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A Prudent Approach. Actively Managed.

The BakerAvenue Prudence IndicatorTM

BAPI LT - Negative ST - Natural

05 May 2020: Prudence Says Negative

We, at BakerAvenue wish to express our sincere concern for everyone impacted by the pandemic. With lives still at risk, we hope that conditions continue to improve as quickly, and as safely, as possible. The day will come when Covid-19 is a memory, but for now investors must continue to manage through the complexities and uncertainties brought forth by the virus. There is no shortage of catalysts, both positive and negative, to consider. For those of you that have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities.

Last month, we wrote that the unprecedented retrenchment in economic activity caused by the pandemic will keep market volatility elevated. However, we also noted most of the shutdown is self-inflicted, not structural, and prone to snapping back once social distancing guidelines are lifted (see In The Throes here). The market (S&P 500) peaked on February 19th, an all-time high. In the past fifty-six trading days we have witnessed the fastest bear market ever, the end to an historic eleven-year bull market run, the sharpest retrenchment in global growth on record and, more recently, the swiftest bear market bounce on record. If the pandemic “felt” worse than the Global Financial Crisis in terms of equity market volatility, that’s because it was. The 30-day standard deviation of daily returns (a measure of volatility) for the S&P 500 peaked out during the Global Financial Crisis at 5.0%. This time around, the peaks was 5.3% (April 8th).

Over the past several weeks, as headlines related to the virus have improved (or, more specifically, turned less bad), a sense of anxious optimism has returned. Investor focus has shifted from infection to economic trajectory (they are clearly linked). While we believe infection rates have crested, uncertainty regarding the depth of the economic contraction remains.

The road back to new highs exists, and given the rally in April (the best month for the S&P 500 since 1987), one could accept that we are well on our way. However, we suspect there will be more twists and turns along the way, even some backtracking. 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 market analyses indicate. In aggregate, our disciplines exited April in better shape than March. Accordingly, while we maintained prudent conservatism in exposure levels, our positioning turned slightly more optimistic. For us, the road ahead will continue to be defined by the output.

Let’s start with the macro backdrop. Continued improvement in virus infection and mortality rates are a must. As the world economies open back up, we do suspect these rates will tick higher. However, while concerning, we don’t believe the uptick will be enough to re-enforce shelter-in-place requirements. A vaccine would, of course, be a game changer. Right now, more than 100 companies and research institutions are working on a COVID-19 vaccine.

While there continues to be a sense that the pandemic is cresting, broad skepticism (which we share) about the prospects for a V-shaped economic recovery is a significant overhang. Recessionary conditions have taken hold, with unemployment claims now surpassing the Global Financial Crisis. A fifty-year low in unemployment (3.5% in February of 2020) seems like a distant memory.

We have spent a lot of time analyzing event-driven (e.g. 2011) vs. secular recessions (e.g. 2001 & 2008). The understandable takeaway is that, for the markets at least, the duration of a recession matters more than the depth. So, while we are seeing the sharp retrenchment in economic activity manifested in the incoming data, at this point we continue to define the pullback as event-driven, and therefore finite. Should this quarter prove to be the trough in economic activity (2nd quarter US GDP may show the steepest contraction in history), the directional movement will go a long way to boost animal spirits.

Finally, and quite simply, we will be watching to see if the historic policy response to the pandemic works. The fiscal response to this crisis dwarfs the Global Financial Crisis in terms of size and speed (Congress has passed three economic support packages worth over $2 trillion). Not to be outdone, the monetary response has been equally impressive (the Fed’s balance sheet will shortly be more than three times larger than it was in 2008). We expect more stimulus in the weeks ahead, but we suspect the political climate for more relief and/or stimulus may be more contentious. Regardless, for the market to recover further it will be important to see tangible signs that what is already in place is working, and that the commitment to accommodation remains.

Fundamentally, we will be focusing on the trend in corporate profits and credit metrics. Over the past couple months, companies have shuttered stores and production, announced cost-savings actions, suspended buybacks/ dividends and tapped credit lines. Visibility remains low and management teams have almost unanimously pulled forward guidance. The net effect will be the largest earnings decline on record. However, markets tend to bottom as quarterly profit growth does, and right now investors are questioning if that trough will be this quarter (2Q) or next (3Q).

We monitor credit closely as a risk metric and measure of liquidity. The credit backdrop has improved, but corporate bond spreads vs. Treasuries are still elevated. Currently, high yield or junk bonds yield over 7% more than Treasuries (lower than the March 23rd stock market low of 14%, but higher than February’s stock market high of 4%). Further improvement in spreads would go a long way towards signaling a more stable investment climate.

Technically, reviewing market internals will be influential to our positioning. Market breadth (a measure of participation) and relative strength carry significant weight in our work. The improvement in relative performance of small-cap stocks in the back half of April boosted overall market breadth. Simply stated, the average stock is starting to participate more in the recovery. The top five stocks in the S&P 500 represent the highest weighting ever, and narrow markets tend not to last, so this is a welcomed development.

The relative strength of various asset classes, sectors and industries will also help guide the way. The best performing sector since the March 23rd lows has been energy, a deeply cyclical (economically sensitive) group. The worst groups have been telecom and consumer staples, both historically defensive sectors. Should investors continue to reward these portions of the market, confidence in the recovery will be emboldened. Currently, our short-term metrics in a neutral position while long-term trends remain negative but are healing. While a deep, prolonged technical retrenchment (a la 2001 or 2008) was never our base case, we continue to see a challenging workout period. We expect a complex bottoming process with a number of jerky, erratic, and volatile moves.

Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. We have remained active in our strategies, holding a de-risked posture while opportunistically deploying capital. Cash levels are elevated, but are below those levels held during the peak of the crisis. Should our base case hold, we plan to use the volatility emanating from the collision between better pandemic data and poor economic numbers to re-engage further. Of course, should the backdrop not stabilize, we will take a more defensive stance.

The road back exists, but it won’t be a straight line. The next few weeks will be influenced by virus-related news flow, and specifically reports of economic traction regarding re-openings. Headlines related to additional policy support and the tail end of earnings season will also carry significant weight. 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 reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments. Stay safe.

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