BakerAvenue Prudence Indicator Says...
Long-term: Neutral | Short-term: Neutral
A Lesson in Positioning
Markets rallied in July with the S&P up the most since November 2020. The month was full of high-profile themes, many of which helping to twist and turn the overriding market direction. This was evidenced by the selloff in commodities, a decline in inflation expectations and a pullback in the price measures of regional manufacturing surveys. There was also some focus on discounting in retail to address excess inventories. While the Fed delivered another 0.75% rate hike and reiterated their commitment to bringing inflation back to target, market takeaways focused more on expectations for a transition away from frontloading rate hikes.
Despite the subtle narrative shift, growth and recession fears picked up throughout the month as the economy contracted for a second straight quarter in Q2, the July services Purchasing Managers’ Index (PMI) fell into contraction and the July manufacturing PMI slumped to the lowest level in two years. While profits held up better than feared, there were some cautious takeaways from Q2 earnings, including retail guide downs on general merchandise softness from inflation and economic normalization, mobile provider remarks about customers taking longer to pay their bills, software companies flagging longer deal cycles, technology (and retail) names pointing to a continued deterioration in digital advertising and consumer electronics, and homebuilder commentary on a slowdown in housing.
So, why the strong move higher? One of the reasons we incorporate technicals into our analysis is that they carry an unbiased assessment of investor sentiment and positioning. Peak inflation and peak Fed tightening narratives are powerful catalysts for stability, but this particular bounce has provided a quick lesson in positioning (e.g., July was only the 18th month of a 9% or more gain in the S&P 500 ever). In June, sentiment readings (e.g., bull-bear ratios), positioning data (e.g., long-short speculative positioning) and general commentary had become too negative. Because the market was priced for something worse, and positioning had become too one-sided (bearish), an outsized move was in store. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher, or lower). The move higher over the past few weeks is encouraging but, naturally, investors will want to focus on what comes next.
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, both our short-term and long-term metrics are in a balanced (neutral) position.
For those who have been following our market updates (), you will be familiar with several of our key concerns and opportunities. We have continually stated that the pandemic-related retrenchment in economic activity, while necessary, was self-inflicted, not structural, and prone to snapping back as re-opening resumed or vaccines entered the narrative. That snapback has now matured, and growth is slowing.
While the backdrop has weakened, we do not forecast a break to our longstanding “normalizing” view. We suspect another year of economic and earnings growth will be enough to offset monetary tightening and support an eventual grind higher in equities. While we expect the direst outcomes can be avoided, we acknowledge uncertainty remains. We want to be thoughtful regarding portfolio construction and risk control in these volatile times.
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. In aggregate, they remain healthy. Our weekly series for forward revenues, earnings, and margins have risen to record highs. On balance, results for the most recent quarter surpassed expectations and provided some needed good news. Concerns about rising input costs have meant little to the robust trend in profit growth. In fact, corporate margins are higher now than they were pre-pandemic. We see more of the same in 2022 and expect earnings growth to again outpace economic growth. Stubborn pricing pressure and supply constraints remain but are getting better. While the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look beatable, and another double-digit expansion in profits is within reach.
Valuations have corrected and are now below long-term averages. The pace of the expansion in corporate profits has far exceeded stock prices over the past couple of years, so multiples are now well below where they were at this point last year. Valuation dispersion remains high with a sizable gap between the secular growers and the more economically sensitive recovery stocks. Predictably, the backup in rates has caused this dispersion to shrink as the more speculative assets have corrected to a greater degree. We continue to see less dispersion going forward as investors embrace a more balanced view. The past few weeks has seen the relative strength of higher growth assets pick up.
The credit backdrop has stabilized over the past few weeks, supporting the move higher in stocks. Both investment-grade and high-yield spreads vs. Treasuries are somewhat elevated but remain at non-recessionary levels. Dividend reinstatements (or increases) are running well ahead of dividend cuts.
The macro discussion must start with a view on the global economic recovery. Incoming data last month supported our slowing but not recessionary growth narrative (e.g., unemployment reached a post-COVID low last month, manufacturing reports are slowing but have stayed in expansionary zones, etc.). Recent worries have centered on the mix of higher inflation, combined with slowing growth and the beginning of the Fed exit. While these certainly have our attention, we expect the inflation scare will subside as conditions generating the price spikes ebb (e.g., bottlenecks ease, labor supply increases) and economic growth continues. Geopolitical conflicts have historically had little economic impact, provided they don’t result in a prolonged cutback in consumer spending.
Interest rates will be the fulcrum by which investors express their economic growth views, and we are encouraged by the stability in longer-term rates (e.g., 10-year Treasury yields are at the same level they were in April of this year). Yield curves have inverted as the front end of the curve has moved higher with the prospects of rate hikes. Curve inversion should be respected, as they have a very strong track record in signaling recession over the past 40+ years. What they cannot predict accurately is the timing of the recession, nor its depth and magnitude. As mentioned, one of the most pressing questions for investors is: Can the Fed get control over inflation without causing a deep recession? It is going to be tricky, but at this point we believe they can.
Technical conditions remain choppy, but the recent rally has healed some wounds. The rebound over the past few weeks has improved many of the short-term indicators we monitor, moving several off their previous oversold condition. Internal metrics are mostly balanced at this point. For example, the number of new highs vs. new lows is starting to move higher, and several price change indicators are flagging a noticeable pickup in momentum. However, longer-term downtrends remain in place (e.g., most indices are below key moving averages). We are on the lookout for sustained stability in these metrics with a more balanced short-term outlook.
Tactically, risk-on barometers (e.g., discretionary over staples, high Beta over low Beta, etc.) are picking up relative strength vs. the more defensive pockets of the market. These are encouraging signs, but there is more work to be done. We expect the market to broaden and leadership to continue to adjust as we move further into 2022. Healthier markets tend to have strong participation rates, so we will be looking for improvement here. Admittingly, we are discouraged by the higher correlations we are seeing within sectors and industries. Lower correlations should come with macro-healing later in the year, and will support a more active approach, an environment we welcome.
Investor sentiment is still quite bearish, which, from a contrarian point of view, is bullish. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, Consumer Sentiment, etc.) point to a skeptical investor base with the number of “bears” still elevated. Despite the move recently, tactical positioning data (e.g., put-call ratios, cash balances, etc.) is still leaning defensive and will act as a catalyst should the macro backdrop improve. As higher interest rates have hurt bond performance, money flows have started to reverse their years-long preference for fixed income over stocks. Encouragingly, there is still more than $2 trillion in money market funds available to invest.
We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. We see no reason to change that view given the recent volatility. 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 the recovery matures and growth slows.
Volatility should stay elevated given the macro uncertainties. Systemic risks that could result in prolonged recessionary or bear market conditions exist, but are not overwhelming, given the accompanying growth backdrop. Our forecast for a maturing but sustained economic expansion (e.g., a braking, but not breaking economy) strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all. That “how” should continue to include both secular growth and cyclical allocations.
Our investment philosophy is based on a dual mandate of growing and protecting client assets. We have been focusing on strategy positioning vs. our respective benchmarks to control risk, but given the volatility, will now include exposure adjustments. Of course, should the backdrop continue to destabilize, we will take a more defensive stance.
Disclosure: Past performance is not indicative of future performance.