leaders), we expect other asset classes to continue to close the performance gap. Healthier markets tend to have strong participation rates, so we are on the lookout for improvement here. We are encouraged by the higher performance dispersion within sectors and industries, as it supports more active oversight. We expect the lower correlations backdrop will continue as we start the new year, an environment we welcome.

Investor sentiment is now more balanced (e.g., bull-bear surveys reflect a neutral bias), but positioning (e.g., investors have poured well over $7 trillion into money market funds) 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, particularly on pullbacks.

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. Globally, last month saw further encouraging signs of economic optimism, particularly out of China (stimulus related) and increasingly Europe (growth has stabilized a bit). For some time, macro worries have centered on slow global growth and still tight financial conditions (i.e., restrictive monetary policy). We understand the concerns but continue to see plenty of growth optionality and view easing Fed policy as a sustained catalyst.

Interest rates will continue to carry outsized significance. We believe ultra-low interest rates are a thing of the past and investors should embrace more normalized levels. We expect lower, but not low, interest rates going forward with a milder cutting cycle in which the Fed recalibrates the policy rate. With decent growth, the Fed doesn’t need to be aggressive with the size and number of rate cuts. The Fed is trying to find a neutral rate, which in their eyes is neither accommodative nor restrictive, and we suspect they find it this year. For some time, one of the most pressing questions for investors has been: Can the Fed find a neutral policy rate without causing a deep recession? So far, so good.

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. We are aware of the uncertainty associated with a new administration, but see counterbalances (e.g., tariff uncertainty vs. deregulatory tailwinds) ultimately offsetting any impact. 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.

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 acceptable demand trends. Estimates for revenues and profits have been revised higher over the past several quarters and remain a stalwart defense against any recession forecast. We expect earnings growth rates to accelerate this year.

Valuations are now above long-term averages. However, valuation dispersion within sectors and industries remains elevated 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 a check on fundamentals and a proxy for risk tolerance. 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 are stable and remain well below recessionary levels. Corporate cash flows remain healthy and capital market activity (e.g., M&A, IPO’s, etc.) is showing signs of picking up.

Concluding Thoughts

We see more positives than negatives as we enter the new year. Economic growth has proven to be resilient, earnings are poised to accelerate, and investor positioning looks constructive. However, following '23-'24's breakneck pace, the odds of more normalized returns have increased. 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 volatility to harvest losses while opportunistically deploying capital where appropriate. Our cash weightings remain residual in nature, and we 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.