BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Oversold
The Fog of War
Russia’s attack on Ukraine has injected material uncertainty into the capital markets. Risk appetites have disappeared, and financial conditions have tightened, driven primarily by the spike in commodity prices. The world has settled into an uncomfortable war of attrition, with investors pondering the circumstances and timing of de-escalation or worsening global economic drag. Encouragingly, the and corresponding market correction are happening against a backdrop of strong economic growth and record corporate profitability.
Last month, we wrote that while we remained optimistic, investors would have to get comfortable being uncomfortable this year. That outlook was based on tighter monetary policy headwinds (i.e., higher interest rates), not war, but the message remains the same. The S&P 500 hit an all-time high on January 3rd of this year but has since corrected back below its long-term trend line. Risk appetites are under significant pressure as there is legitimate concern the war will expand, or Russia will be cut out of most global trade. Stagflation concerns (e.g., prolonged inflation with slow economic growth) are and should not be dismissed.
Our baseline view is that while there will be limited direct impact to U.S. equities from the Russia-Ukraine conflict (e.g., revenue exposure for the broader market is less than 2%), the indirect impact via the commodity and sentiment channels is . The prospects for recession or stagnation have increased. Fortunately, the shock to energy prices is hitting when the US economic recovery is on relatively solid footing and corporate and consumer balance sheets are in good shape. Also, many states are removing restrictions on activity as vaccination rates increase and COVID cases decline labor markets displaying notable resiliency. Even with the Fog of War lingering uncomfortably in the background, the US economy is poised for above-trend growth in 2022 (e.g., according to Bloomberg’s survey of economists, GDP is forecasted to grow 3.5% in 2022, almost double its 20-year average).
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 an oversold position, while long-term trends paint a slightly more optimistic picture.
For those who have been following our market updates (), 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 another year of above-trend economic growth, robust consumer spending, inventory restocking, and double-digit earnings growth will be enough to offset monetary tightening and support a further grind higher in equities. Consolidations and pullbacks are to be expected and, provided recessionary or bear market odds stay low, should be bought. The issue, of course, is that the prospects of an war have dampened that outlook.
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 we are monitoring, but so far strong demand has more than compensated. 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 lower than 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 . 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 remains supportive. Despite some widening over the past few weeks, both investment-grade and high-yield spreads vs. Treasuries remain 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 in 2021 (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 discussion must start with a view on the global economic recovery. Incoming data at the start of 2022 has supported our sustainable recovery narrative (e.g., unemployment reached a post-Covid low, retail sales remain strong, manufacturing reports are firmly in expansionary zones, etc.). 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. Geopolitical conflicts have historically had little economic impact, provided they don’t result in a prolonged cutback in consumer spending. The oil price spike has our attention, and we will be monitoring sales trends over the next few weeks.
Interest rates will be the fulcrum by which investors express their economic growth views, and we continue to expect them to move gradually higher throughout the year. 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), removing the largest suppressor of rates. 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., fewer bond purchases) is more of a capital market concern than an economic one, but if history is a guide, it will add to volatility.
Regarding Covid, we are encouraged by the latest developments.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. We do expect a shift in spending in 2022 as pent-up services spending starts to outpace goods spending.
The technical backdrop is volatile, to say the least., it remains in decent shape with most major indices remaining in an uptrend, albeit just barely. Admittingly, the corrections over the past few weeks have taken their toll on many of the short-term indicators we monitor. For example, the number of new lows has been outpacing the number of new highs, and several price change indicators are flagging a noticeable slowdown in momentum. Given tactically oversold signs, we are on the lookout for some stability in these metrics.
The market is still 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 expect the market to broaden as we move further into 2022. Healthier markets tend to have strong participation rates, so we will be looking for improvement here. We are encouraged by the declining correlations we are seeing within sectors and industries. Lower correlations support a more active approach, an environment we welcome.
Rotation within market internals continues to be a weekly theme and has been quite pronounced to start the year. Prior to the Russia-Ukraine conflict, leadership was bouncing back and forth between defensives and more economically sensitive groups as macroeconomic influence remains elevated. Recent trends have carried a decisive “risk-off” tone. We expect this churning behavior to continue if macro uncertainty remains but see relative value in the groups less represented last year (e.g., small caps, value, economically sensitive groups, etc.).
Investor sentiment is bearish, which, from a contrarian point of view, is bullish. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, etc.) point to a skeptical investor base with the number of “bears” reaching the same levels as the pandemic peak (i.e., 45%, same as in March of 2020). Tactical positioning data (e.g., put-call ratios, cash balances, etc.) is leaning defensive and supports a short-term oversold view. Money has flown out of equities to start the year, reversing a multi-month trend selling bonds for stocks. Encouragingly, there is still almost $4 trillion in money market funds available to invest.
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 geopolitical volatility. 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 elevated given the Fog of War, 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 continue 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.
Disclosure: Past performance is not indicative of future performance.