December 2021: The BakerAvenue Prudence Indicator

It is time to think about 2022. To cut to the chase, despite a steady drumbeat of negative news over the past few weeks, we remain optimistic regarding the prospects for a sustained recovery. Omicron, tighter Fed policy, persistent supply chain problems, and unresolved budget negotiations have resulted in heightened trading volatility to close out the year. It is also making forecasts uniquely taxing. Nevertheless, as we round out another impressive year of asset returns and look toward 2022, we continue to see the good outweighing the bad.

The fastest pace of the recovery now lies behind us, but we continue to expect strong growth in coming quarters (e.g. 2022 GDP growth should remain well above long-term averages). A consumption boost from pent-up savings and inventory rebuilding spurred on by improving supply chains should provide the necessary tailwinds that counter tighter monetary policy and the uncertainties of Covid. Profit growth has accounted for the entire S&P 500 return in 2021 and will continue to drive gains in 2022. We expect another year of above-consensus growth.

For the last thirty years, declining interest rates have accompanied both rising equity valuations and higher corporate profit margins. This year has been no exception. Central banks responded to the pandemic by flooding markets with liquidity and pushing the funds rate to zero. The 2022 investment environment will be a bit different in that the Fed is likely begin to hike rates. This will, in turn, drive asset class rotations within the market and make for some volatile trading days. However, we expect real rates (rates adjusted for inflation) to stay negative and act as support for active investment strategies.

At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation 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 neutral position. Long-term trends continue to paint a more optimistic picture (positive).

For those who have been following our weekly 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 the pandemic-related retrenchment in economic activity, while necessary, was self-inflicted, not structural, and prone to snapping back as re-opening resumed or vaccines entered the narrative. While we recognize a sustained expansion is quite different than the recent normalization, we suspect favorable policy decisions, economic growth, and earnings will continue to support a further grind higher in equities. Consolidations and pullbacks, should they occur during the final few weeks of the year, should be bought.

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 risen to record highs. Concerns about rising input costs have meant little to the robust trend in profit growth. In fact, corporate margins are higher now than they were pre-pandemic. We see more of the same in 2022 and expect earnings growth to again outpace economic growth. Stubborn pricing pressure and supply constraints are headwinds, but strong demand has more than compensated. While the frequency and magnitude of earnings and sales beats will naturally moderate, consensus estimates look beatable and another double-digit expansion in profits is within reach.

Valuations seem stretched in several pockets of the market but only slightly above long-term averages in others. The pace of the expansion in corporate profits has far exceeded the stock prices in 2021, so multiples are now lower than they were at the start of the year. Valuation dispersion remains at record levels with a sizable gap between the secular growers and the more economically sensitive recovery plays. We see opportunity in both and expect less dispersion going forward as investors embrace a more balanced view.

The credit backdrop remains supportive. Despite some widening over the past couple weeks, both investment-grade and high-yield spreads vs. Treasuries reman near levels that are associated with strong equity markets. Dividend reinstatements (or increases) are running well ahead of dividend cuts. The record pace of deal activity (e.g. IPO’s, M&A, etc.) looks to continue well into 2022 as cash flows remain strong and corporate confidence stays elevated.

The Macro Perspective:

The macro discussion must start with a view on the global economic recovery. Incoming data over the past few weeks has supported our sustainable recovery narrative (e.g. unemployment reached 4.2% last month, a post-Covid low). Recent worries have centered on the mix of higher inflation, combined with slowing growth and the beginning of the Fed exit. While these certainly have our attention, we expect the inflation scare will subside as conditions generating the price spikes ebb (e.g., bottlenecks ease, labor supply increases) and economic growth continues. Real-time estimates for 4Q GDP growth are running around 8%, a notable acceleration from 3Q.

Interest rates will be the fulcrum by which investors express their economic growth views. The Fed has acknowledged that aggressive bond purchases (QE) are not a policy that fits well with a supply-constrained economy. They recently announced plans to taper those purchases (to help address inflation) while holding off on any rate hikes for an extended period (to aid growth). Further, they recently adjusted their views by indicating inflation could stay longer than expected and they could speed up its tapering process. We believe a faster taper (i.e., less bond purchases) is more of a capital market concern than an economic one, but if history is a guide, it will add to volatility.

Low-interest rates, a series of government support packages, a commitment by the Fed and other central banks, and highly accommodative fiscal policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. While these policies are still in place, 2022 will bring about subtle changes in their magnitude. We expect interest rates to move gradually higher in 2022.

Regarding the Omicron variant, we are encouraged by the latest developments. While infections are picking up, symptoms seem milder by comparison. We continue to believe US shelter-in-place mandates are both socially and politically unsought and therefore lower the odds of a self-induced US recession. The high-frequency data we monitor (e.g. hotel occupancy rates, restaurant bookings, retail spending, etc.) support the notion that, while volatile, the recovery is intact.

The Technical Perspective:

Longer-term, the current technical backdrop remains in decent shape. Most major indices remain at, or very close to, all-time highs and corrections over the past few weeks have done little to alter the longer-term trend. Longer-term moving averages (e.g. the 200-day moving average) remain in good standing with approximately 68% of stocks trading above this key threshold (a healthy level). There has been quite a bit of damage done internally over the past couple weeks (e.g. small cap stocks have retrenched back into a range, market breadth has rolled back over) and it remains to be seen if these moves are a knee-jerk reaction to the recent Omicron and Fed news, or something more sinister. At this point, we side with the former.

The market remains a bit top-heavy with the top twenty companies in the S&P 500 making up over 40% of its market cap, and the top five over 25%. The “average stock” simply hasn’t kept pace with the largest, predominately technology, companies. We do expect the market to broaden out as we move into 2022. Healthier markets tend to have strong participation rates, so we will be looking for improvement here.

Rotation within market internals continues to be a weekly theme. Leadership is bouncing back and forth between defensives and more economically sensitive groups as macroeconomic influence remains elevated. We expect this churning behavior to continue as long as Covid uncertainty remains, but see relative value in the groups less represented of late (e.g. small caps, value, economically-sensitive groups, etc.).

The recent bout of volatility has resulted in an aggressive and quick shift in investor sentiment (e.g., the percentage of AAII bearish investors hit the highest level in over a year this month, the Put-Call ratio is at the highest point of the year, etc.). The Volatility Index (VIX) futures curve inverted recently (implying investors are paying more for short-term protection). Historically, in bullish regimes, an inverted VIX curve has put you in the vicinity of a tradable low. Positioning remains neutral by our work as money flows into equities have picked up but remain well below those of bonds and cash.

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 as we move into a new year. 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. 

Volatility should stay somewhat elevated but systemic risks that could result in recessionary or bear market conditions remain low 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. 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. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to destabilize, we will take a more defensive stance.

Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical, and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please contact BakerAvenue. We are happy to share our thoughts in greater detail and welcome your questions or comments.