BakerAvenue Prudence Indicator Says...
Long-term: Neutral | Short-term: Neutral
The Death of TINA?
“It's worth remembering that it is often the small steps, not the giant leaps, that bring about the most lasting change.”
– Queen Elizabeth II
For the longest time, lower interest rates meant that, for most investors, There Is No Alternative (TINA) to stocks and like assets to meet long-term financial objectives. With yields backing up across the curve, risk-free rates have moved from an afterthought to a consideration and the bar for sustained outperformance has been set higher. While the new rate backdrop will make the recovery road bumpy, we do not think it is enough to short circuit growth.
Currently less than 15% of stocks in the S&P 500 yield more than the 2-year Treasury bill, while just shy of 20% have dividend yields above the 10-year – levels last seen in 2006. The higher risk-free yields, courtesy of a Fed on a mission to squash inflation via a series of rate hikes, has injected an unfamiliar feeling across the capital markets. After all, the decades-long downtrend in rates was recently broken, and more than a few investors have yet to experience an environment defined by a series of higher bond yields.
We suspect that uneasy feeling has do to with investors inability to allow for (and thus model for) economic and price 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. Importantly, that doesn’t mean stocks are not investable. Higher rates are often associated with strong economic backdrops that carry with them elevated inflation. In many of those cycles, stock markets do quite well.
Nevertheless, post the Global Financial Crisis, historically low interest rates, and corresponding deflationary backdrop, investors felt comfortable reaching out on the risk curve in a search for yield and returns. There really was little alternative. But now, with 2-year Treasuries yielding over 3.7%, it seems there is now another alternative to at least consider. Importantly, over the long-term, whether or not that decision comes to the detriment of stocks will depend on growth. Should the growth backdrop avoid prolonged recessionary conditions (our forecast), the new rate backdrop is not enough to short circuit growth.
The tricky summer for investors finished with August giving back some of July’s big gains (e.g., the S&P 500 was -4%). While comfortably off the lows set in June, the summer re-risking petered out on hawkish Fed talk and geopolitical concerns. 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. In aggregate, they remain healthy. 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 Q3 earnings 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 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 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 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 commodity prices 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. It has been a compelling response off tactically oversold levels, but 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 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 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. 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. 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 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 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.