BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
"What is right to be done cannot be done too soon."
- Jane Austen
Two relentless considerations investors have had to embrace over the past few months are the heightened scrutiny of interest rates and a decidedly narrow marketplace. The correlation between rate moves and stocks has rarely been this negative, and the market rarely this concentrated. We suspect both factors are poised for change, but, importantly, they don’t have to provided the growth backdrop remains in place.
Globally, the interest rate cutting cycle has begun. With the European Central Bank (ECB) and Bank of Canada (BoC) both cutting interest rates last week, there is now a building pivot away from restrictive monetary policy around the world. Most central bank cycles work in unison and have material impacts on capital markets, so they are important to monitor. Of course, the start of this cycle won’t be completely endorsed without the Fed joining the party, and their pivot is taking longer than most had predicted. Lingering inflation plus steady economic growth has given the Fed the license to take the slow road toward less restrictive monetary policy here in the US.
Encouragingly, the goldilocks-ish macro backdrop has overcome higher interest rates and served to keep a positive asymmetry for markets. We have continuously emphasized the importance of growth. Growth, be it economic or earnings-related, can overcome many headwinds. From greater cash flow to support increased shareholder returns, to more tax revenues to pay off elevated debt levels, the benefits of strong growth are widespread. We are comfortable with the higher rate backdrop provided growth remains intact.
That positive asymmetry has developed with increasingly narrow participation. The top10 stocks in the S&P 500 now account for 36% of the index's total capitalization, a new all-time high. 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. Almost half of the S&P is flat or down on the year and only 33% of stocks in the S&P have beaten the index over the past year. The relative performance of the Equal-Weight S&P 500 Index and the small cap-focused Russell 2000 Index have moved to new lows.
Market concentration has risen further as recent earnings results reinforced technology exceptionalism. With investors captivated by the artificial intelligence boom, the technology sector has expanded its dominance considerably, cementing its role as the biggest sector in the S&P, with a 31% weighting. The next closest groups are financials and health care at around 12%. Growth is the antidote here as well. We have championed an accelerating earnings growth view and continue to expect corporate profits to set a record this year. Should the growth backdrop be sustained, we would expect the relative profit contribution from lagging sectors and industries to increase, and with it, broader market participation.
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 much better technical shape relative to last fall, 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.
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 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. 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 or rates) 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.
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 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 are comfortable with the repricing (higher) of interest rates, primarily because of resilient economic and earnings growth. The technology-driven narrowness of the market has us on guard, but we continue to forecast a gradual pickup in participation. 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.