Tactical Rules Turn Bullish

SUMMARY

• The Fed has opened the door to rate cuts.
• The Trend remains positive, benefitting from recent market pullback.
• Crowd sentiment pulls back from optimistic extreme.

Since our last update of the Three Tactical Rules on June 25, 2024, equity markets have retraced most of the rally from the spring. The change in market sentiment came abruptly, due to the labor market showing signs of weakness as the number of jobs available per unemployed worker fell to 1.2 and the unemployment rate rose to 4.3%. The recent market volatility has had a dramatic impact on our tactical rules. From a tactical perspective, the tactical rules of “Don’t Fight the Fed,” Don’t Fight the Trend,” and “Beware of the Crowd at Extremes” collectively are a flashing green light, which is two steps higher on our ratings continuum versus our previous update.

Don’t Fight the Fed: Fed Opens the Door for Rate Cuts - GREEN LIGHT

The Fed has left the effective fed funds rate steady at 5.33% for six consecutive meetings due to mixed but generally positive economic data. However, a recent 0.5% increase in the unemployment level - admittedly from historically low levels - now has markets anticipating upcoming Fed cuts.

Previously, the Fed had been laser-focused on containing inflation and lowering core PCE (Personal Consumption Expenditure) towards its 2% target. Currently, it sits at 2.6% as inflation expectations fall. The Fed believes that the economic risks of its interest rate policy must be balanced between its dual mandate of full employment and price stability. Given that the core PCE has fallen by more than 1.5% since the Fed raised rates for the last time in July 2023, and the unemployment rate has risen by 0.80%, from 3.5%, some would say that the Fed’s interest rate policy is currently restrictive. Hence, Chairman Powell’s recent comments opening the door to rate cuts in September.

Given the current economic backdrop, and the Fed’s bias towards cutting interest rates, we believe that the Fed is on the side of the investor. However, our forecast remains below the market’s expectation for 5 rate cuts, as we expect the Fed to only cut 1 or 2 times towards year-end. Regardless of the magnitude of rate cuts, however, it’s clear to us that the Fed is moving to the next phase of normalizing rates. Thus, we have upgraded our tactical rule of “Don’t Fight the Fed” to a ‘green light’.

Internationally, the Bank of England (BOE) and the European Central Bank (ECB) both cut their policy rates by 0.25% at their last meeting. Market participants are expecting the BOE and the ECB to cut rates two and three more times respectively, before year-end. We believe the major central banks are fully aligned with “Don’t Fight the Fed” and all are a green light now, except for the Bank of Japan (BOJ) which is now raising interest rates.

Don’t Fight the Trend: Trend Starting to Decelerate to a more Sustainable Pace Zone (Domestically) - FLASHING GREEN

The trend on the S&P 500, which we define as the 200-day moving average, has slowed its ascent since our last update, due to the index’s recent pullback. The trend is rising at an annualized rate of 33% but is decelerating (see chart right). If the index remains range bound over the next month, the trend will continue to decelerate to a pace we believe is more sustainable and beneficial for above average returns.

Given that the recent economic data has been mixed and investors are concerned about a growth slowdown, we do not foresee a catalyst that would cause the trend to reaccelerate in the near-term. Historically, a positive trend is good for future stock returns, and we believe that this time will not be different as we have gotten the healthy pullback in the S&P 500 that we wrote of needing in the last Three Rules update. Domestically our rule of “Don’t Fight the Trend” is signaling a ‘flashing green light’.

International Trend: Trend Remains Healthy but Decelerating (Internationally) - GREEN LIGHT

Internationally, the trend of the MSCI ACWI ex-USA index has accelerated since our last update in June. The international primary trend is currently rising at an annualized rate of 19%, but like its domestic counterpart it is beginning to decelerate. If the MSCI ACWI ex-USA index remains at the current level or higher, the international trend will remain positive through year-end, which reiterates the higher probability of receiving above average returns over the next 3 to 6 months. Hence, the international trend is still signaling a ‘green light’.

Beware of the Crowd at Extremes: Optimism has Moved Down to Neutral - YELLOW LIGHT

We regard Crowd Sentiment as the ‘contrary’ indicator of the Three Tactical Rules, meaning that too much optimism can be negative for near-term future returns, and vice-versa. The chart at the top of the next page 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, though we use our own analytical framework from which to draw conclusions on sentiment.

Since last December, when the Fed signaled it was done with rate hikes, the Crowd had been in the extreme optimism zone. However, with the recent labor market weakness and the subsequent pullback in the equity markets, the Crowd has lost some of its enthusiasm. The Crowd is now in the neutral zone, waiting to see if the pullback is a normal reset in a bull market, or the beginning of a recession (we believe the former, not the latter…but are monitoring economic data closely). We believe that the Crowd is looking for the Fed to cut rates and fuel further earnings growth in stocks, which will enhance the soft-landing narrative. The neutral zone is typically positive for stocks. We stated in our previous update that we would become more constructive on the Crowd once there was a pullback, hence we have upgraded our qualitative rating from a ‘red light’ to a ‘yellow light.’

For international markets, there is no analog to the NDR Crowd Sentiment indicator. Therefore, in its’ place we use a price relative strength indicator (RSI) as a proxy. This indicator does not appear to be extremely optimistic to us after the recent market volatility, and thus we give it currently a ‘flashing green light.’

Conclusion: The Tactical Rules Signal Flashing Green Light Domestically and Green Light Internationally

In our view, the tactical rules collectively signal a ‘flashing green light’ due to a more accommodating Fed, the trend decelerating to a more sustainable pace, and a less euphoric crowd. The flashing green light signal helps serve as confirmation that the pullback was needed to reset expectations after the strong rally in the first half of 2024. Given that earnings season has been solid, the three rules give us greater conviction to maintain the portfolio’s composition favoring stocks over bonds, with a bias towards domestic stocks over international stocks in our balanced portfolios.

Internationally, the tactical rules signal a ‘green light,’ driven by (mostly) dovish central banks, a positive trend, and less extreme RSI readings. While international markets appear slightly more attractive than the US on a short-term tactical basis, we will continue to temper our enthusiasm for the asset class until we see earnings growth structurally improve.

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.