Tactical Rules Signal Risk-On

SUMMARY

• The Fed is more likely to cut than raise rates… thus it is on the investor’s side.
• The Trend has turned positive, creating an opportunity for US stocks to test the all-time high.
• The Crowd’s neutral stance signals selective buying of stocks, in our opinion.

Since the last update of our ‘Three Tactical Rules’ on May 6^th, both domestic and international equity markets have rallied, up roughly 7% and 4%, respectively. The changing fortunes of the equity market has been driven by a strong first quarter earnings season that highlighted the resilience of corporate America in the face of tariff policy headwinds. As a result, investor sentiment became less pessimistic, which helped demand for stocks and in turn helped the trend to reverse its downward path. The S&P 500 has yet to reverse the “death cross”, the condition when the 50-day moving average falls below the 200-day moving average. We highlighted the death cross in the last update, and encouragingly its 50-day moving average is no longer falling… and is now rising faster than the 200-day moving average. Additionally, the number of tariff policy headlines have also slowed, which has also helped investor sentiment. Hence, our Tactical Rules have improved over the period.

The fed fund futures market is now expecting the Fed to cut interest rates two times this year, down from three cuts in May. Since both monetary and fiscal policy can operate with a lag, and tariff negotiations are still not completed, we are not expecting the full impact of these decisions to be known until at least the early fall. 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 green light” - a more bullish rating relative to our previous neutral rating.

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

After cutting interest rates by a total of one hundred basis points last year (1 percentage point), the Fed has held interest rates steady through its first three meetings of 2025. We believe that the Fed will again remain on hold at its upcoming June 18^th meeting, as signs of economic weakness have dissipated due to a strong labor market and slowing inflation. Currently, the unemployment rate is at 4.2% and headline CPI is 2.4%. Headline CPI has been at or below 2.4% for the last 3 months, indicating progress has been made on inflation despite tariff headwinds. Up until now, the Fed has been reticent to preemptively lower interest rates, despite prodding from President Trump. However, if inflation continues to trend lower after tariff negotiations conclude, the Fed will be faced with a tough decision; to lower or not. Thus far, it appears that the Fed has taken the appropriate approach because there has been a disconnect between the survey (soft’) and the economic (hard’) data.

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, and the hard data has surprised so much to the upside that the Atlanta Fed’s forecast for Q2 GDP growth is now at 3.8% through June 9^th. While the rebound in GDP from last quarter’s contraction might not end up as strong as the Atlanta Fed’s model is currently forecasting, the economy will avoid a technical recession of two negative quarters of growth, in our opinion.

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, and the economy remains resilient, the FOMC is willing to wait for the weight of the evidence before making more interest rate moves.

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, we believe the bar is higher for the Fed to hike rates than for it to lower them, so it remains on the investor’s side, in our opinion. Thus, we rate our ‘Don’t Fight the Fed’ rule as a “flashing green light.”

Internationally, the Bank of England (BOE) resumed cutting its policy rate at its May 8^th meeting, after pausing in March. The BOE lowered rates by 25 basis points, bringing the policy rate to 4.25%. The BOE is expected to continue lowering its policy rate, based on information derived from the overnight index swaps market. Currently, the swaps market is forecasting the BOE to cut rates twice more this year. However, inflation ticked back up in April, which could slow further rate cuts. Meanwhile, the European Central Bank (ECB) has cut its deposit rate by 200 basis points since last June and is approaching its 2% inflation target. CPI was 2.2% in April on a year-over-year basis. 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 thus 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’: Positive Slope Creates Opportunity - GREEN LIGHT

The trend on the S&P 500 - which we define as the 200-day moving average - has perked up, as the technology sector has led the index to rally within less than 3% of the all-time closing high of 6144. To put the trend’s turnaround into perspective: in our last update we were hoping for the trend to stabilize and turn positive if the index could rebound to 5745 and remain above that level for 7 days or more. Currently, the trend is rising at a 12% annualized rate, and if history is any guide, this condition should bode well for stock returns over the next 3 to 6 months, in our opinion.

This optimism is reflected across our balanced portfolios, as the portfolios are currently overweight US stock exposure. We believe that US ‘economic exceptionalism’ is not dead, and corporate America will continue to successfully adjust to any economic headwinds that may appear in the coming months. Hence, domestically our rule of “Don’t Fight the Trend” is now signaling a “green light”.

International Trend: Outshining Expectations - GREEN LIGHT

Internationally, the trend of the MSCI All Country World ex-US index (ACWX) has also accelerated over the last six weeks. The run rate of the primary trend is currently rising at a 16% annualized rate, compared to a 2% annualized rate on our previous update. The outperformance of international equities has slowed since our May 6^th update, as investors have re-engaged US stocks after their early year drawdown. However, international equities continue to outshine our expectations for 2025 as they are finally showing signs of having sustained earnings growth. A positive trend increases the probability of receiving above average returns over the next 3 to 6 months. Given that the trend reaccelerated as expected, we are maintaining its “green light” rating that we initiated back in mid-March.

Beware of the Crowd at Extremes: Sentiment Changing with Improved Economic Data - YELLOW 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 excessive 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 aligned after the market pullback last week. The Daily sentiment had risen into the lower end of the excessive optimism zone but fell back into the upper end of the neutral zone. The Weekly sentiment meanwhile remains in the middle of the neutral 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 six weeks ago, as the economic data has improved. The Crowd is no longer signaling a strong buying opportunity for equities like our previous update. While still constructive overall, instead the weight of the evidence is signaling more selective buying of equities, in our opinion. Hence, we have downgraded our rating for the Crowd of a “yellow light” from a “green light” previously.

Conclusion: The Tactical Rules Move to a Bullish Signal - FLASHING GREEN

The tactical rules signal a “a flashing green light” as the trend has turned positive domestically, and the crowd has become less pessimistic after tariff policy de-escalation and stronger economic data. The flashing green light signals that the economy is more resilient than market participants thought just six weeks ago, in our opinion. Corporations have proven their ability to adjust to tariff headwinds on the fly, while producing solid Q1 earnings. We believe that the worst-case scenario regarding tariffs was avoided, which allowed the stock market to reset after the pullback experienced from February to March. Hence, our Tactical Rules are giving us a more bullish signal. Over the next 3 to 6 months, we believe that market conditions favor both domestic and international equities as both have central banks and strong trends on their side.

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.