October kept its reputation as one of the most volatile months intact, further consolidating a pullback that started in September. The market has been restless and agitated over the past few months as headlines related to the pandemic and politics sucked all the air out of the room. However, we believe the associated volatility may have peaked with a path for resolution on both fronts. One way or another, we are close to settling the political debate. And, arguably more importantly, we are inching ever closer to a vaccine that should go a long way toward restoring some of the normalcy that was disrupted by the virus.
We suspect that as the year closes out investors will once again refocus their energy on the key pillars of stock market returns, building blocks that define long-term risk and returns . Virus influence will wane, but metrics like growth and valuation will be here forever. Presidents will come and go, but interest rates and technical strength will forever play a role in investing. We welcome the move back to the basics.
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 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 as social distancing guidelines are lifted (see The Road Back, Resilient, or Delusional?, Escape Velocity, Navigating the K-Shaped Recovery and Election Vexation here). We also wrote last month that during election cycles , it is important to maintain a disciplined approach to investing. When it comes to investing, there are more important considerations than who sits in the Oval Office.
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 macroeconomic market analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends, also neutral, are influenced by our recessionary and bear market views and are increasingly painting an optimistic picture.
For us, the macro discussion centers around policy. The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low interest rates, government support packages and a commitment to highly-accommodative policies buffeted the pandemic shutdowns and laid the groundwork for a recovery. While the stock market retrenched again last month, interest rates and yield curves were stable. We believe that had a lot to do with the monetary ‘backstop’ in place. The Fed has stated numerous times that they will remain accommodative, regardless of political volatility (or, in spite of).
There are growing concerns that the US recovery may lose steam without further fiscal stimulus. Political uncertainty remains, particularly as it relates to the Senate, but the worst outcomes for the market seem to have been avoided. Divided governments historically had best long-term return profiles.
Technical trends have improved significantly from the March 23rd lows but have further work to do. For most of the recovery, large-cap stocks (particularly mega-cap technology stocks) have been doing the heavy lifting, but, as the past few days have highlighted, they remain vulnerable to profit-taking. There is ample room for improvement in the small-cap and value side of the rotation debate. We will be watching to see if the recent pickup in market breadth (a measure of participation) continues. Despite the move back to all-time highs, we think investor sentiment remains subdued. There is still over $1.0 trillion in money market funds and, despite the advance, flows into equities remain negative year-to-date.
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Mirroring the economic contraction, we suspect the pullback in corporate profits troughed in April. For the past two quarters, earnings reports have surpassed projections by more than 20%. We expect the upside surprises to continue. Valuations are stretched in some pockets of the market, but only slightly above long-term averages in most. Of course, historically low interest rates make the earnings yield offered by stocks attractive relative to bonds and provides a counter-point to valuation concerns. The credit backdrop has improved with both investment-grade and high-yield spreads closing out the month at levels not seen since the beginning of the pandemic. Because continued tightening here is consistent with a rally in stocks, it was encouraging to see little movement (widening) in spreads as equities sold off last month.
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. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to hold our positioning steady. Of course, should the backdrop start to de-stabilize, we will take a more defensive stance. The building blocks will play an increasing role for us in determining those allocations.
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.