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SUMMARY
- The Fed appears on track to decelerate the pace of its rate hikes, but far from a rate cutting pivot, in our opinion.
- The trend remains negative but is beginning to show signs of reversing to an uptrend.
- The crowd is in extreme pessimism, but not low enough by historical standards to warrant a significant stock rally, in our view.
Our Three Tactical Rules - “Don’t Fight the Fed”, “Don’t Fight the Trend”, and “Beware of the Crowd at Extremes” - have been challenged in the second half of 2022 by bear market rallies. The tactical rules have warranted caution for the past 6 months, as the Fed raised rates and started to shrink its balance sheet, and the trend became more negative. Given a still hawkish Fed, the falling trend, and a crowd not at pessimistic extremes, our tactical rules continue to suggest caution.
Don’t Fight the Fed: Deceleration Does Not Mean a Rate Cutting Pivot
Since March, the Fed has attempted to tighten financial conditions to fight inflation through rate increases and balance sheet reduction in the form of Quantitative Tightening (QT). The Fed chose to front-load rate hikes to avoid a repeat of the late 1970s and early 1980s, when inflation appeared to peak only to rear its head and climb higher. Over the last six meetings, the Fed raised the fed funds target range from 0% to 0.25% to 3.75% to 4%. This rapid pace consisted of an initial increase of 0.25%, followed by a 0.50% increase, and then four consecutive 0.75% increases.
Recent economic data has shown inflation may be cooling, causing the Fed to contemplate slowing the pace of rate increases. We agree with Chairman Powell that the effect of monetary policy works with a considerable lag, and the impact has not been felt on the economy yet. For this reason, the Fed indicated that it will be more data dependent and its next rate decision will come in mid-December, a day after November’s CPI data is released. Therefore, if headline CPI comes in at or below expectations, the Fed appears on track to slow the pace of its rate hikes. A 0.50% rate hike is still large by historical standards, so the Fed will remain at odds with investors. Currently, the fed funds futures market is showing a 75% probability of 0.50% rate hike at its December 14th meeting.
The European Central Bank (ECB) and the Bank of England (BoE) have also responded to high inflation by raising interest rates. The ECB has raised its main refinancing rate from 0% in July to 2% in just three meetings. The BOE on the other hand was the first major central bank to raise interest rates in December 2021, but at a slower pace, moving from 0.10% to 3.00%. While both central banks are lagging the Fed’s course of action, they both remain resolute to defeat inflation. Thus, we do not regard the global central banks as being on the investor’s side, as decelerating the pace of rate hikes is far from a rate cutting pivot.
Don’t Fight the Trend: Trends Need to Stay Above 200 Day Moving Average
The S&P 500’s trend is currently falling at an annualized rate of -14%. Trading just below 4100, the S&P 500 recently broke above its 200-day moving average, meeting the first criteria for breaking out of an 11-month downtrend (see chart, right). The S&P 500 must remain above the 200-day moving average for the trend to turn positive over the next three months. While we see rising odds of this happening right now, we recognize that the stock market will applaud any signs of the Fed becoming less restrictive.
Internationally, the trend of the All-Country World Index ex-US (ACWX) is currently falling at an annualized rate of -22%. Much like the S&P, ACWX has recently broken above its 200-day moving average, and it too must remain above it for the trend to turn positive over the next three months (see chart, left). While ACWX’s trend is improving, it still faces some headwinds, including the economies of the UK and Eurozone which continue to deal with inflation pressures, rising energy prices, and the fallout from the Ukrainian and Russian war.
For now, we would classify both trends as negative, which suggests below average returns over the next three months, in our view. A decisive breach above the red line (200DMA), would be an early indication that the trend is improving, in our view. For now, we believe the trends are not investors' friends.
Beware of the Crowd at Extremes: Crowd is Not at the Outer Limits of Extreme Pessimism
We regard Crowd Sentiment as the contrary indicator of the Three Tactical Rules. Over the last year, the crowd has experienced highs and lows as investors attempted to handicap and navigate the evolving monetary policy landscape. The chart below shows a measure of investor sentiment 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 way to measure investor psychology. Generally, we believe sentiment is a contrarian indicator, meaning we look for opportunities to buy when there is extreme pessimism and vice versa. Currently, the crowd is pessimistic, which has historically been a contrarian (bullish) signal. However, by historical standards, sentiment is not depressed enough to warrant a significant stock rally. There could be a window of opportunity over the coming months to add stocks, as worst-case scenarios get discounted into stock prices, in our view. In the meantime, we are proceeding with caution.
Conclusion:
Our three tactical rules of “Don’t Fight the Fed”, “Don't Fight the Trend”, and “Beware of the Crowd at Extremes” are collectively sending a signal of caution, warranting no better than a neutral portfolio positioning, in our view. Despite recent signs of improvement in stock prices, we do not believe the odds favor fighting the Fed and the trend, until there is more clarity surrounding the path of inflation and ultimately interest rates.
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.