Recently, one of our co-workers here at Burrows Capital celebrated the birth of her baby (as did we - woo hoo!) and it couldn’t help but remind me of my favorite book to read my own children when they were little – Goodnight Moon by Margaret Wise Brown. The book opens with the following (somewhat condensed for space):
In the great green room, there was a telephone
And a red balloon, and a picture of
The cow jumping over the moon
And there were three little bears sitting on chairs
As January unfolded, I couldn’t help but think of this opening in terms of the markets (my apologies in advance for the potential corruption of this wonderful book) and what the team here sees in the markets. The great green room is the markets finding ways to paint my screen green, The telephone is the calls we get asking us how to position for the great green room. The red balloon is the Fed (and other CBs) and the environment/business cycle position. The cow jumping over the moon is the “Magnificent 7” or tech generally. The three little bears sitting on chairs is our team looking at the great green room versus the red balloons and unable to “buy in” to the market’s story.
The Great Green Room
In January, the equity markets once again painted our screens with green, well, except for small caps and emerging markets, as the market continued to find its footing for a higher climb despite the red balloons.
Within the equity market, growth outperformed value, and large caps outperformed both midcap and small caps.
Unfortunately, the majority of the fixed-income market was not on the same page as equities and nearly every sector provided negative returns. This occurred as longer-dated Treasury rates increased, and the price impact wasn’t offset by the (marginal) spread tightening that occurred.
The move in Treasury rates was not, however, a parallel move as the belly, or intermediate, maturity range of the Treasury curve (where we are predominately positioned) outperformed.
The Red Balloon(s)
Would a note of caution be replete without a mention of the Fed? Like it or not, we don’t believe so. As we spotlighted in an earlier publication (The Fed Conundrum) the market continues to be ahead of the Fed (as measured by the Summary of Economic Projections – “SEP”, or the projections of each individual participant, not the FOMC as a body). With the exception of the March 2024 rate expectation, Federal funds futures implied rates closed January near where they started – despite the Fed restating their view differed. As the SEP does not include meeting by meeting, but rather annual projections, the lack of movement by the market towards the FOMC projections is a concern to us. The following chart shows the progression of the implied rate during January for certain meeting dates.
Consistent with our opinion published in multiple publications last year (an opinion unchanged since then, even after considering valuations and data), we believe the “cow jumping over the moon” is also a red balloon.
Then there is the cow jumping over the moon, which to us is a red balloon. While many view it as only the “Magnificent Seven” we also see it in the tech laden NASDAQ 100 Index.
It is worth noting that whilst we hear of comparisons between today’s tech market and the dot.com era (which some of us will never forget if for no other reason than the television commercials for these companies leading up to the inevitable bloodbath), we aren’t taking that bait for two primary reasons:
- The price earnings multiple is significantly lower than the dot.com bubble days. The current market does not appear as frothy and reminiscent of the 1600s tulip mania.
- The companies leading the charge higher are companies with an actual product, actual cash flows, and, for the most part, viable businesses. They are not dot.com or “blockchain.com” companies.
While we view the lofty levels of these indices as “troublesome”, we view the concentration within the S&P 500 a bigger factor, as it is a whopping 28 percent of the index. If the tide goes out, the S&P 500 goes with it. This can be shown by the difference between the equal weighted S&P 500 (”SPW”) and the market capitalization weighted S&P 500 (“SPX” the way the index is calculated).
Of course, concern isn’t solely confined to equities. The current risk premium for corporate bonds is below average and could have the momentum to go even lower (there is strong demand for spread product and corporate bonds, in particular. While this is a concern to us as “tighter” spreads (lower risk premiums) imply lower risk – somewhat odd as we are headed toward a weaker economy and significant maturities that will have to be financed at higher rates - we still like corporate credit due to the cushion it provides (the spread and resultant coupon/yield) and the satisfactory condition of corporate balance sheets.
There are, of course, other red balloons we are watching and trying to gauge the impact upon the economy and, therefore, the markets. Among these are:
- The conflict in the Middle East and the potential for its expansion into a more regional conflict.
- The targeting of ships in the Red Sea (as the result of the above, and a contributor to the above) as ships are now routing around Africa, adding time and costs to delivery, which is ultimately inflationary.
- The Chinese stock market is currently troublesome (and has been for a while). While many dismiss it as an emerging market, one must realize that it is approximately 3% of the MSCI All Country World Index, a higher weight than countries Such as France, Germany, or Canada.
- The US presidential election (among other countries) has the potential to add volatility as campaign promises are made (whether they are ever kept is a different discussion).
The Three Bears, sitting on chairs
Whilst not truly bears, per se, we are not as optimistic as many. We see the red balloons and believe they will impact returns in the near-term. As a result of this viewpoint, we believe in taking some risk off the table. This is not to say “sell large caps and buy a bunker” (although a good bunker is hard to put a price on), but instead, simply dial back some of the risk of the portfolio. We have tilted to value within large cap space, remain at weight to slightly overweight midcaps and small caps, and overweight fixed income (predominately in the intermediate sector of the curve) with a bias towards spread product (corporate bonds and mortgage-backed securities). The ability to tactically shift a bias – not to make a bet - in a controlled and pre-defined fashion, allows investors to stay diversified whilst tweaking the risk profile of their portfolio. Survey the room, note the red balloons, ignore the noise, and focus on the long game – in short, have a plan.
With that, we will leave you with the final three lines of Margaret Wise Brown’s wonderful story:
Good night noises everywhere
The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.
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