BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
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Mid-Year Summary: Growing but Slowing, Trending With Few Contributing
"If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties."
- Sir Francis Bacon
Fifty percent of 2024 is in the books and markets are performing better than many would have guessed six months ago. Big technology stock gains and US growth exceptionalism have combined with peaking interest rates and hopes for rate cuts to produce a solid first half. June continued a trend we have been discussing at length in our market updates: decent economic growth, but extremely narrow participation. Growth is slowing a bit (e.g., last week saw the first downtick in consensus ’24 GDP growth forecasts) and the historically narrow market (e.g., more than half of all stocks are down year-to-date) is raising some eyebrows.
Our outlook remains supportive, but we acknowledge some prudent scrutiny is warranted. Economic data point to some moderation but less than meets the eye as labor incomes are still growing at a solid pace. We suspect the US economy is settling into an equilibrium of steady payroll gains, labor income growth and underlying activity. But the Fed admits rates are restrictive, and datapoints are building that growth is certainly not running away (the odds of rate cut have increased recently). The prominence of the US equity market, and the technology sector in particular, is not necessarily irrational, but reflects a long period of superior fundamentals - a good thing. But concentration still raises risks for investors. The S&P’s five biggest stocks - Microsoft Corp., Apple Inc., Nvidia Corp., Alphabet Inc., and Amazon.com Inc. - are responsible for more than half of the S&P’s gains this year.
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 with several indices holding steadily above key moving averages. Price momentum is strong, but internal metrics (e.g., market breadth, new highs vs. new lows, etc.) remain at depressed levels. Small cap and equally weighted indices have lagged significantly over the past year and remain at multi-year relative lows. Despite the narrowness, there remains opportunity for tactical positioning as leadership moves from pro-cyclical, to defensive, and back. 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 do expect the market to broaden out as the year progresses. 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 into 2024, an environment we welcome.
Investor sentiment is now more balanced (e.g., bull-bear surveys reflect a neutral bias), 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, albeit off the pace of early ‘24. Globally, last month saw further encouraging signs of economic optimism. 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) as we move deeper into 2024.
Interest rates will continue to carry significance. 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 almost two years 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.
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 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 slightly higher than 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 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
A mid-year reflection reveals few changes to our long-standing narratives. Growth has slowed a touch, but resilient economic and earnings growth remain. The technology-driven narrowness of the market has us on guard, but we continue to forecast a gradual pickup in participation as investor confidence builds. 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.