Tactical Rules: A Tale of Two Economies

SUMMARY

• The Fed is likely to raise rates once more in 2023, in our view.

• The Trend is positive for now and positive Q3 earnings surprises could pull the S&P 500 out of its trading range.
• We believe crowd sentiment is searching for direction

Since the last update of the Three Tactical Rules in the August 1st Weekly View, much has changed…and a lot has stayed the same. Financial markets continue to hope for the end of the Fed’s rate hiking cycle, while the economic data has been mixed without any clear signal. Hence, the focus remains on corporate America’s ability to adapt to the new economic reality, and thus the stability of earnings. Over the past two months, our tactical rules have seen a big change in crowd sentiment, while the Fed and the trend have been steady.

Our qualitative ratings on the Three Rules are represented by a 6-increment color scheme, with Green Light being the most favorable. “Don’t Fight the Fed” is currently a solid red light, “Don’t Fight the Trend” is a flashing green light, and “Beware of the Crowd at Extremes” has moved from a flashing red light to a yellow light since August 1, 2023. While the individual rules collectively would align with a yellow light, the heatmaps we overlay onto the tactical rules are more favorable, due to the recent market pullback. This nuance shifts our combined tactical rating on the stock market to a flashing green light.

DON’T FIGHT THE FED: Fed is Prepared for Additional Hikes, Despite Inflation Easing. RED LIGHT

The Fed held the fed funds target range steady at 5.25 -5.50% at its last meeting, but left the door open for one more hike this year if the economic data remains relatively resilient. The Fed sees inflation as being elevated, as headline inflation increased to 3.7% in August due to rising oil prices. The Fed is focused on core inflation which strips out the volatile categories of food and energy. Its preferred inflation gauge, core Personal Consumption Expenditures (PCE), currently sits at 3.90%, well above the 2% target. Additionally, the continued strength of the labor market has made the Fed more determined to slow the economy before declaring victory over inflation. Therefore, we believe that the Fed will raise rates once more this year as indicated in its summary of economic predictions at its September 20^th meeting. Our forecast is for the fed funds terminal rate to be 5.625% at year-end, with the Fed holding that level until at least Q3 2024. Given that we expect another rate hike, we believe that the Fed is at a red light.

Internationally, the Bank of England (BOE) and European Central Bank (ECB) find themselves in similar positions to the Fed, having recently hiked interest rates to tame persistent inflation. The BOE left its policy rate at 5.25% in September, despite having the highest inflation rate of the G7 nations at 6.7%. As for the ECB, it raised its deposit facility to 4.00% and its main refinancing rate to 4.50% on September 14^th, and like the Fed left the door open to do more, as inflation is still well above their 2% target. We believe the willingness of international central banks to contemplate additional hikes means they too have moved back to a red light.

DON’T FIGHT THE TREND: Trend Is Slowing and Testing Support Levels. FLASHING GREEN LIGHT (Domestically)

The trend of the S&P 500, which we define as the 200-day moving average, has decelerated since our last update, and the index has traded in a range between 4250 and 4600. We see meaningful support at 4200. Despite the recent pullback, the trend is rising at an annualized rate of 13.5% as of this past Friday. The trend will continue to be positive for several months even if the S&P 500 holds its current level of 4288 (as of September 29, 2023). Historically, a positive trend is good for future stock returns, and we believe that this time is no different, however Q3 earnings will have to be significantly beat expectations to pull the S&P 500 out of its recent trading range. Thus, domestically our rule of “Don’t Fight the Trend” is signaling a flashing green light which calls for stock exposure slightly above long-term targets.

International Trend – FLASHING RED LIGHT

Internationally, the trend of the MSCI ACWI ex-US Index is rising at an annualized rate of approximately 5.75% as of this past Friday, but it is decelerating rapidly, with the price now below the trend. Unlike its domestic counterpart, the international trend will turn negative if it does not reaccelerate over the next month and current levels were to hold. Therefore, the international trend is a flashing red light signaling lower stock exposure relative to long-term targets.

BEWARE OF THE CROWD AT EXTREMES: Neutral, No Signal. YELLOW LIGHT

We regard Crowd Sentiment as the contrary indicator of the Three Tactical Rules. Since the beginning of the year, the crowd has been either neutral or in extreme pessimism as investors attempted to handicap and navigate the evolving monetary policy landscape. The chart below shows a measure of investor sentiment as calculated by Ned Davis Research. When the line is high it shows extreme optimism, and when it is low, extreme pessimism. This is our preferred data source to measure investor psychology, though we use our own analytical framework from which to draw conclusions. Currently, the indicator is in the neutral zone and searching for direction, a state that is typically good for stocks, just not great. However, our quantitative process, which combines sentiment and trend, is positive. Thus, viewing the Crowd at Extremes through this combined lens indicates a yellow light in our rating continuum.

CONCLUSION: Signals Are Mixed, But Quantitative Process Signaling a Flashing Green Light Domestically.

The combined signals looking through the qualitative lens as discussed through this piece are signaling a flashing yellow light. However, our quantitative process, which combines trend and crowd sentiment to forecast the probability of the S&P 500 having positive returns over the next three months is signaling a flashing green light. When we combine the qualitative and quantitative signals, we arrive at a more positive conclusion than the three rules would suggest in isolation domestically. For this reason, we continue to slightly favor stocks over bonds in our balanced portfolios.

The combined signals looking through the qualitative lens as discussed through this piece are signaling a flashing yellow light. However, our quantitative process, which combines trend and crowd sentiment to forecast the probability of the S&P 500 having positive returns over the next three months is signaling a flashing green light. When we combine the qualitative and quantitative signals, we arrive at a more positive conclusion than the three rules would suggest in isolation domestically. For this reason, we continue to slightly favor stocks over bonds in our balanced portfolios.

At the other end of the spectrum, internationally both our qualitative and quantitative signals are signaling a flashing red light.

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.