- The Fed is prioritizing price stability.
- The trend is a ‘frenemy’ as it fluctuates between being positive and negative.
- Crowd sentiment is leaning “bullish.”
Financial markets have been volatile all year as investors have worried about inflation, rate hikes, a banking crisis, and recession. During this time our three tactical rules of “Don’t Fight the Fed”, “Don’t Fight the Trend”, and “Beware of the Crowd at Extremes” have each fluctuated individually, but when combined have given a neutral reading. Hence, our portfolios have generally had a neutral equity positioning versus their benchmarks. The S&P 500 has been ‘range-bound’ between 3800-4200 during this time; however, the market’s resilience in the face of so much uncertainty has our tactical rules beginning to show signs of improvement. The tactical rules currently are collectively flashing a yellow light, with the potential to turn green if either the Fed stops raising interest rates or the trend improves.
Don’t Fight the Fed: Prioritizing Price Stability – Red Light
The Fed has been the most consistent negative tactical indicator over the last year, due to the FOMC embarking on a dramatic rate hiking campaign that took interest rates from being anchored at zero to the current target range of 4.75%-5%. While the Fed has consistently reiterated that rates would climb to above 5% and stay there for an extended period, both the stock and bond markets have recently underestimated the Fed’s fortitude from here, in our opinion. Stocks have persistently operated under the thesis that the Fed would cut interest rates in the second half of the year, which we believe would help stocks. The bond market on the other hand has constantly predicted that the Fed would slow the economy too much, which would result in a recession. While the ending of the story is yet to be written, one thing is clear: financial markets are fighting the Fed at every turn, in our opinion.
We believe that the Treasury market has overreacted to rate hikes, the banking crisis, and in its’ prediction for an imminent recession. As we wrote in last week’s Weekly View, “The Fed: Tap Dancing on a Tight Rope,” we believe the bond market’s recent opinion change in the future path of interest rates is too extreme. This is illustrated in the chart below which shows that the two-year Treasury, which is the most sensitive to Fed rate changes is nearly 100 basis points lower than fed funds. Thus, two-year Treasuries are now suggesting to us that interest rates have peaked. We believe the Fed will choose to prioritize price stability, as it believes that it has the tools at its disposal to provide financial stability if further issues arise in the banking industry. Hence, we see the Fed continuing to raise rates if inflation does not decline at a faster pace. Unlike financial markets, we are choosing not to fight the Fed.
Internationally, the Bank of England (BOE) and European Central Bank (ECB) are also facing tough decisions of whether to continue their rate hiking campaigns. Both central banks recently raised their policy rates in meetings in March. The BOE raised its bank rate to 4.25% from 4%, while the ECB raised its main refinancing rate to 3.50% from 3%. In both instances the central banks had to raise in the face of additional circumstances other than simply inflation, such as the Ukrainian war. In any case, the willingness of the central banks to remain committed to fighting inflation despite additional headwinds in their economies reiterates that central banks globally are not on investor’s side, in our opinion.
Therefore, we would conclude that our first tactical rule is flashing an extended red light.
Treasury Yields Fighting Fed Rate Hikes
Source: Refinitiv Datastream, RiverFront; data daily, as of March 31, 2023. Chart shown for illustrative purposes.
S&P 500 Composite
Don’t Fight the Trend: Investor’s ‘Frenemy’ – Flashing Yellow
The trend on the S&P 500 has been declining since January of 2022. However, the recent resilience of the index has caused it to trade in a narrow range, improving the primary trend, which we define as the 200-day moving average. Currently, the trend is falling at an annualized rate of -3%. If the current level on the S&P 500 of 4109 continues to hold over the next month, the trend could turn positive for the first time in over a year. This would be a monumental turnaround and possibly a momentum changer for stock returns over the next 3 to 6 months, according to our ‘heatmap’ analysis of historical probabilities of future positive market returns under various trends. However, if the S&P stalls, the trend will turn negative again over the subsequent month.
Internationally, the trend of the MSCI All Country World ex-US index too has been declining since January 2022. The international trend is currently falling at a -3.6% annualized rate. Like the domestic trend, it will turn positive over the next month if it holds at current levels but will have to accelerate higher to stay positive. Given that both the US and international’s trend will need to avoid significant pullbacks in the coming weeks to remain positive, we do not yet believe that the trend has become the investor’s friend. We do believe that it is encouraging that both markets are above their trends. The trends are currently ‘frenemies’ of investors as they continue their balancing act.
MSCI AC Chart
Beware of the Crowd at Extremes: Window of Opportunity Beginning to Open – Flashing Green
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 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 to measure investor psychology, though we use our own analytical framework from which to draw conclusions on sentiment. 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, like our update three months ago, the crowd is not at an extreme within the pessimism zone, thus we have not reached a level which could warrant increasing our stock holdings. By historical standards, sentiment is not depressed enough to warrant a significant stock rally.
The tactical rules currently are collectively flashing a yellow light that has the potential to turn green. There could be a window of opportunity over the coming months to add stocks, if the Fed stops raising interest rates and begins cutting rates as the futures market is predicting, in our view. Currently, the portfolios are positioned closer to neutral until we get a definitive upward shift in the trend.
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.