Cirrus Market Outlook: Q4 2023 Soft landing and interest rate risk point to a Value tilt.

Soft landing and interest rate risk point to a Value tilt. A rebound in earnings expectations and better-than-expected economic data have been hinting at a stabilization in the profit cycle. While a bottoming profit cycle is critical to a fundamental shift away from Growth to Value, a spike in rates is the accelerant to a break in speculative strategies and the turn to a value-sensitive swing.

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The information contained in this Podcast report ("Podcast") is based on sources we believe to be reliable at the time it was produced and distributed but it is not necessarily complete, and its accuracy is not guaranteed. Neither Cirrus nor any of our affiliates or any other person makes any representation or warranty, express or implied, as to the Podcast 's accuracy, completeness, or correctness. To the maximum extent permitted by law, neither we, any of our affiliates, nor any other person, shall have any liability whatsoever to any person for any loss or expense, whether direct, indirect, consequential, incidental or otherwise, arising from or relating in any way to any use of or reliance on information contained herein. This Podcast is not a research report, solicitation, or offer, to buy or sell any security or claim and is being provided solely for informational purposes. Nothing in this Podcast constitutes legal, accounting or tax advice or individually tailored investment advice. Any opinions or estimates contained in this Podcast represent our judgment at the present time and are subject to change without notice. Cirrus has no obligation to advise you of any such changes.This Podcast was prepared for general circulation and without regard to the individual financial circumstances and objectives of persons who receive or obtain access to it and it may not be suitable for all investors. No one listening, receiving or accessing this Podcast should make any investment decision without first consulting his/her own personal financial advisor and conducting their own research and due diligence, including but not limited to carefully reviewing any applicable prospectuses, press releases, reports and other public filings of the issuer of any securities being considered. There is not enough information contained in this Podcast to make an investment decision and past performance should not be taken as an indication or guarantee of future results. Third-party trademarks, logos and brand names contained in this Podcast may be the trademarks, registered trademarks or other property of their respective owners. Any use in this Podcast of trademarks, logos or brand names is for identification purposes only and does not imply or express any sponsorship, affiliation or endorsement by the respective third-party owners of this Podcast, or vice versa, or that any such third-party owner has authorized the use of its trademark, logo or brand.

Transcript

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Welcome to Market Elevation is Cirrus Research Podcast. Market Elevation is a casual and compelling conversation amongst market insiders made up of equal parts expertise, relevance, and this is Satya Pradhuman of Cirrus Research, and welcome to this episode of Market Elevation. In this episode, we walk through the Cirrus Research House View, a lot of the focus has been on the profit cycle, our work suggests that the profit cycle of spheres to be stabilizing and forecast appears to be climbing. This implies a very different market going forward the next 612 months. Some of the discussion in this will evolve around this idea about a rotation from growth to value from larger stocks, at least to slightly smaller stocks. In addition to that, some of the implications for active management, the the opening of this year has been awful for some of the active comparisons, what changes if we begin to move more towards an earnings driven market? Then finally, stepping back and looking globally at market? Relationships? The idea of the anything but China trade, Will that continue. And that's really a focus on markets that really can benefit as investors begin to shun China, as the economic comparisons in China continues to slow, where do they go. And we really hope you enjoy this episode, do take a look at the full quarterly outlook that really accompanies this call. That's the Cirrus Dispatch. Thank you the title of this report, soft landing and interest rate risk, point to value tilt. And today, what I'm going to do is really walk through several key points defending why we think there is a real change underway year to date, we've seen a dramatic breakaway of the largest or so seven technology or technology related stocks, the rest of the market has really lagged quite a bit. We've seen over 1000 basis point edge, favoring large caps over small, a massive gap has also opened between large growth and small growth, to no have to really no surprise, we've seen a very, very, a very tough relative performance environment for active management. So some of these changes that we think might be underway, not only will affect I think the rest of the year, but this goes well into 2024. So here, we're going to frame out really the risk to leadership, the extended Fang growth run, as we've seen the air close. Also, we like to be able to defend the profit cycle cycle is stabilizing. And you know, begin to freely use the term soft landing, we've already been doing it. But I think this is still a jump ball in some people's minds. And I think we need to sort of address that. In terms of this value rotation, how severe what are the contours? What are the side effects. So we'll walk through some of those items. One, one critical area, though, is this area of active management that our our model, performance numbers really echo what we're seeing in the real world, the active large cap growth results have been just downright awful. And I'll try to walk through some of those. Some of the reasonings behind that and why there is, I think, legitimate reason for hopes going forward here to that for this to turn around. In addition to that outside of the US, we definitely want to focus a little bit on the global profit cycle as well. And this leads us to sort of like the ABC strategy, as we've been calling it or the anything but China's story. So we'll walk through, you know, what are the key implications of what we're seeing there, this divergence between the East and the West. And then finally, focus a little bit on one of the special topics on housing home builders, we'll try to walk through what's been going on there a lot of weakness given the recent interest rate moves, but to some degree, we think there's still a real opportunity to buy and not sell. So let me start really with the punch line. And that is, if we're right about some sort of a value rotation. Our active strategies are going to have to recognize evaluations become more important as we go forward here. And so this, when we look at the active blends that the Cirrus blends that we're running, we run traditionally three active growth blends, so they are aggressive growth, Garp, and quality growth, given what we're thinking, the shift We're going to be making is really moving from a quality growth bias, which we've had for well over 18 months, almost two years. I think that that now shifts over the guard the Garp model. Similarly, in the value arena, what we're looking at is moving from a quality value to a relative value stance. And so at the end of the day, evaluations matter more, the Garp model has a higher weighting. In terms of valuation exposures, we are going to lose some of the emphasis on earnings visibility. But at the same time, we put we put a little bit more focus on business momentum, and more on valuations. The aggressive growth model has probably worked the best here trending factors have really taken off in the larger growth arena. We think if we're right about this potential rotation of value, this, this strategy becomes probably believed the laggard in in the marketplace to be seen. And then the other question, though, is that if we're beginning to lean value, in a why not deep value, why not? Why not go pure. And the reality though, is that what we're not coming out of is a deep recession, what we're coming out of potentially is a slowing in the profit cycle, never going into a recession, and therefore, looking to some sort of profit expansion. In other words, whatever we're seeing on the profit cycle, it is less week potentially stabilizing, not dramatic, sort of deep cyclical bounces. So the deep value model really doesn't deserve this sort of focus that you could see if we were indeed, looking at a true blue, deep value sort of rotation. That's not really the situation as far as we see it here. The coverage chart from the report, we thought this made was definitely cover worthy in using a Seinfeld phrase. The idea here is that interest rates, interest rates, interest rates, we've seen a bear market in the bear bond market in the last few months. If you look at the purple curve, it's basically backed up. It's gone from like, let's say at the low end of this year at about 3.4, to about 4.5 4.6. Even climbed up well into 4.8. Temporarily. This is over 100 basis point backup in the 10, year 10 year. What we've seen overlaid here is the growth of value bias. At the heart of this is that in the last several months, as this has intensified, we've seen the market really give back, probably a net in the larger cap rate of 5%. And we've started to see some quiet rotations going on not consistently, but roughly about a 300 basis point 400 basis point advantage of value over small cap growth. So that is something that is that's very different from the way the first six months of the year, had turned. And so the question is, you know, what's the likelihood that this is just a fluke, and, you know, very short term in nature. Another way to think about this is the markets run so much, you had to have some sort of a pause. It really, if we think about this, several things come to mind. Number one, we really do have historically tight labor markets. What you're seeing right now with the amount of strikes, these are all basically pricing effects on a service economy. And so it's exactly why the tone of the Fed has been to be a lot more wary and really watchful over the economic comparisons that are coming through. So this idea about an interest rate relief, we've been using that term relief quite a bit this year, which is this sense that since the first quarter, I also think probably the real reason that it really triggered this sort of like, nifty seven type of move was that there was a hope in the first quarter that the US economy was going to plunge into a recession, given the historic and historic rate of tightening that the Fed had really pursued. You know, several quarters later, we're like that is not a rate cut is not a 23 event, potentially it's a 24 event, but at this point, it may get pushed out in the back half of 24. Probably not even the first half of 24. But more or less stories that this interest rate risk is going to remain in place. And in order for high multiples to really stay aloft. You really need a supportive interest rate backdrop in terms of some of the macro elements. The what you're looking at here, in terms of the liquidity regime models that we If we've got, that model continues to signal to the Fed, you know, we really are on a tightening of liquidity, not a relaxing of that. And so even if the Fed interest rate hikes potentially go on pause, they're still continuing to shrink their balance sheets, what we have found historically is that more liquidity is very good for risk assets. So this is something that puts a pause on how excessive multiples can trade. In other words, if we're looking at a profit cycle, that's stabilizing a period in which rates will not come to the rescue, you're looking to more of an earnings driven market. And when we look to the earnings profit cycle, what we're seeing is some sort of stabilization that's underway. When we look at the revenue curves, we've seen, really a rotation or a fade in the top line growth across markets, notably in the US as well. But what we're also beginning to recognize is that the forecast, the forward year, estimates are starting to stabilize, we've had an 18 month window of where earnings estimates had really, really come off sharply, probably for the right reasons. The markets also reacted accordingly in the last year and a half. But what we're now starting to witness is more of a stabilization in the estimates, fewer cuts, in estimates, and quietly a few increased estimates as well. So in general, this is a backdrop that does stack well for fundamentals to start working. And so this is really the very different picture than what we were looking at 18 months ago. One of the one of the signals that we've built out in, in our work in our toolkit is the style oscillator. Simply put, this signal basically moves between a growth overweight and a value overweight. And what you'll notice is really in the last year or so, we've had a severe growth overweight, no surprise, given the concerns of the fallout in the economy, given the reversal of the central bank liquidity that has steadily been in this growth camp. And then know most notably, in the last three, four months, we've really seen a reversal in the growth bias, where we're now at least in this style reading, we're now in a lien value world, this indicator is updated every month, you can it can be found in our monthly report called signals. And that's really one of our macro reports, it puts a bunch of things in there, such as stocks versus bonds, small versus large growth versus value. And what this is suggesting empirically, is that we do have a world in where this is suggesting we begin to add valuation sensitivity to the portfolios. And, you know, just to be really clear, we're not suggesting to growth managers become value overnight, and so on. What I think makes sense, though, is that if you are a growth manager, you're probably likely to focus more on your valuation than you had the last 18 months. And if this is right, that allows you to outperform the growth benchmarks. And for the value manager, I think if you've been on your heels, looking at the most defensive names, in the slowdown in the cycle, this allows you to sort of relax that assumption, and maybe begin to look more in really play offense in the value box. Okay, we'll take a break here, we've just covered really the the changes in the system, this idea that the earnings cycle is starting to reverse, the Fed has probably done quite a bit already in the last 18 months. So what does this lead us to? So this next section that follows really gets into this idea of, you know, if we do move and migrate to a value sensitive market? What does that mean? One of the tougher things to accept is that you're really in a lower returns market. In addition, though, how do some of the risk models that we track? How do they fare and what do they look like in this backdrop, to some degree, I think they're net favorable, the idea that the risk models are not registering an overly speculative moment, that would be very challenging if we were to move more towards a valuation sensitive market, and at the same time, a very, very speculative backdrop. Finally, this section really covers how do we put this changing environment to work? Enjoy. So the question is, you know, what else? What else comes of this moment? What are the implications if we're right? One of the areas that that's, that's that's sort of tough to accept, is this idea that you In a value cycle, we typically see more of a lower returns marketplace. And this is, in other words, you know, there really is no such thing as a free lunch. The idea that more fundamentals are going to matter earnings drive or share prices. That's great stuff, right? Because if you're you're looking at financial statements, you're looking at the company's business line, that should help you figure out where to go. The reality though, is that from a macro stance, and interest rate stance, really a weaker economy, which allows for more some really constructive interest rate backdrop, also allows for multiple expansion markets. And empirically, if you look back at the last 30 years or so, what you'll see is that the market as a whole tends to have a higher annualized return in a growth cycle zone. In the value zone, what we find is that the market as a whole tends to have a lower absolute return. Now, the reality is that, to no surprise, what we've done here to measure this type of statistic is to look at the last 30 years, define, really call out multi periods of performance of growth over value, and that became the growth samples, and vice versa. The reality in the last 30 years, though you've had a very growth heavy world because you've had a disinflationary period that lasted multi decades. That said, though, I think empirically, this is probably closer to the truth, that if you are in a world where the profit cycle is stable to accelerating, there's a good chance not only do you not have an interest rates, supportive backdrop, but an adverse interest rate cycle, where the Fed is potentially concerned with overheating of the economy. And that's really where you get the potential pause on gains in the market, less of a multiple expansion story. So this idea of a of a value run does suggest more of a an active manager benefit. It also does suggest, though, it's a lower returns market that we really should be framing in our outlook. In terms of the other knock on effects, one other model that we run monthly is the size premium model. And what we're beginning to notice is that there was a serious, large cap overweight going back the last 1218 24 months. And what we're noticing is some sort of a reversal of that, maybe I'll be at quite slow, but we have moved out of an extreme overweight in large caps. And now we're in a sort of lean large moment. So things are changing. I do think that this growth, value rotation tends to line up with a size premium. In other words, if you're moving more towards the value market, I think, not to overgeneralize. But one logical takeaway is that you're probably looking at a broader market, more of a fee roll, smaller cap arena. So to some degree, this, this is, you know, to no surprise, I think this is very consistent with what we're seeing. And so take, for instance, the stock bond allocation model that we published each month in the signals report, that model had a record high exposure into the 80%. Going back maybe 18 months ago. What we're seeing is that number has faded this year from the 70 handle down to about a 60% equity allocation. But make no mistake about it. This is an overweight in equities still. So even with the run we've seen, what we're saying is that this model, and it's driven by a number of things, such as credit spreads, which you understand is actually not terrible, is driven by a bunch of relative valuation comparisons. This would suggest that the risk assets are still on the menu. And as a result, even if we do get a sort of like intra market rotation and or break in leadership, this is not telling us to rush to a cash or bond allocation moment. Additionally, risk taking behavior, you know, it has stabilized. And it's recently been on the mend. But at the heart of this, what we're not seeing is a market that's super speculative, where risk appetite readings are well beyond normal. And so this is, I think, really important to recognize that the downside risks tend to be most extreme when When you have a very heightened speculative market, so the question is why, you know, given the dramatic gains of the seven or so stocks and the AI run, why aren't these readings more excessive, and at the heart of this model, is the idea that you've had a lot of stocks punished. And so what you're looking at is a 10% or so gap performance gap between the largest in the large stock index and the smaller names. In other words, a bunch of stocks have been punished in this marketplace. And so this risk appetite reading, is telling us that, you know, as as dramatic as the performance spreads are, we're not sort of a flashing red moment with this measure as well. And then the other very, very important topic that people really tend to focus on is the amount of crowding. Why, because it's just, you know, it's at a gut level, it's a really important thing to understand that, if just a handful of stocks are leading the market, how far, you know, are all market participants going to chase those names. And so our polarization measure is a pretty neat proxy for measuring this. And this model is basically more of a valuation driven model, we basically price, we look at the valuations of the most expensive stocks, and that reading is benign. I'm surprised by this, I think a few months ago, about two, three months ago, we did see this reading get to an extreme. And actually, we've also seen a fairly soft market in last two or three months. And I'm not trying to relate one to the other. I think the bond market had plenty to do with the pullback in the last few weeks and months. But the heart of this model is also telling us that if I look at the leadership basket, leadership basket is it's got in the large cap arena, it's got plenty of technology in there. But it's also quite diverse. It's got the the other larger components of exposure are in industrials and also healthcare. And so this is we're not at a point where this was like the early pandemic moment where interest rates went practically to zero. And it was like a 70% exposure to technology and health care, the most speculative form of health care for that matter. So it is a very different makeup of leadership. So if there is change underway, I don't think there's such a, the more of a, like the classic traditional break, it just doesn't seem like it's in the cards, I think we're still sort of struck, though, by the dramatic moves in the 10 year. And that's really still driving. That's the driving narrative right now in terms of absolute returns. But some of these components within the market market microstructure, they're not flashing red. And I think that's super important to just bear in mind. And so if we move about to this change, and I raised the subject about active versus passive, it's just been a terrible year for active managers, especially in the growth arena, especially in the larger cap arena. And so when we look at our own active blends, because I think they're a good proxy for some of the active results that are out there. What you'll notice is that our large cap, Garp model, as an example, has outperformed the growth benchmark in the last year by about 15%. And when we look at, when we look at the app, sorry, the large cap growth proxy has lagged by by 500 basis points, whereas in the small cap growth arena has actually led its benchmark by about 15%. So the large cap managers have really been under fire, this gap is fairly extreme, they should move together, or at least more in sync. When we look to the value side, we see a very different story. We see in the smaller cap arena, our active blends are outperforming sharply by about 1500 basis points. And in fact, even in the large cap side, they're also outperforming by about 500 basis points. So the bottom line, though, is what we've seen that's made life very painful, clearly are the sort of like very select stocks that have hit, you know, near a double for the year, and the rest of the marketplace. And so when you think about active management in their portfolios, they tend to be a lot more diverse. They're looking they're looking to protect on risk. They're looking for fundamental growth, reasonable valuations. A number of those elements, which just were not on the menu this year. And so as we look for this turn, if there's a broad thing, I do think this is probably going to be one of the most dramatic reversals, we're likely to see where the actual results begin to quietly work. If we look to leadership currently in the larger cap camp, versus the smaller cap arena, what you're going to notice is an interesting makeup where the technology exposures in the upper arena, no surprise, right? It's practically it's a little bit over a third in our trending basket. This is how we would define leadership to just look at a one year trend, measure the top decile of those names and then look at the sector exposures. What's important, though, is Healthcare's there as well in a sizable way. But if you'll notice that the industrial exposure is roughly about a 19 20% exposure in large cap camp. So what this is suggesting is that the market is more diverse underneath it. And if we are right, the fundamentals are actually moving in that direction. And so that's that would potentially support why you don't have this dramatic fallout. But also, it also says that as we get this rotation and valuations begin to matter, the active manager will come back to the forefront. And we've already been seen witnessing a much more diverse mid and small cap portfolio exposure and down cap, the markets been more fundamentally driven. That explains a little bit of what why the smaller cap results have actually been quite good for the year they're active, I should say the benchmark itself has really been punished. So in terms of shifting gears a bit, I wanted to talk a little bit about the global picture and how this sort of fits into the US strategy. And probably the one thing that's really jumped out at us has been really this, you know, as we call it, the ABC strategy, or put another way, anything but China's strategy. When we look at the profit cycle globally, what we've begun to recognize, as we stated earlier, is that the top line growth for most Western markets is that we're starting to see some sort of stabilization, or a less slowdown, less slowdown as we get each reporting period. When we juxtapose that to China, what we're seeing is this fallout in growth, and it seems to be accelerating. Importantly, when we look to the forward year projections, what we're also seeing is that the estimates have really begun to reverse course, in the West, the US is an example Europe is also an example. The Chinese estimates though, even though they've been fairly fairly defensive, we continue to see more of a downward pressure there. So the bottom line is that this profit cycle story is stabilizing across markets, but we're recognizing a very divergent picture when you look at the east versus West. You know, comparisons. Importantly, this is filtering into the other risk measures that we watch. When we look at risk appetites. Japan, Asia, Pacific risk appetites have been on the downtrend, when we look in the West, the US, Europe, UK, those markets, the risk appetites have been benign, too, right raising being raised. So this is I think, something that's goes part and parcel to this profit cycle story that if markets tend to chase, you know, earnings, earnings seem to be stabilizing in the West, they're not stabilizing. There's still a you know, really a lot of challenges when we look at the Chinese economy and the fallout to its neighbors. And so this will continue to drive benchmark patterns. One of the important subjects we published back in late 20, too late last year, was this idea about you know, what's in your Emerging Market Index. And so if China is like an exception to the story, does it end up, you know, inadvertently causing the emerging market indices to look weaker than they are? Because at the same time, as much as that's been going on, if you look at Latin America, as an example, what we'll see are fairly strong gains, partly because of the commodities and partly because of nearshoring. So I think the story is, you know, a lot more complex, but, you know, fast forward, what we're recognizing across the planet is a stabilization in the profit cycle, the East driven really, but that Chinese comparisons are quite a contrast. So this ABC strategy, we think, is, you know, will continue to work and, you know, investors, global investors are looking for ways to retaining their emerging market exposure without potentially by, you know, lowering the Chinese component in that and so we think that will likely continue as we go through into 24. All right, so we've covered a lot but I want to make sure that you know, I leave with the leave you with the main takeaways, one, there is a soft landing, I think we can defend the interest rate risk. that will surface because of profit stabilizing, is telling us to become more valuation sensitive. We're looking when we notice the earnings estimates that is certainly leading us to more of a fundamental focus on the menu. One of the realities, unfortunately, of the value cycle, though, is that we're looking at more of a lower absolute returns marketplace, historically, at least that lines up intellectually, I think it lines up perfectly. The reality here is that if we are in a world where the Fed is not going to be on our side, unlike the last 30 years, what what what do we do, we focus on the fundamentals, we focus on earnings. And so you don't get the free lunch or the multiple expansion driven by rates, but you do Chase earnings. And so this is more of a fundamental market that I think we migrate to active management under fire. I think we do get some relief here as we close this year. And as we go into 24. And then a couple of things globally, what we're noticing in the profit cycle story that supports the US view, is the idea that across the regions, we're seeing a stabilizing in the forward estimates, which tells us that the analysts on the ground are seeing something in terms of an improvement, not a deterioration. And again, the the Chinese experience is quite different. And then finally, the focus on on home builders, the strategy, the active strategy, in terms of how we're delivering portfolios, how we're looking at portfolios, we are looking broadly to become more valuation sensitive in some of the bespoke work we deliver. Clearly, we've been in this camp to suggest strongly to be in our quality growth arena. Here, we're going to begin to make the shift towards a Garp focus and for our value clients. Moving away from the high earnings visibility focus, we've had the last couple of years, moving more into a relative value portfolio, which will allow for more of a cyclical bias. So that pretty much concludes my remarks. Thank you very much for joining us today. Thank you for joining us for this episode of Market Elevation, we hope you enjoyed the coverage. The bottom line here is it looks as if we are moving into a more sort of a fundamentally driven market, we've lived through 18 months, maybe longer of a Fed tightening cycle. While liquidity continues to be removed from the system, clearly a very different market that we're going into with any questions, feel free to reach out. And of course, we love your feedback. Thank you for joining us for this episode of Market Elevation. We hope you've enjoyed it. And as always, feel free to send us any questions or comments. It's always welcomed and helpful. Thank you. You've been listening to Market Elevation, a Cirrus Research Podcast. Thanks for listening and tune in again. The information contained in this podcast report is based on sources we believe to be reliable at the time it was produced and distributed, but not necessarily complete, and its accuracy is not guaranteed. Now, the surest nor any of our affiliates, or any other person makes any representations or warranties express or implied as to the podcast accuracy, completeness or correctness. to the maximum extent permitted by law, neither any of our affiliates nor any other person shall have any liability whatsoever to any person for any loss or expense, whether direct or indirect, consequential, incidental or otherwise, arising from or relating in any way to any use of or reliance on information contained. Herein. This podcast is not a research report, solicitation or offer to buy or sell any security or claim and has been provided solely for informational purposes. Nothing in this podcast constitutes legal accounting or tax advice, or individually tailored investment advice. Any opinions or estimates contained in this podcast represent our judgment at the present time and are subject to changes without notice. Service has no obligation to advise you of any such changes. This podcast was prepared for general circulation without regard to the individual financial circumstances and objectives of persons who receive or obtain access to it, and it may not be suitable for all investors. No one listening and receiving or accessing this podcast should make any investment decision without first consulting us or her own personal financial advisor and conducting their own research and due diligence, including but not limited to carefully reviewing any applicable prospectus. These press releases, reports and other public filings of the issuer of any securities being considered. There is not enough information contained in this context to make an investment decision and past performance should not be taken as an indication or guarantee of future results. 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