BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
Good Trends, Messy Internals: What Gives?
"Success is a science; if you have the conditions, you get the result."
- Oscar Wilde
The stock market has rarely been this concentrated. At one point in time last month, the recently coined “Magnificent 7” (Alphabet (aka, Google), Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) represented more than 100% of the year-to-date gains in the S&P 500. A few weeks ago, Microsoft joined Apple as the second individual company that has a larger market capitalization than the combined market capitalization of all stocks in the small-cap Russell 2000. Small caps are currently trading at their lowest level vs. the S&P 500 (total return) in more than 20 years and represent less than 4% of the total US equity market, their lowest percentage in more than 70 years. This type of concentration can be challenging, particularly from a relative return perspective, but we are most concerned with the messaging.
Healthier markets tend to get everyone involved, so to speak. We are, therefore, focused on the factors contributing to the current concentration and what it means going forward. Essentially, how will this overly concentrated market play out over the next year? Our view on interest rates, and growth, play an important role here. We believe we are near the end of the Fed’s tightening campaign and see few signs that higher rates have completely derailed the global growth outlook. We are well aware of the fact that tighter financial conditions (e.g., higher interest rates) work with a lag, but so is the Fed. If rates are indeed peaking, investor appetite for things outside the "Magnificent 7" should increase. Secondarily, if forecasts for economic expansion hold (we suspect they will) the investment environment should turn more hospitable. A more inviting macro backdrop historically has helped broaden the appetite for investment outside the most obvious candidates. We expect that backdrop to slowly materialize as we move into the new 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. The fact that we have a concentrated market has not changed that view. 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 do recognize that resolution won’t come easy, and therefore 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 autumn, with several indices holding steadily above key moving averages. As mentioned earlier, price momentum is strong, but internal metrics (e.g., market breadth, new highs vs. new lows, etc.) are on the weaker side. Small cap and equally weighted indices have lagged significantly over the past year and remain at multi-year relative lows. 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 final stretch of 2023. 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 lower correlations will continue with macro-healing later in 2023, an environment we welcome.
Investor sentiment remains poor (e.g., bull-bear surveys) and light positioning (e.g., cash balances, put-call ratios, etc.) 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 for the last several quarters and estimates for the current quarter remain positive (and have recently revised higher). Recent macro worries have centered on the mix of higher inflation combined with slowing growth and tighter financial conditions (e.g., restrictive monetary policy). While these certainly have our attention, we expect the inflation scare will continue to subside.
Interest rates will be the fulcrum by which investors express their economic growth, inflation, and thus Fed policy views. 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. We are now waiting for the full impact of the large and rapid increase in interest rates to show up in the data.
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 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 slightly below 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. 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 (e.g., despite the volatility in equities, credit spreads have been mostly stable). 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 somewhat elevated but remain at non-recessionary levels. Corporate cash flows remain healthy with dividend reinstatements (or increases) running well ahead of dividend cuts.
Concluding Thoughts
We continue to see markets gradually shifting towards more bottom-up (micro) influence, particularly those centered on growth prospects. That shift should include a less concentrated market. 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 do believe the frequency by which investors can actively tilt portfolios towards those pockets of opportunity or away from risk will become more pronounced as correlations come down. 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.