BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
The Storm Before the Calm?
"It's in vain to recall the past, unless it works some influence upon the present."
- Charles Dickens (David Copperfield)
Last year the bear case centered on a view that the Fed would have to tighten monetary policy aggressively because the Fed was behind the inflation curve and had to scramble to catch up. That would cause a recession, which is the only way to bring inflation down, according to the narrative. As a result, valuation multiples would tumble, and so would earnings. That scenario played out as the market fell into the fall. However, the bear market was mostly attributable to a sizable plunge in the market valuation (e.g., P/E). Earnings rose during the bear market because the recession never happened.
Bonds had a historic down year last year as well. To start this year, bond yield uncertainty continued as the market has tried to find its footing (e.g., interest rate volatility is higher than stock volatility so far this year). Bond prices are well off their lows, and we are looking for more stability, but fear we may not get it until the Fed reaches its terminal rate. This rate is debated, and this uncertainty should keep volatility elevated for the time being. If the Fed pauses their interest rate increases soon, we could see calmer waters in bonds and stocks.
This year, the bear case is centered on a growth slowdown, invariably linking the storm of volatility-inducing headlines to start the year (e.g., rate hikes, bank failures, geopolitical volatility, etc.). However, global GDP estimates for Q1 continue to rise, including the US where growth has been revised up to 3.3%. Will corporate profit margins and earnings be similarly resilient? Time will tell, but we do get the sense a run of less macro influence is in store for the markets. That puts more pressure on the growth data, which we believe will be a welcome reprieve for investors.
Earnings will play a key role in the next several weeks. The chatter about a lack of downward earnings revisions from analysts with interest rate increases possibly continuing with good economic data will play itself out. If analysts are right and earnings are in line with estimates, equities have room to go higher. If earnings miss poorly, we could see more volatility and a downdraft in equities. We have seen wide dispersion in equity prices lately and we anticipate getting similar dispersion in earnings amongst companies.
A quick follow up on the banking crisis: We wrote last month that contagion was not our base case, based primarily on the view that the relatively quick regulatory response, essentially guaranteeing deposits for these banks and others, should be enough to prevent the worst outcomes from materializing. In the weeks and months to come, we will see how the broader market may be affected, but at this time our views on the banking crisis remain unchanged.
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 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 the monetary tightening in place and its fallout (the current banking crisis) 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 past several weeks have reinforced 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. We have championed a “braking but not breaking” view in regard to corporate profitability. Importantly, 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 are slightly 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. We see opportunities in both groups.
The credit backdrop will be important to monitor as growth concerns persist. The banking issues only reinforce this key fundamental input. 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 of the global economy. Incoming economic data continues to support our slowing but not recessionary growth narrative (e.g., unemployment is close to a fifty-year low). Real-time GDP estimates for the first quarter of this year remain positive. 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 and easing supply chain pressures amid softening demand and tighter policy suggest 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.
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 Technical Perspective
The technical backdrop remains volatile, but structurally intact. We believe the market is in better shape relative to last autumn, with several indices moving back above key moving averages. Internal momentum and breadth metrics haven't collapsed (e.g., advance-decline lines are still holding well above October lows). Recently, leadership has shifted from a pro-growth bias to a more defensive makeup. We are intently focused here as we consider portfolio tilts.
We expect the market to broaden and leadership to continue to adjust as we move through 2023. Recently, the market has narrowed with a handful of stocks (primarily large cap technology stocks) driving gains. Healthier markets tend to have strong participation rates, so we expect improvement here. We are also 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 has improved but on average tilts 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, fund flows, 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 continue to 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 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 and unresolved banking stress. Systemic risks that could result in prolonged recessionary or bear market conditions exist but are not overwhelming given the accompanying growth backdrop. Again, we see the contagion risk stemming from the bank failures as low. 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 any 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.
Disclosure: Past performance is not indicative of future performance.