Tactical Rules Hovering Above Neutral

SUMMARY

• The Fed could be ‘slower to lower’, but still on the investor’s side.
• The Trend continues to rise but ascending at a more sustainable level.
• Crowd could stay too optimistic into 2025 due to seasonality and post-election trends.

Since our last update of the ‘Three Tactical Rules’ on October 1, 2024, we witnessed equity markets hit a new all-time high and then stall. The rally was fueled by further monetary policy easing, along with the expectation of faster growth in 2025 as the Trump administration pushes through deregulation and lower taxes. We believe that the monetary and fiscal policy combination will benefit equity markets but recommend proceeding with some caution in the near term, as our Tactical Rules are no longer giving an all-clear signal. Currently, the Three Rules are collectively a “flashing yellow light” which is a slight downgrade from the “flashing green light” in our last update. The tactical rules of “Don’t Fight the Fed” and “Don’t Fight the Trend” remain unchanged at positive readings, but the “Beware of the Crowd at Extremes” has become excessively euphoric, giving us near-term pause.

Don’t Fight the Fed: Fed on the Investor’s Side - GREEN LIGHT

Since September 18th, the Fed has cut interest rates by 75 basis points, and financial strategists anticipate another 25-basis point cut in December. Additional cuts are expected in 2025, but as we stated in last week’s Weekly View, we believe the Fed will be “slower to lower” rates going forward given the strength of the US economy. Inflation has slowed and the labor market has been resilient, which has contributed to consumers continuing to spend. The continued economic strength has caused strategists to lower the number of rate cuts they are predicting for 2025 to three 25-basis points cuts, from four in just the last week. Hence, there is a chance that the Fed pauses and leaves the fed funds rate unchanged in December, in our opinion.

Chairman Powell has communicated that the Fed does not need to be in a hurry to cut rates, as the “the risks to achieving its employment and inflation goals are roughly in balance”. However, despite opening the door to a slower pace of rate cuts moving forward, the Fed still has a bias towards cutting rates if the data justifies further action. Hence, we believe that the Fed remains on the investor’s side because its current monetary policy is conducive to an expanding economy.

Internationally, the Bank of England (BOE) and the European Central Bank (ECB) both have begun cutting their policy rates as well. However, the international central banks have taken a slower approach, opting to move in 25-basis point increments. The ECB has cut its policy rate 75 basis points since June and the BOE has cut 50 basis points since August. While the speed of monetary policy easing is different among major central banks, we believe they are fully aligned with “Don’t Fight the Fed” and are on the investor’s side. The Bank of Japan (BOJ) is the one exception, as it is currently raising interest rates after leaving them artificially low for an extended period.

Don’t Fight the Trend: US Trend Will Become More Sustainable - GREEN LIGHT

The trend on the S&P 500, which we define as the 200-day moving average, continues to rise at a fast pace, but has begun to slow down. After a year-and-a-half of rising at a torrid pace, we welcome the slower pace, which we deem as more sustainable and beneficial for above average returns in stocks over the next 3 to 6 months. Currently the trend is rising at an annualized rate of 27% but will likely fall to mid-20s or lower, depending on the path of the index in the final trading days of the year. Since we expect more moderate returns going forward, we believe that the trend will continue this gradual deceleration to a more sustainable pace. Historically, a positive trend is good for future stock returns, and we believe that this time will not be different. The combination of accommodative monetary policy from the Fed and fiscal stimulus from the incoming Trump administration should provide the catalysts for additional earnings growth, and thus further upside in the S&P 500. Domestically our rule of “Don’t Fight the Trend” is signaling a “green light”.

International Trend: Decelerating but Remains Positive - GREEN LIGHT

Internationally, the trend of the MSCI All Country World ex-US index (ACWX) has decelerated since our last update in October. The international primary trend is currently rising at an annualized rate of 10% and continues to decelerate faster than its domestic counterpart. Despite the economic headwinds internationally, the trend will remain positive through year-end, in our view. Additionally, if ACWX remains at its current level of 329.54 or higher in the near-term, the trend will remain positive for the next three months. A positive trend increases the probability of receiving above average returns over the next 3 to 6 months, in our view. Hence, the international trend is still signaling a “green light”.

Beware of the Crowd at Extremes: Nearing an Optimistic Extreme - FLASHING RED

We regard Crowd Sentiment as the ‘contrary’ indicator of the Three Tactical Rules. The chart below shows a measure of investor sentiment as calculated by Ned Davis Research. When the line is high, it suggests extreme optimism; 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 on sentiment.

Crowd sentiment has moved into the extreme optimism zone for both the NDR Daily and Weekly Sentiment Polls. Historically, we have given more weight to the Weekly for this publication, despite incorporating both measures of sentiment in our overall rating. The Daily tends to be a good indicator of the investors’ ‘real time’ view of financial markets, while the Weekly gives longer term perspective of the Crowd. Given that both indicators are in the extreme optimism zone, we analyzed the data to determine the magnitude of the current extreme readings in a historical context. In the review of Daily Sentiment, its current level of 64.4 ranks in the 76th percentile of all occurrences in the dataset going back to the early 1980s, whereas the Weekly Sentiment level of 72.5 (shown in the chart below) ranks in the 97th percentile of all occurrences going back to the mid-1990s. Hence, we view the Crowd as having become too optimistic but acknowledge that this condition could persist into early 2025 due to seasonality and historical post-election trends. Collectively, we rate the Crowd as a “flashing red light”.

Conclusion: The Tactical Rules Signal a Flashing Yellow Light - FLASHING YELLOW

The tactical rules signal a “flashing yellow light” due to an accommodative Fed, our view that the trend will remain positive while decelerating to a more sustainable pace, and a crowd that has become overly optimistic, in our view. The flashing yellow light signal serves as affirmation that accommodative monetary policy along with stimulative fiscal policy is good for the stock market over the next 3 to 6 months but warrants proceeding with caution for investors with a very short-term trading mentality. Overall, however, we are cautiously optimistic. The tactical rules give us the confidence to maintain the portfolio’s composition favoring stocks over bonds, with a bias towards domestic stocks over international stocks a in our balanced portfolios.

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.