- The Fed is walking the monetary policy ‘tightrope’, in our view.
- The Trend is positive both domestically and internationally.
- Crowd Sentiment in extreme optimism zone but could reset with a pullback.
Since our last ‘Three Tactical Rules’ update on November 20, 2023, equity markets have rallied further as central banks have signaled the end of their rate hiking campaigns. In the case of the S&P 500, it continues to make all-time highs as investors have cheered the end of rate hikes. Combine that market optimism with an economy that grew at 3.3% year-over-year in Q4 2023, an unemployment rate under 4%, and core inflation under 3%, and you have ‘Goldilocks’ for financial markets. As it pertains to our tactical rules of “Don’t Fight the Fed”, “Don’t Fight the Trend”, and “Beware of the Crowd at Extremes” they are collectively now rated as a flashing yellow light.
Under the hood, a lot that changed within the three rules to generate this rating. Over the last two months, the Fed has moved from a “red light” to a “flashing green light”, the trend has moved from a “flashing green light” to a “green light”, and the crowd from a “flashing yellow light” to a “red light”. From a purely quantitative perspective, our indicators have deteriorated in the last two months, moving from a “green light” to a “flashing yellow light”. The combination of improved qualitative indicators but more extreme optimism leads us to a generally “neutral” overall rating this time around.
Don’t Fight the Fed: Fed is Walking the Tightrope - FLASHING GREEN
The Fed has left the effective fed funds steady at 5.33% for four consecutive meetings, despite the preferred inflation gauge of core PCE coming down more rapidly than economists predicted. In our last ‘Three Rules’ update, core PCE was 3.7%; today it stands at 2.9%, which is now entering the zip code of the fed’s 2% target. Additionally, core PCE has fallen by 1.3 percentage points since the Fed raised the effective fed funds rate last July, resulting in ‘real’ (inflation-adjusted) yields rising by a similar degree and tightening financial conditions further.
At first glance, one would expect the Fed to cut rates sooner rather than later, given the progress made on inflation in a short period of time. However, as we pointed out earlier, equity markets are at all-time highs, the economy has been growing faster than its 2.5% post-Financial Crisis average and the Atlanta Fed is anticipating this growth to continue, currently forecasting Q1 2024 GDP at 4.2%. Additionally, the consumer continues to spend, due to the strong labor market. Thus, if the Fed cuts rates when the economy has proven that it can thrive without cuts, it runs the risk of supercharging an already strong economy and possibly reigniting inflation in the process. Therefore, in lieu of rate cuts, the Fed did the next best thing in our view, by signaling additional rate hikes were no longer on the table. The Fed will remain data dependent regarding both the timing and magnitude of future rate cuts.
While we believe the Fed is once again ‘our friend’, we only expect the Fed to cut 1 or 2 times later in 2024 - versus the consensus of 5 times. Regardless of the magnitude or timing, the bottom line is the Fed is not raising rates and is looking for the moment to cut; thus our tactical rule of “Don’t Fight the Fed” has now improved to a flashing green light.
Like the Fed, international central banks such as the Bank of England (BOE) and the European Central Bank (ECB) have also halted further rate hikes. However, unlike the Fed, they are not contending with an economy growing at or faster than pre-COVID-19 levels. While both central banks are hesitant to cut rates too soon, we believe that the ECB will be the first to cut, as it has the weakest economy of the three major central banks. Thus, the BOE and the ECB are currently also rated at a flashing green light.
Don't Fight the Trend: Trend Continues to be Strong (Domestically) - GREEN LIGHT
The trend on the S&P 500, which we define as the 200-day moving average, has accelerated since our last update, due to the index making an all-time high above 4900. The trend is rising at an annualized rate of 24% and will remain positive for most of 2024, if the S&P 500 averages above 4900, which we believe is likely. Historically, a positive trend is good for future stock returns, and we believe that this time is no different. Thus, domestically our rule of “Don’t Fight the Trend” is signaling a green light, which calls for stock exposure above long-term targets.
International Trend - FLASHING GREEN
Internationally, the trend of the MSCI All Country World ex-US index turned positive in mid-December. The international primary trend is currently rising at an annualized rate of 5.4%. Like its domestic counterpart, we believe the international trend will remain positive for most of 2024 if current levels were to hold, which we expect. Therefore, the international trend is signaling a flashing green light.
Beware of the Crowd at Extremes: Optimism Has Hit an Extreme - RED LIGHT
We regard Crowd Sentiment as the ‘contrarian’ indicator of the Three Tactical Rules. The chart below shows a measure of investor sentiment as calculated by Ned Davis Research (NDR). When the line is high, it suggests extreme optimism, and when it is low, extreme pessimism. This is our preferred data source to measure investor psychology, which we run through our proprietary analytical framework to help draw conclusions on sentiment.
Since last December when the Fed signaled it was done with rate hikes, the crowd has been in the extreme optimism zone. Extreme optimism when viewed in isolation typically is not good for stocks, thus our qualitative rating of a “red light”. That said, a bull market typically oscillates between neutral and optimism, where a return to neutral often coincides with a brief and shallow pullback, rather than a tradable correction. Our quantitative process, which combines sentiment and trend, is giving a more neutral signal. Thus, viewing the ‘Crowd at Extremes’ through this lens only would indicate a flashing yellow light in our rating continuum. Furthermore, we believe that some of this optimism could erode this month, as February tends to be one of the worst months of the year for stocks historically.
Conclusion: Both our Qualitative and Quantitative Processes are Signaling a Flashing Yellow Light - FLASHING YELLOW
The combined signals looking through both our qualitative and quantitative lenses as discussed through this piece are signaling a flashing yellow light overall, which we believe warrants a neutral to slight overweight positioning in the portfolio’s US stock composition. We believe that any market pullback we experience in the first quarter will be short-lived and relatively contained, given that stocks recently hit an all-time high, a condition that typically signals more strength to come in the market (See our Weekly from 1/29/24). Any routine pullback could help to improve the odds of positive returns going forward, as investor sentiment eases. For this reason, we are taking a ‘wait and see’ approach, while continuing to slightly favor stocks over bonds in our balanced portfolios.
Internationally, our qualitative lens is signaling a yellow light, while the quantitative lens is signaling a flashing green light. The quantitative lens is helped by a trend that is positive but not too strong. However, the international trend relative to the US remains weak, thus tempering our enthusiasm for investing in international.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.