The answer to the question posed above depends on your frame of reference. In the picture, do you see an old lady, or a young girl? Or both? This picture is one of the most famous optical illusions and usually requires a long stare to see both sides. This market is no different. With all that is going on, it is easy to see how many smart investors can come to completely opposite conclusions about the state of the market. “Justifiably resilient! Delusional to the risks!” The BakerAvenue investment team has had more than one conversation debating the merits of each over the past several weeks. The sharpest bear market in history (-20% in twenty days; -30% in twenty-two days), followed by the sharpest rally in history (+40% in fifty-three days), will test anyone’s outlook.
To remove the suspense, we’ll say up front that the market’s resiliency is warranted. And as fiduciaries, that’s a conclusion we don’t take lightly. Amidst a global pandemic, heightened trade/geopolitical tensions between the US and China, unemployment at eighty year highs, rising uncertainty in regards to the upcoming elections, and protests in nearly all major US cities, it is also justifiably debatable. For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and potential opportunities. We have previously stated 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, and The Road Back here).
Over the past several weeks, as headlines related to the virus have improved (or, more specifically, turned less bad), a sense of optimism has returned. Investor focus has rightfully shifted from infection to economic trajectory (they are clearly linked). While we believe infection rates have crested, uncertainty regarding the reopening remains. And that’s where the justified resiliency comes into play. By our work, optimism regarding pandemic trends are justified, while continued economic uncertainty makes the move higher a resilient one. Importantly, not delusional.
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. Our disciplines exited May in better shape than April (and April was better than March, in aggregate). Accordingly, while we maintained some prudent conservatism in exposure levels, our positioning has turned more optimistic. Our interpretation of the market going forward will continue to be defined by the output from our disciplines.
Let’s start with the macro backdrop. Continued improvement in virus infection and mortality rates are a must. As the world’s 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 the pandemic is cresting, broad skepticism about the prospects for a V-shaped economic recovery remain. We believe the worst of the economic contraction occurred in April, but May’s recovery only reverses a small fraction of that retrenchment. Odds are this quarter will show the steepest contraction in modern history, but most investors are focused on directional improvement. As such, interest rates have ticked higher, yield curves have steepened and the US Dollar has sold off.
While markets have been focused on the growth outlook recently, we believe that monetary and fiscal policy will remain a key driver of the market rebound. The Fed’s balance sheet is now three times larger than it was in 2008, and they got there in record time. The fiscal response to this crisis has been equally impressive and dwarfs the Global Financial Crisis in terms of size and speed (Congress has passed four economic support packages worth almost $3 trillion). All of that liquidity has been added to the capital markets at a blistering pace.
Once we move past directional improvement, we believe investor focus will soon shift towards how long it takes to get economic activity back to pre-pandemic levels. Here we are a bit more guarded and suspect more of a U-shaped recovery. We believe intensifying US-China tensions have increased trade uncertainty but, much like last year’s trade war, will ultimately avoid the most dire scenarios.
Fundamentally, we will be focusing on the trend in corporate profits and credit metrics. Mirroring the economic contraction, we suspect the pullback in corporate profits troughed in April. Visibility remains limited (more than half of the companies in the S&P 500 have withdrawn guidance), but it is improving as the reopening gains steam. In a testament to sustainable high margins, despite the largest earnings decline on record, the S&P 500 is set to earn more at the trough of the this crisis than it did at the top of the mid-2000s housing bubble.
We monitor credit closely as a risk metric and measure of liquidity. The credit backdrop has improved with both investment-grade and high-yield spreads more than halfway back to their old pre-crisis levels. Continued tightening here is consistent with the ongoing rally in stocks. Capital raises (e.g. secondary offerings, corporate bond issuance) have exploded as balance sheets are fortified.
Valuations are stretched with the S&P 500 now trading north of 20x forward earnings. Sector and industry valuations differ, of course, with a record amount of dispersion (last month the top 20% of the S&P 500 traded at 27x vs. 9x for the bottom 20% - the widest in 20 years). The move off the March 23rd lows has been entirely driven by valuation (multiple) expansion. We get the sense now is the time for earnings growth to take over.
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. Both are showing signs of improvement. The improvement in relative performance of small-cap and value stocks has boosted overall market breadth. Simply stated, the average stock is starting to participate more in the recovery. A month ago the top five stocks in the S&P 500 represented 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 are in a neutral position, while long-term trends, which are influenced by our recessionary and bear market views, have healed (also neutral). While a deep, prolonged technical retrenchment (ala 2001 or 2008) was never our base case, we did expect a more complex bottoming process than we have seen thus far. Pull backs and consolidations have been few and far-between.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. We have remained active in our strategies, opportunistically deploying capital while keeping cash levels somewhat elevated (our cash position is well below those levels held during the peak of the crisis). Should our base case hold, we plan to use any pandemic-related volatility to re-engage further. Of course, should the backdrop not continue to stabilize, we will take a more defensive stance.
We would be remiss not to comment on the movement sweeping the nation. It goes without saying that racism has absolutely no place in any society. The folks at BakerAvenue believe we must tackle this issue head on and fight to make this country a better place for everyone (read our CEO Simon Baker’s statement here). We also wish to express our sincerest concern for everyone impacted by the pandemic. With lives and businesses still at risk, we hope that conditions continue to improve as quickly, and as safely, as possible.
The market has been resilient, and we believe justifiably so. It’s not lost on us that, like the picture, if you stare at it long enough you might get a different view. And that, in turn, will keep us busy over the next few months. The next few weeks will be influenced by virus-related news flow, and specifically reports of economic traction regarding re-openings. Headlines related to geopolitics and corporate earnings 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.