BakerAvenue Prudence Indicator Says...
Long-term: Neutral | Short-term: Neutral
Seasonal Stabilization?
“The question is not what you look at - but how you look and whether you see.”
– Henry David Thoreau
Somewhat half-heartedly, we have had the song “Wake Me Up When September Ends” in the back of our minds over the past few weeks. September certainly lived up to its reputation of underwhelming market returns and elevated volatility (e.g., the S&P 500 was down 9.3% in September). Encouragingly, the seasonality setup is improving. While the S&P 500 has historically advanced around 0.5% in October, the seasonality setup greatly improves during mid-term election years. During mid-term election years dating back to 1928, the S&P 500 has historically produced average October, November, and December returns of 2.2%, 2.0%, and 1.2%, respectively.
While October is often one of the more volatile months, it often sets the stage for the markets best six-month seasonal stretch (e.g., November through April). While 2022 was the worst start to a year since 1974 and 2002, both of those bear markets bottomed in October. Of course, seasonality alone will not do the trick. Investors will need help settling some of the big macro concerns (e.g., tighter policy, higher interest rates, geopolitics, etc.).
All market bottoms are a process / evolution that takes time - this one happens to be especially messy because alongside the reset in equities, we are seeing a generational transition in our interest rate environment. We suspect that uneasy feeling has do to with investors inability to allow for (and thus model for) economic and multiple expansion in a rising rate environment. Until this matter is dealt with and settled properly, the financial markets are likely to remain quite volatile. Encouragingly, with sentiment historically poor, turning the page on the calendar is a welcome sign.
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 backdrop 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. 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.
The Fundamental Perspective
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Earnings takeaways over the next several weeks will go a long way in defining the market backdrop. Our weekly series for forward revenues, earnings, and margins have stopped going higher, but remain positive on a year-to-date basis. S&P 500 net profit margins remain well above pre-pandemic levels, but upcoming reports and management guidance will test if that resilience and investor confidence can continue. On balance, quarterly results have surpassed expectations and provided some stalwart defense against any recessionary narrative. While the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look beatable, and another double-digit expansion in profits (for ’22) 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 credit backdrop will be important to monitor as growth concerns persists. One of the defining criteria between pronounced or shallow recessions has been the behavior of credit. 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 economic recovery. Incoming economic data continues to support our slowing but not recessionary growth narrative (e.g., employment remains strong, manufacturing reports are slowing but have stayed in expansionary zones, etc.). Forecasts have GDP growth resuming to positive territory after two consecutive negative quarters. 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 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. While tactically oversold, the range that has defined much of the last several months has still yet to be resolved. Internal metrics are mostly balanced at this point. For example, the percentage of stocks trading above key moving averages (low by historical standards) is indicating markets are fairly washed out. However, longer-term downtrends remain in place (e.g., most indices are below key 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 price weakness, 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 towards the final months of 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. 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. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher, or lower).
Concluding Thoughts
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. The higher interest rate backdrop also does little to alter that view. 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 (i.e., gloomy, yes, but doom, no) 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 are staying active, using the volatility to harvest losses while opportunistically deploying capital where appropriate. We have lowered our cash weightings, are currently 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.