October 2024: The BakerAvenue Prudence Indicator

BakerAvenue Prudence Indicator Says... 

Long Term: Positive  |   Short Term: Neutral

Geopolitical Risks Growing, But So Are Profits

"He who awaits much can expect little."
- Gabriel Garcia Marquez

Markets don’t like uncertainty, and October tends to have more than most (e.g., October is the most volatile month of the year, historically speaking). This year, anxiety is a bit elevated given geopolitical tensions and the looming election cycle. Fortunately, pre-existing trends tend to numb the pain, and we are blessed with a relatively strong year-to-date setup. Additionally, with inflation cooling, central banks and investors alike are betting that monetary policy is almost certain to become ever-more accommodative. Economic and earnings growth remain respectable, long-term interest rates are low, and credit spreads are tight. On balance we continue to see far more volatility in asset prices than the underlying earnings and economic estimates.

The historical experience during geopolitical scares suggests market volatility gradually recedes back to “normal.” If the associated growth fears abate, as we expect, then tactical selloffs represent opportunities for portfolio adjustments (e.g., reallocations, tax-loss harvesting, etc.). 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 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.) have some room for improvement. Just as former leaders (e.g., technology) have started to lose relative strength, equally weighted indices have started to pick up and have helped to broaden the market a bit. 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 participation to broaden as the year progresses. Healthier markets tend to have strong participation rates, so we are on the lookout for even more 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 approach the end of 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 well 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 slightly off the pace of early 2024. Globally, last month saw further encouraging signs of economic optimism, particularly out of China (stimulus related). For some time, macro worries have centered on slowing growth and still tight financial conditions (i.e., restrictive monetary policy). We understand the concerns but see easing Fed policy as a sustained catalyst. We expect growth metrics to carry more influence as we move deeper into 2024 (a “good news is good news” backdrop).

Interest rates will continue to carry outsized significance. We don't think the lagged effects of prior policy tightening has been fully digested, thus our focus on growth. We expect lower, but not low, interest rates going forward with more Fed cuts coming this year. 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.

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. 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 few months and remain a stalwart defense against any recession forecast. This past earnings season brought strong year-over-year growth (11.5%), the highest in over two years. We expect slightly lower growth this quarter, but feel estimates remain beatable.

Valuations are in line with 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 are stable and remain at non-recessionary levels. Corporate cash flows remain healthy with dividend reinstatements (or increases) running well ahead of dividend cuts.

Concluding Thoughts

Rising geopolitical tensions and the outcome of the forthcoming US presidential election are sure to play a role in shaping market trends. Fortunately, corporate profits continue to push higher, the economy has remained resilient, and the Federal Reserve has resumed easing. 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 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.