BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
Summertime Grind?
"Don't count the days, make the days count."
- Muhammad Ali
Markets continued their push higher last month, buoyed by an accelerating economy, decent earnings results and, we suspect, FOMO (fear of missing out) buying by reluctant bears. Soft landing optimism has increased, and with it, bond yields. We believe the bar for further outperformance has increased, raising consolidation odds, but we remain encouraged by our supporting analytics. As better data collides with seasonal headwinds, consolidation (a.k.a. summertime grind) odds increase. Encouragingly, the preponderance of data would indicate those consolidations will be bought.
In downgrading the US sovereign rating, Fitch noted its concern about the growing debt burden and erosion of governance. We share their concerns but note that a worsening fiscal profile is well telegraphed, and investors have come to expect last minute resolutions of a debt limit impasse that mute broader fears and contagion. Seeing the announcement, we were especially attuned to the impact on bond yields. The day of the announcement, there were several “good” economic reports (e.g., consumer confidence, durable goods, employment) which helped propel the oft-cited economic surprise index to multi-year highs. So, offsetting datapoints. One, conceptually at least, with negative ramifications (the downgrade) and the other positive (better data). Both should push rates higher, but for different reasons.
The effect was a choppy, grinding market with no discernable change to the long-term trend. Investors should brace for more conflicting datapoints which often comes with a less comfortable tenor (e.g., higher volatility). The S&P 500 returned 3.2% in July, its fifth straight monthly advance, as lower recession odds, a less-hawkish Fed and improving data buffered potential selloffs. “Soft-landing” optimism continued to grow with formerly bearish outlooks increasingly adjusting to the more nuanced (e.g., slow, but non-recessionary) backdrop we have been articulating.
We understand it is tricky out there, but we have benefited by not overly discounting the less discussed optimistic scenarios. 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.
After a notable downtick, we do believe volatility will increase here in the dog days of summer. However, ultimately, another year of economic and earnings growth should be enough to offset the monetary tightening in place and support an eventual continued grind higher in equities. We want to be thoughtful regarding portfolio construction and risk control in these volatile times.
The Technical Perspective
The technical backdrop remains volatile, but structurally intact. We believe the market is in much better technical shape relative to last autumn, with several indices holding steadily above key moving averages. Price momentum is strong, and internal metrics (e.g., market breadth) are showing signs of improving. Small cap and equally weighted indices outperformed last month, a sign of breadth expansion. Leadership has shifted back-and-forth from a pro-growth to defensive value over the past few weeks. 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. A handful of stocks (primarily large cap technology stocks) still account for the majority of gains this year. Healthier markets tend to have strong participation rates, so we are on the lookout for 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 remains a catalyst by our work, but less so relative to last month. Investor sentiment has improved (e.g., bull-bear surveys have moved notably higher), but positioning (e.g., cash balances, money flows, etc.) should continue to act as a catalyst as the macro backdrop improves. While not the overriding factor, investor positioning often influences the order of magnitude in market moves (higher or lower).
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, economic surprise models are running near multi-year highs). GDP growth has surprised on the upside for the last two quarters (2.4% last quarter) and estimates for the current quarter remain positive (and have recently revised higher). 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 continue to subside.
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 Fundamental Perspective
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Headwinds, such as higher financing and input cost pressure, are balanced by consumer spending resiliency and improving supply chain commentary. Our weekly series for estimates of revenues and earnings have increased over the past couple months. Importantly, they remain far from recessionary. We are at the end of another important earnings season. Results have bested expectations and continue to provide a stalwart defense against any profit-recession narrative.
Valuations are in line with long-term averages. However, valuation dispersion within sectors and industries remains high with a historically sizable gap between the highest and lowest priced assets. We see opportunities in both groups. Several of the secular growers are commanding high multiples, but also market-leading profitability. Value-oriented pockets offer opportunity, but investors will need to be selective.
The credit backdrop will be important to monitor as growth concerns persist. So far, the credit backdrop has supported the move in equities (e.g., spreads contracted again last month). One of the defining criteria between recessions and slowdowns 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.
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. 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 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.