To be clear, we are talking market leadership, not Washington leadership. But they are related. Despite the increase in new infections, the Democratic win in the Georgia runoffs, combined with the OPEC oil supply cuts and stronger-than-expected economic data, has provided support for further rotation across and within asset classes. Small-cap stocks have continued to lead their large-cap brethren, cyclical and value pockets of the equity market have led long-time winners growth and momentum, and ten-year interest rates have broken above 1% as inflation forecasts have ticked higher. It’s a new year, but already there are signs new leadership is taking hold.
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, Back To Basics and Inoculating The Unprecedented 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 the worries of today are an afterthought. We expressed confidence that a vaccine would take us from pandemic to panacea, towards normalcy and away from these ‘unprecedented’ times.
That optimism was picked up by the market with further gains in December to close out a volatile, but profitable year (the S&P 500 was +3.7% in December, and +16.5% for 2020). A highlight of the ‘risk-on’ rotation, small-cap stocks posted their best quarter in history (the Russell 2000 was +30.9% in the fourth quarter of 2020). Of course, this comes in a year where they also had their worst quarter ever (-31.0% in the first quarter of 2020). The year’s best performing sectors and asset classes stalled out (e.g. technology, consumer discretionary, momentum, etc.) and former laggards picked up relative strength (e.g. materials, financials, economically sensitive groups like energy, etc.). Investors further embraced the idea that a return to normalization is at hand, spurred on by vaccination hopes and historic fiscal support.
One of the most enduring features of the past several years has been the secular outperformance of growth stocks vs. value and, to a lesser extent, defensives relative to cyclicals. There have been rotations, but these have generally been short-lived. The drivers of these long-term trends have been the combination of low interest rates, low inflation and economic growth, coupled with the extraordinary success of the technology sector vs. ongoing headwinds in the financial and commodity sectors. The gap started to close at the end of last year, and we noted there is ample room for that rotation to continue. We are sticking with that view.
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 analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends, influenced by our recessionary and bear market views, 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, a series of 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 well into 2021. While the Fed is anchoring short-term interest rates, longer-term rates are sniffing out a recovery and are pushing higher.
Inflation expectations have increased, and the dollar has continued its weakening trend, both encouraging signs of a global economic recovery. Inflation has been relatively non-existent since the Global Financial Crisis (arguably for 40 years) and is worth watching in 2021. Right now, broad measures of inflation look contained and, at these levels, we welcome any narrative shift from deflation to inflation. After all, Treasury yields have been in a bull market for nearly 40 years since peaking at 16% in 1981.
Political uncertainty remains, but we think a new era in Washington has more to do with positioning than the market, in aggregate. The Georgia Senate runoff was a game-changer from a fiscal spending point-of-view. In short, we expect more. The further stimulus will help to bridge the gap between economic reality and wide-spread vaccination. According Bloomberg, consensus forecasts for global GDP growth in 2021 is almost 6%, the highest in many decades.
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, and the highly concentrated market of 2020 continues to ease. A broad market is a healthier market, so we welcome this development.
Despite the move back to all-time highs, we still don’t think investor sentiment is euphoric; we sense healthy skepticism. There are still trillions of dollars in money market funds and, despite the advance, flows into equities are far below those of bonds and cash. The strong price moves of late increase the odds of a technical consolidation, but we feel pullbacks present opportunities to deploy capital for the long-term.
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Earnings estimates continue to be revised higher and we suspect 2021 will end with profit levels at record highs. Valuations are stretched in some pockets of the market, but only slightly above long-term averages in others. Valuation dispersion is at record levels with a big gap between “haves” and “have nots.” During this rotation, it’s the “have-nots” that have benefited most. It is worth noting that historically low interest rates make the earnings yield offered by stocks attractive relative to bonds and provides a strong counter-point to any valuation concern.
The credit backdrop has improved with both investment-grade and high-yield spreads starting the year 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. Many of those assets are rotational beneficiaries. 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.
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