BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
Earnings March, Into March
"The greatest danger for most of us is not that our aim is too high, and we miss it, but that it is too low and we reach it."
- Michelangelo
With another earnings reporting season ending, here are the numbers (for the S&P 500 vs. beginning of quarter expectations): earnings growth of +10.3% (vs. +3.8%) and revenue growth of +3.6% (vs. +1.5%). The earnings “surprise” (the amount beating consensus forecasts) was +6.8%, well above the pre-pandemic average of +5.2%. And finally, revisions for the current quarter and full year are running above the historical trend; by all counts it was a very constructive season. Respectively, with no shortage of macro uncertainty, and with markets near all-time highs, it needed to be. Better earnings have helped equities cope with interest rate uncertainty, hawkish inflation reports and geopolitical volatility.
Thematically, AI-driven, large-cap technology stock exceptionalism remains apparent in almost all-earnings season metrics (e.g., technology stocks drove more than half of the growth this quarter). Across industrial sectors, capital return and capex programs saw a nice boost as most firms sounded positive on dividend and buyback programs. Within credit-sensitive pockets of the market, management concerns about bank credit availability remain contained, an encouraging update given the turmoil at New York Community Bank. For the first time in several quarters, we noticed most companies discussed improved labor availability. In some instances, management teams also indicated that this improvement is translating to an easing in wage pressures. Finally, the number of companies citing recession was almost back to pre-Covid levels (e.g., less than 10% having peaked at 45%).
We have championed an accelerating earnings growth view and continue to expect corporate profits to set a record this year. We acknowledge the path will be challenged by an uneasy macro backdrop, but it is important to give credit where credit is due. This past season got progressively better, helping markets shrug off less favorable interest rate commentary as well as lingering valuation concerns. Expect more of the same 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. 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 new highs that have recently been established. The sharp 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.
Disclosure: Past performance is not indicative of future performance.