Three Tactical Rules: Flying with the ‘Fasten Seatbelt’ Sign On
- With over $25 trillion of assets on the books, we believe the Fed and central banks are firmly planted on the side of investors.
- As the trend levels off, our analysis shows the odds of positive returns improve, albeit at a slower pace.
- The crowd has been the beneficiary of monetary and fiscal stimulus, along with strong corporate earnings thus far this year.
The second quarter is coming to an end as the global economy is set to reopen. Therefore, we thought that it would be a good time to revisit our “Three ‘Tactical Rules” related to the Fed, the Trend, and the Crowd - to see what they are indicating for the next three months. Thus far in 2021, all three have combined to keep the portfolios favoring equities while proceeding with caution. In honor of the service sector reopening, we are going to use an airline industry analogy to discuss the Three Tactical Rules in this update. The Federal Reserve (Fed) will serve as the air traffic controller, the Trend is defined by the takeoff and landing, while the Crowd is represented by the quality of the journey (smooth, turbulent, etc.).
Don’t Fight the Fed: Growing balance sheet provides stock market support
The Fed along with other major central banks around the world currently are serving as the air traffic controllers of monetary policy. Like air traffic controllers at airports, the Fed and its fellow central banks oversee managing the appropriate timing of QE tapering and rate increases (take-offs), and rate decreases (landings) to ensure the most effective monetary result. Over the last 15 months, global central banks have stepped up their various bond buying programs to guide their respective economies through the pandemic. As the chart below shows, there has been a more than 24% increase in the combined balance sheets of the Fed, the European Central Bank (ECB), Bank of Japan (BOJ), and the Bank of England (BOE). With over $25 trillion of assets on the books, these central banks are firmly planted on the side of investors. However, in the coming months we expect Central Banks to begin slowing their bond purchases (tapering), making them less accommodative.
Don’t Fight the Trend: Unsustainably strong trend may constrain near-term returns
The Trend is defined in the domestic equity market as the 200-day moving average of the S&P 500. Currently, the trend in the US is rising at an annualized rate of 33% (as of June 11, 2021), so its take-off has been superb. However, after an airplane takes off there comes a point when the pilot must level out the plane and stop climbing. We think the S&P 500 has reached that point and the trend’s current growth rate is not sustainable. When combined with sentiment, and using our proprietary heatmap process, our analysis shows the odds of having a positive return over a given 3 -month period are below the long-term average due to the strength of the trend. The odds improve as the trend levels off at lower growth rates, just as a plane ride improves after cruising altitude is reached. The international trend, represented by the 200-day moving average of the MSCI All-Country World Ex US Index, suffers from a similar problem as the US trend, rising at an annualized rate of 31% (as of June 11, 2021). Note the new all-time high on the World Ex US, an encouraging longer-term sign in our view.
Beware of the Crowd at Extremes: Exuberance May Fade This Summer
The Crowd has been the beneficiary of monetary and fiscal stimulus, along with strong corporate earnings thus far this year. These factors have allowed the Crowd Sentiment to fly high above the clouds, delivering a smooth ride for equity markets to set new highs. However, as stocks enter the summer months when the trading volumes are typically light, we are concerned that this exuberance could easily give way to pessimism if economic data disappoints, as we expect. In our opinion, the Crowd could experience some unwanted turbulence given the current levels of equity markets. Given the current optimism of the Crowd, our third rule is indicating that we should fasten our seatbelts in preparation for that potential turbulence.
Conclusion: Choppy air
The Fed, the Trend, and the Crowd point to the portfolios continuing to cruise with the ‘fasten seat belt’ light on this summer. We remain overweight equities across all portfolio time horizons, but after slightly lowering risk levels in the portfolios a few weeks ago, we continue to watch our risk indicators closely. We acknowledge that both the trend and the crowd are stretched, yet the Fed’s loose monetary policy continues to provide the flight plan for markets.