We are ready to stop using the word “unprecedented” when discussing the financial markets. This year’s “unprecedented” hall of fame includes the historic fall off (and corresponding recovery) in economic activity, the sharpest bear and bull market in history, the widest performance gaps between growth and value stocks on record, historically low bond yields and, lest we forget, the greatest (and quickest) policy support ever. And the year is not even over! We are confident a vaccine can take us from pandemic to panacea, towards normalcy and away from, yes, these unprecedented times.
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. Since the beginning of the pandemic we stated that the retrenchment in economic activity, while necessary, is self-inflicted, not structural, and prone to snapping back as re-opening resumes or vaccines enter the narrative (see The Road Back, Resilient, or Delusional?, Escape Velocity, Navigating the K-Shaped Recovery, Election Vexation and Back To Basics 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. We noted that investors are beginning to discount what the backdrop may look like six-to-twelve months from now, a time when worries of today are an afterthought.
November was the tenth best month in the past seventy years (+10.7% for the S&P 500). Coming off the consolidation in September-October, markets sprang to life. Resolution of two issues that had been keeping investors jittery and anxious, politics and the pandemic, was the catalyst. We aren’t out of the woods yet, but one way or another, we are close to settling the political debate. And, arguably more importantly, we are inching ever closer to a widely-distributed vaccine that should go a long way toward restoring some of the normalcy that has disrupted so many lives. The recent resurgence and corresponding shut-ins are a reminder that the process will take time, but it is our belief that return-to-normal is closer than not.
We suspect that as the year closes out investors will continue to 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. This extraordinary year of 2020 will soon give way to one where investors focus on more traditional factors.
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, influenced by our recessionary and bear market views, and are increasingly painting a more optimistic picture (positive).
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 by the Fed to highly-accommodative policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. They will continue to be tailwinds. As the stock market reached new highs last month, interest rates climbed higher and yield curves steepened. While the Fed is anchoring short-term interest rates, longer-term rates are sniffing out a recovery and are pushing higher. Inflation expectations increased and the dollar continued its weakening trend, both encouraging signs of a global economic recovery.
Political uncertainty remains, particularly as it relates to the Senate picture, but the worst outcomes for the market seem to have been avoided. Divided governments historically have the best long-term return profiles. There are growing concerns that the US recovery may lose steam without further fiscal stimulus. We continue to believe another stimulus program will be agreed upon, and it will help to bridge the gap between economic reality and wide-spread vaccination. Consensus forecasts for global GDP growth in 2021 is almost 6%, the highest since 2010.
The current technical backdrop remains in good shape, although many of the short-term metrics we monitor are a bit stretched (e.g. put-call ratios are low, the percentage of stocks trading above key moving averages is high, etc.). Encouragingly, market breadth is expanding with smaller names catching up to their large-cap peers. The highly concentrated nature of the market has started to ease. A broad market is a healthier market, so we welcome this development.
Rotation amongst asset classes is almost a daily occurrence. The much-maligned value and cyclical growth sectors are slowly making a comeback as inflation pressures return. We note there is ample room for continued improvement on the small-cap and value side of the rotation debate. Despite the move back to all-time highs, we think investor sentiment is not euphoric. There are still trillions of dollars 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 well in to 2021. 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. Dividend reinstatements (or increases) are now running well ahead of dividend cuts. As corporations confidence in their outlook continue to improve, we expect share buybacks to follow.
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 extent of those allocations (or, tilts) are predicated on the continued move away from, or an inoculation of, the “unprecedented” backdrop of 2020.
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.
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