January 2023: The BakerAvenue Prudence Indicator


BakerAvenue Prudence Indicator Says... 

Long-term: Neutral   |   Short-term: Neutral

BAPI_LT Neutral ST Neutral 2021


Evolving Influence: Less Macro, More Micro

Better a little which is well done, than a great deal imperfectly.


Last month we wrote about how it is common for markets to have competing signals, particularly at turning points. The vagaries of lag effects of market variables on different asset classes often lead to challenging juxtapositions for investors. Those conflicts, heavily macro-influenced, led to more volatility in the last month of ’22 (e.g., the S&P 500 was off -5.9% in December). Encouragingly, when we think through the litany of macro concerns, we can argue the uncertainty associated with each is closer to the end than the beginning (e.g., the Fed has already started to slow its pace of interest rate hikes, China has embraced a reopening cadence, supply chains are getting better, not worse, etc.). The impacts on individual security growth, however, remain diverse and unresolved, and thus carries more significance in this new year.


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. Reflecting this view, dispersion amongst securities within sectors and industries are starting to increase as investors shift from a ‘one size fits all’ backdrop to a more bespoke environment. This increased attention to micro analysis should provide tailwinds for active and research-driven approaches. 


Last year was unique in many ways, but one thing that stands out to us was the dramatic reset in valuations across many asset classes (e.g., corporate profits grew in ’22, it was valuation contraction that did all the damage). There is a myriad of reasons why valuations were reset, but few would argue they mostly centered on macro uncertainty. While the reset arguably brings with it the most attractive entry point for stocks and bonds in over a decade, we suspect capitalizing on the opportunity will require shifting your analytical lens to micro factors.


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 (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated that while growth is slowing, the downturn is more cyclical rather than secular. We do not forecast a break to our longstanding “growth normalization” view.

We do believe volatility will stay elevated, but ultimately, another year of economic and earnings growth should be enough to offset monetary tightening and support an eventual grind higher in equities. We want to be thoughtful regarding portfolio construction and risk control in these volatile times.

The Fundamental Perspective

Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Earnings takeaways over the next several weeks should reinforce our belief that, while the growth backdrop remains challenging, there are offsets. Headwinds like dollar strength and input cost pressure are slowly abating and are balanced by consumer spending resiliency and improving supply chain commentary. Our weekly series for forward revenues, earnings, and margins are well off their peak, but remain far from recessionary. While the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look reasonable. On balance, we expect corporate results to match expectations and provide some stalwart defense against any profit-recession narrative.


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 providing a compelling opportunity for long-term investors, but prospects are not universally favorable. Valuation dispersion remains high with a sizable gap between the secular growers and the more economically sensitive stocks. Predictably, the backup in rates has caused this dispersion to shrink as the more speculative assets have corrected to a greater degree.


The credit backdrop will be important to monitor as growth concerns persist. One of the defining criteria between pronounced or shallow recessions 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.


The Macro Perspective

The macro discussion must start with a view on the global economy. Incoming economic data continue to support our slowing but not recessionary growth narrative (e.g., unemployment is at a fifty-year low). After two consecutive negative quarters to start ‘22, GDP growth accelerated back to positive territory to close out the year. Real time estimates forecast the best quarter of the year to be the last. 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 continue to expect the inflation scare will subside. Cooling input prices (e.g., transportation costs, used car prices, etc.) and easing supply chain pressures amid softening demand and tighter policy suggests inflation momentum has peaked.


Interest rates will be the fulcrum by which investors express their economic growth, inflation, and thus Fed policy, views. Yield curves have inverted as the front end of the curve has moved higher with the prospects of further 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.


The Technical Perspective

The technical backdrop remains choppy with the recent action keeping most benchmarks within a volatile trading range over the short term. The range that has defined much of the last several months has still yet to be resolved. For example, the percentage of stocks trading above key moving averages (improving, but still low by historical standards) continues to indicate markets are fairly washed out. However, longer-term downtrends remain in place (e.g., most indices are below key long-term moving averages) and volatility has remained elevated. We are on the lookout for sustained stability in these metrics with a more balanced short-term outlook.


Despite the volatility, internal metrics have improved over the past couple months (e.g., expanding new highs vs. new lows, improving market breadth, etc.). Relative strength in more cyclically oriented pockets of the market is picking up vs. defensives, an encouraging sign. We expect the market to broaden and leadership to continue to adjust as we move into 2023. Healthier markets tend to have strong participation rates, so we will be looking for improvement here. As stated earlier, we are 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 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. Tactical positioning data (e.g., put-call ratios, cash balances, etc.) are still leaning defensive and will act as a catalyst should the macro backdrop improve. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher, or lower).


Concluding Thoughts

We see markets in 2023 gradually shifting towards more bottom-up (micro) influence, particularly those centered on growth prospects. We have championed an active approach of investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a 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 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 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 the volatility to harvest losses while opportunistically deploying capital where appropriate. We have lowered our cash weightings 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, please contact BakerAvenue. We are happy to share our thoughts in greater detail and welcome your questions or comments.


Disclosure: Past performance is not indicative of future performance.