Tactical Rules Move to Neutral

SUMMARY

• The Fed has time on its side, and it is on the investor’s side, in our opinion.
• The Trend has turned negative, creating another headwind for domestic stocks.
• Crowd is extremely pessimistic as tariffs create recession and stagflation worries simultaneously.

Since our last update of our ‘Three Tactical Rules’ on March 14th, equity markets have been volatile. During this time, the SPX 500 saw its 50-day moving average fall below its 200-day moving average, a condition referred to as the “death cross” by market technicians. A barrage of daily headlines regarding the constantly changing tariff policy out of Washington has been the biggest headwind for markets over the past seven weeks. Hence, our Tactical Rules have deteriorated over the period. The fed fund futures market is expecting the Fed to cut interests three times this year. Currently, the fed funds futures market is pricing in a recession. Since both monetary and fiscal policy can operate with a lag, we are not expecting the full impact of these decisions to be known until at least the second half of 2025. Hence, we turn to the three ‘Tactical Rules’ – Don’t Fight the Fed, Don’t Fight the Trend, and Beware the Crowd at Extremes – to help guide us for the next three months. Currently, the Three Rules are a “flashing yellow light” - a roughly neutral rating which represents a slight downgrade from the “flashing green light” in our last update.

‘Don’t Fight the Fed’: Fed on Hold, but Still on Investors’ Side - FLASHING GREEN

After cutting interest rates by a total of 100 basis points last year, the Fed held interest rates steady at its first two meetings of 2025. We believe that the Fed will again remain on hold at its upcoming May 7th meeting, despite signs of economic uncertainty due to ongoing tariff negotiations. What is keeping the Fed from preemptively lowering interest rates when the survey (‘soft’) data has been coming in weaker than expected?

First, the survey data captures the emotional reactions of businesses and consumers to headlines, meaning that there could be a disconnect in what they say in a survey and what they do in the real world. This has been the experience thus far, as the economic (‘hard’) data has not weakened to the extent that the survey data would indicate. Second, Fed officials are hesitant to lower interest rates without first understanding the impact of the final negotiated tariff deals. Chairman Powell has indicated in the past that he does not want to repeat the Fed inflation mistake of 1980. In March 1980, the Fed lowered interest rates from 20% to 9.5% thinking that inflation was under control, only to raise interest rates in December 1980 back to 18%, as inflation reaccelerated. Given that the impact of tariffs will not be known for months, the Federal Open Market Committee (FOMC) is willing to wait for the weight of the evidence before making more interest rate moves.

If one were to look at first quarter GDP which contracted by -0.30% quarter-over-quarter, one might expect the Fed to begin cutting rates immediately.

However, GDP was negatively impacted by the influx of imports ahead of tariff announcements, as companies built up inventories as a precautionary defense against price increases. These actions by corporations resulted in a significant negative net trade (exports minus imports) number for the quarter. The net trade deficit subtracted -4.8% from GDP, while the inventory build added 2.2%. We believe these dynamics will likely reverse in the next couple of quarters and contribute positively to GDP. Hence, the Fed may view the negative GDP print as transitory, in our view. Furthermore, core PCE Inflation remains elevated relative to the Fed’s 2% target. Conversely, the unemployment rate is at 4.2%. Even with federal government job cuts coming, we believe it is unlikely that the rate will rise above the threshold of what is historically considered ‘full employment’ at around 4.5%.

The Fed wants to make sure that fiscal policy based on tariffs does not derail its efforts to fight inflation before it cuts again, in our opinion. Thus, we believe that the Fed could be on hold for the foreseeable future. Despite the Fed holding rates steady, it is not hiking rates and driving up borrowing costs, so it remains on the investor’s side, in our opinion. The Fed is a “flashing green light”.

Internationally, the Bank of England (BOE) paused at its March 20th meeting after lowering rates in February by 25- basis points. The BOE is expected to continue lowering its policy rate, as inflation drifts closer to its 2% target. Currently, CPI in the UK is rising at 2.6% year-over-year as of March. Meanwhile, the European Central Bank (ECB) has cut its deposit rate by 175-basis points since last May and is approaching its 2% inflation target, as CPI was 2.2% in March. While the speed of monetary policy easing is different at each of the major central banks, we believe the major central banks 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’: Negative Slope Creates Headwind - RED LIGHT

The trend on the S&P 500, which we define as the 200-day moving average, is rolling over as the index has pulled back since making an all-time high in February. The S&P 500 is down just under 7.5% from its high, after rebounding from a sell-off that witnessed a roughly 19% drawdown from the peak. Currently, the trend is falling at a -3% annualized rate, and if history is any guide, this condition does not bode well for stock returns over the next 3 to 6 months. Hence, we believe that stock selection will play an important role for domestic equity returns in the coming months. We believe that for the trend to stabilize and become positive again, the index must rebound to roughly 5745 and stay at or above that level for a minimum of 7 days. Hence, domestically our rule of “Don’t Fight the Trend” is now signaling a “red light” as it pertains to the future direction of the index.

International Trend: Better Positioned than its’ Domestic Rival - GREEN LIGHT

Internationally, the trend of the MSCI All Country World ex-US index (ACWX) has slowed over the last seven weeks. The run rate of the primary trend is currently rising at a 2% annualized rate but could accelerate to roughly 12% in the coming weeks if the index stays around its current level. The outperformance of international equities thus far this year has led to the dramatic turnaround in fortunes. The international trend continues to outshine our expectations for 2025. A positive trend increases the probability of receiving above average returns over the next 3 to 6 months. Given that the trend is currently lower than in our previous publication but expected to reaccelerate, we are maintaining the “green light” rating that we initiated back in mid-March.

Beware of the Crowd at Extremes: Reacting to Recession and Stagflation Fears - GREEN LIGHT

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 (NDR). When the line is high it shows extreme optimism, and when it is low, extreme pessimism. NDR research suggests that historically, extreme pessimism can create attractive entry points for tactical investors. This is our preferred data source to measure investor psychology, though we use our own analytical framework from which to draw conclusions on sentiment.

Currently, the NDR Daily Sentiment and the NDR Weekly Sentiment Polls are giving slightly different signals. The Daily sentiment has risen just enough to be in the lower end of the neutral zone, while the Weekly sentiment remains in the extreme pessimism zone. 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 the current levels of the polls, we believe that the Crowd has become less pessimistic than seven weeks ago, as recession and stagflation fears have subsided. The Crowd is still signaling a buying opportunity for equities, in our opinion. Hence, we maintain our rating for the Crowd of a “green light”.

Conclusion: The Tactical Rules Move to a Neutral Signal… - FLASHING YELLOW

The tactical rules signal a “a flashing yellow light” as the trend has turned negative domestically, and the crowd has become a bit less pessimistic after tariff policy de-escalation from the Trump administration. The flashing yellow light signal serves as a reminder that uncertainty remains, which may lead to further volatility, in our opinion. We believe that the worse-case scenario regarding tariffs will be avoided, but the market will need time to adjust to the potential inflation implications that will accompany the final deal. Hence, our Tactical Rules are giving us a more neutral signal. We believe that the pullback experienced over the last couple of months will be good for the stock market long term. Over the next 3 to 6 months, we remain cautiously optimistic that domestic stocks will rebound. Technology companies have only had earnings decline slightly, despite experiencing significant multiple compression. Hence, we believe technology companies can help the domestic trend regain its footing, in our opinion. Additionally, international stocks should continue to improve given the positive trend and their accommodating central banks, in our view.

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.