After gains in the preceding five months, September posted the first down month since the market bottomed. While the consolidation of recent gains was natural, we suspect the associated volatility got an added boost from this year’s election developments. The agendas of the candidates are getting plenty of airtime, and rightfully so. After all, their policy priorities will indeed have economic consequences. However, we see bigger forces in play. It will be important for investors to sift through the noise and stay focused on the real, sustainable drivers of risk and return.
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, and Navigating the K-Shaped Recovery here).
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. During election cycles, this discipline becomes important as the noise level rises. 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).
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 last month, partly on growth concerns, interest rates, yield curves and the US Dollar were stable. We believe that had a lot to do with the monetary ‘backstop’ in place.
There are growing concerns that the US recovery may lose steam without further fiscal stimulus. The recent passing of Supreme Court Justice Ruth Bader Ginsburg and the process of confirming her replacement now adds a new dimension to the political landscape and could re-shape stakes in a number of key Senate races. We will be watching closely. Election-related volatility is sure to pick up as the days tick by, but, like most elections, it will most likely play second fiddle to the economic backdrop (click here to register for our upcoming election webinar).
Technical trends have improved significantly from the March 23rd lows but have further work to do. Large-cap stocks (particularly mega-cap technology stocks) have been doing the heavy lifting, but, as the past few days have highlighted, 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. Investor sentiment remains subdued (a good thing). There is still over $1.5 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. Visibility remains limited (more than half of the companies in the S&P 500 have withdrawn guidance), but is improving as reopening gains steam. 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 more than halfway back to their pre-crisis levels. 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.
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.