Tactical Rules, The Divide Continues:

SUMMARY

• The Fed is likely to hold rates steady throughout 2024, in our view.
• The US Trend is positive, but stocks remain rangebound between 4300 and 4600.
• We believe Crowd Sentiment is once again searching for direction.

Since the last update of our Three Tactical Rules on October 2nd, equity markets have rallied as central banks withheld additional interest rate hikes. Financial markets increasingly believe that the Fed is done hiking interest rates, highlighted by the drop in Treasury yields and the fed funds futures market now predicting two rate cuts in 2024.

In our last update we suggested focusing on earnings and Corporate America’s ability to adapt to the new economic reality, in order to determine if the S&P 500 could rally and break out of its trading range. Earnings season appears to have been successful, but the fear now is the market has got ahead of itself and is now pricing in a fair amount of positive earnings news over the next year. Over the past 7 weeks, the scores on our tactical rules have changed, as the Fed has improved, the Trend decelerated slightly, and crowd sentiment has yo-yoed between neutral and extreme pessimism. “Don’t Fight the Fed” is currently a yellow light, “Don’t Fight the Trend” is a flashing green light, and “Beware of the Crowd at Extremes” has moved from a yellow light to a flashing yellow light since it is barely out of the extreme pessimism zone. While the individual rules collectively would align with a flashing yellow light, we feel the heatmaps we overlay on the tactical rules are more favorable due to the recent market pullback… and thus the combined quantitative signal is a flashing green light.

Don’t Fight the Fed: Fed is Prepared for Additional Hikes, Despite Inflation Easing - YELLOW LIGHT

The Fed has held the fed funds target range steady at 5.25 -5.50% at its last two meetings but is prepared to hike interest rates further to bring inflation down to its long-term 2% target, according to Chairman Powell. The Fed’s strategy of pausing rate hikes has been appropriate thus far, as inflation has shown signs of cooling, with headline inflation falling to 3.2% in October due to the recent decline in oil prices. Additionally, the Fed’s preferred inflation gauge, core Personal Consumption Expenditures (PCE), has also fallen and currently sits at 3.7%. While both inflation indicators are trending in the right direction, they remain well above the 2% target. Hence, the Fed’s reluctance to take further rate hikes off the table.

In our last update we pointed to the strength of the labor market as a deterrent for the Fed to declare victory over inflation. While the labor market has shown signs of softening, the economy is still creating 157,000 jobs per month, which is well above the 100,000 jobs per month that must be created to maintain full employment. Therefore, we believe that as long as the labor market remains stable, the Fed will keep rates high throughout 2024. Given this and the low probability of further hikes, we believe the Fed is now a yellow light.

Internationally, the Bank of England (BOE) and European Central Bank (ECB) find themselves in similar positions to the Fed, holding rates steady as they wait for previous hikes to filter through to their economies. The BOE left its policy rate at 5.25% earlier this month, and saw inflation fall in October to 4.6%. As for the ECB, it held its deposit facility to 4.00% and its main refinancing rate to 4.50% in late October, and like the other central banks, is data dependent as inflation is still well above their 2% target. While we believe the international central banks are closer to cutting than the Fed, for the time being they are maintaining their hawkish stances…thus, we believe they too warrant a yellow light.

Don't Fight the Trend: Trend is Slowing and Testing Support Levels (Domestically) - FLASHING GREEN

The trend on the S&P 500, which we define as the 200-day moving average, has decelerated since our last update, and the index has traded in a range between 4300 and 4600. Despite the recent deceleration, the trend is still rising at an annualized rate of ~10%. We believe the trend will continue to be positive for the next 5 to 6 months even if the S&P 500 holds its current level of around 4500. Historically, a positive trend is good for future stock returns, and we believe that this time is no different. Thus, domestically our rule of “Don’t Fight the Trend” is signaling a flashing green light, which calls for stock exposure slightly above long-term targets, in our view.

International Trend - RED LIGHT

The trend of International (as represented by the MSCI ACWI) is decelerating at a rapid pace. The international primary trend is currently falling at an annualized rate of -6%. We believe, unlike its US counterpart, the international trend will remain negative for most of the next 7 to 8 months if it does not reaccelerate. Therefore, we feel the international trend is signaling a red light for lower stock exposure relative to long-term targets.

Beware of the Crowd at Extremes: Once Again Searching for Direction - FLASHING YELLOW

We regard Crowd Sentiment as the ‘contrary’ indicator of the Three Tactical Rules. Since the beginning of the year, the crowd has been either neutral or in extreme pessimism, 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 source to measure investor psychology, although we also run this data through our own analytical framework to draw our final conclusions.

Currently, the indicator is in the neutral zone and searching for direction, a state that is typically ‘good but not great’ for stocks. However, our quantitative process, which combines sentiment and trend, is more positive. Thus, viewing the Crowd at Extremes through this lens only would indicate a flashing yellow light in our rating continuum, given the crowd is at the lower end of the neutral zone.

Conclusion: Signals are Mixed, but Quantitative Process Signaling a Flashing Green Light Domestically

In the US, the 'three rules' - in isolation is signaling a flashing yellow light and would warrant a neutral to slight stock overweight in the portfolios, in our view. However, when combined with our quantitative process, which forecasts the probability of the S&P 500 having positive returns over the next three months, we arrive at a more positive conclusion…thus we rate the signal a ‘flashing green light’. We continue to slightly favor stocks over bonds in our balanced portfolios.

International appears to be at the other end of the spectrum, since both our qualitative and quantitative signals are signaling a flashing red light. Hence, our balanced portfolios continue to favor US stocks over international stocks.

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.