A volatile third quarter of 2019 has come and gone. Despite ongoing fears regarding trade, attacks on Saudi oil facilities, more Brexit drama, problems in the repo market, and, finally, the possibility of impeaching the President of the United States, the American economy is holding up well in relative terms. The S&P 500 managed to register a small gain over the summer months while the small-cap laden Russell 2000 posted a small loss.
Many of the themes we have been highlighting continue to push and pull on investor sentiment. We believe trade-related headlines are proving to be the most influential with daily swings between the prospects of a new cold war with China and hope for a more congenial resolution. We place higher odds on the later, but our patience is being tested. Coming into the summer, our disciplines were tilting positive and we felt the market had room to run. We also noted that while the pace of returns should slow, bear market or recessionary conditions simply were not prevalent (see Trade Tirade here).
Currently, our short-term metrics are bouncing back and forth between positive, neutral and negative (neutral as of this writing). We continue to expect choppy and erratic trading as investor anxiety levels are elevated, particularly surrounding the macro backdrop. Encouragingly, longer-term metrics remain positive. While the S&P 500 is only a few percentage points from another all-time high, there is a noticeable absence of bulls. We continue to note one of the most positive aspects of this market is the overwhelming lack of optimism from investors (e.g. AAII bullish levels are muted, cash levels are elevated, positioning is decidedly bearish, etc.).
We are cognizant of the fact that this bull market (and economic expansion) is setting records for duration. However, in the capital markets at least, age really is just a number. There will need to be a notable deterioration in the fundamental backdrop for true recessionary or bear-market conditions to develop, and that is not our base case. The opportunity for a volatile mid-year stretch giving way to calmer seas, particularly if the volatile macro backdrop ebbs, should not be overly discounted. But, clearly, further gains won’t come easy. 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.
The technical trends have remained uneven with choppy short-term metrics offset by more supportive longer-term reads. When looking at bottom-up trends, 61% of the S&P 500 constituents are trading above their longer-term 200-day moving average (a healthy level) while shorter-term averages are showing some pressure as just 18% of stocks are above their 20-day moving average. Market breadth (a measure of participation) has been pressured by the lack of small-cap participation. The relative performance gap to large-caps is the widest since the Great Recession. We expect to see that gap close when the macro volatility subsides. This will, in turn, improve market internals and bolster our short-term outlook.
Despite all the macro volatility, there has been little change to revenue and earnings estimates over the past several weeks. Growth rates have slowed, but they remain positive and speak to corporate resiliency. We expect both revenues and earnings growth rates to pick up as the year progresses. Company valuations are neither expensive, nor cheap. There are pockets of over- and undervaluation, but on balance we don’t see valuation as a catalyst although lower interest rates have historically helped (e.g. more than 60% of stocks in the S&P 500 yield more than 10-year Treasuries). We find the rejection in the public markets of some private market valuations prudent (e.g. WeWork). Credit metrics remain supportive with corporate spreads to Treasuries remaining at supportive levels.
We expect global growth to slow to around 2.5% (from 3.5% last year) but believe most major economies will continue to avoid recessionary conditions. The historic move lower in global bond yields over the past few months reflects a significantly more pessimistic outlook. In fact, there is now roughly $15 trillion in negative yielding sovereign debt. For reference, the figure stood at $6 trillion a year ago and reached as high as $17 trillion in just the last month. We don’t take the corresponding inverted yield curves lightly as they are a powerful signaling tool, but our “slower, but not recessionary” narrative remains in place.
The incoming economic data does suggest that the slump in industrial manufacturing and trade has spilled over into the wider economy. However, the labor markets remain resilient and not all survey data last month was gloomy (e.g. housing data, wage data). Like the 2015-2016 slowdown, lower rates are helping; last year the average yield on the 10-year Treasury was 2.9% vs. 2.2% this year. in light of the economic softness, the Fed continued to loosen monetary policy last month with its second interest rate cut this cycle.
We have kept our strategies relatively tight to our benchmarks and remain comfortable with our exposure levels. Market action over the next several weeks will continue to be heavily influenced by trade-related news flow (the US and China are meeting this week) and central bank meetings (we expect dovish signals from the Fed and ECB over the next several weeks). Market technicals will play an important role in determining how the balance of 2019 plays out. While the flirtation with rotation was violent in September (e.g. into value stocks from growth, into small-caps from large, into international from domestic, etc.), our best guess is that such a move will be fleeting until investors are confident that global growth expectations have bottomed. We will continue to monitor the technical developments and use the output to help drive our strategy positioning and risk profiles.
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.