Flashing Yellow Light Guides Three Rules

Since our last ‘Three Tactical Rules’ update on June 9^th, the S&P 500 is up less than one percent. The stagnation by the equity index has been due to the cooling of the AI trade. Like the S&P 500, the Three Rules have also been stagnant, as each of the rules maintained their ratings from our previous update: the Three Rules are still collectively a ‘flashing yellow light’. Over the last seven weeks our Fed rating was impacted the most; inflation came in lower than expected, reducing the pressure on Fed members to hike rates at its July 29^th meeting. The Trend stalled over the period, as short-term momentum slowed due to the AI selloff. The Crowd’s optimism decreased when viewed through the combined lenses of the Weekly and Daily Sentiment Polls. Collectively, the Three Rules continue to favor a cautious optimism towards stocks in balanced portfolios.

'Don't Fight the Fed': Cooling CPI Keep the Fed on Hold - FLASHING YELLOW

Leading up to the July 29th FOMC meeting, the Fed funds futures market is forecasting the Fed to hold rates steady at the next meeting… but expects a 0.25% increase in interest rates later in the year. The Futures market is predicting that inflation does not continue to subside, despite headline CPI declining to 3.5% and Core CPI falling to 2.6% in June. The ceasefire announcement between the US and Iran and the signing of memorandum of understanding (MOU) in mid-June had caused inflation to moderate. However, with hostilities intensifying between the two sides recently, inflation worries are now back on the minds of investors, as brent crude is back above $80 per barrel.

From the Fed’s perspective, it is important to uphold its dual mandate of full employment and price stability… but currently the focus is on price stability according to Chairman Warsh. We believe that the market has taken Warsh’s focus to heart, leading to the anticipation of rate hikes. Given the heightened attention to inflation by Fed members, we no longer see the Fed squarely on the investor’s side — the war has changed that calculus.

However, we believe that the Fed has the luxury of being patient because the impact of higher energy prices on inflation is seen as ‘transitory’ if oil flows freely. Furthermore, we would reiterate what we wrote seven weeks ago: higher bond yields since the beginning of the Iran War has sufficiently tightened financial conditions, giving Warsh cover not to have to raise rates. Given the fluidity of the Iran War negotiations, the Fed does not need to make any changes to the fed funds rate currently in our opinion. Hence, we are maintaining our Fed rating of a 'flashing yellow light.'

Internationally, the Bank of England (BOE) has held rates steady thus far this year. However, they are leaning towards hiking rates to offset inflationary pressures from higher energy prices and wages that have risen 3.4% over the 3-month period ending in May. With wage increases exceeding the BOE’s inflation target, there could be additional pressure put on the central bank to raise rates. The European Central Bank (ECB) for its part recently joined the Bank of Japan (BOJ) in hiking rates to fight inflationary pressures and their economies’ energy dependence. The Overnight Index Swap (OIS) markets are now pricing at least one hike for each of three central banks through year-end. Further delays in ending the war will likely cause the major international central banks to raise rates in the coming months. Globally, we now view central banks as neutral rather than on the investor’s side…however, we do not see a prolonged hiking cycle ahead.

‘Don’t Fight the Trend’: Positive US Trend Remains the Investor’s Friend - GREEN LIGHT

The S&P 500's primary trend, defined as the 200-day moving average, is rising at a 17% annualized rate…down from 23% during our last update. The trend’s modest deceleration is due to slower short-term momentum, as the AI trade came under pressure. The index increased by less than 1% in the last seven weeks, versus the 6% increase in the previous eight weeks. Despite the index not appreciating as quickly, the trend will remain positive if the index simply remains at its current level for the next 9 months.

Historically, the S&P 500 has risen over any given three-month period two-thirds of the time. Given the trend’s positive slope and positive short-term momentum, the odds of having a positive return over the next 3 to 6 months are higher than average, according to history. We believe the trend remains the investor’s friend. This is why we prefer US stocks over bonds in our balanced portfolios. We continue to maintain the Trend’s rating as a ‘green light.’

International Trend: Still Positive, but Lagging Domestic Performance - GREEN LIGHT

Internationally, the MSCI All Country World ex-US index (ACWX) trend also decelerated over the past seven weeks; ACWX’s primary trend is now rising at a 22% annualized rate, down from 29% at our last update. Like the US trend, during this period the international trend experienced a slowdown in short-term momentum. Over the last seven weeks, the international equities have underperformed domestic equities by nearly 0.5%, narrowing the year-to-date edge to just 2.9%.

Despite the international trend slowing, ACWX could remain at its current level for over seven months before turning negative. This is an encouraging sign, as our tactical work suggests that a trend above zero increases the odds of a positive return over the next three to six months. We are therefore maintaining its ‘green light' rating.

Beware of the Crowd at Extremes: Weekly and Daily Polls Combine to Dampen Optimism - YELLOW LIGHT

Crowd Sentiment serves as the 'contrary' indicator within the Three Tactical Rules. The chart below reflects investor sentiment as measured by Ned Davis Research (NDR), where elevated readings signal excessive optimism and depressed readings signal extreme pessimism. Historically, NDR research suggests extreme pessimism has created attractive entry points for tactical investors. While NDR is our preferred data source for measuring investor psychology, we apply our own analytical framework to draw conclusions.

Currently, the Daily and Weekly NDR Sentiment Polls are sending mixed signals. The Daily Sentiment Poll is sitting in the middle of the neutral zone, while the Weekly Sentiment Poll remains in the extreme optimism zone. The divergence in the two polls is due to Weekly Sentiment being primarily survey-based, while the Daily Sentiment includes more market-based analytics such as: put/call ratios on both indices and equities, volatility, and investor surveys. Historically, we have weighted the Weekly more heavily in this publication, as it provides longer-term perspective, while the Daily better captures investors' real-time views. Given that we have entered the period before mid-term elections when markets are more volatile based on history, we are giving the Daily more ‘air, heat, and light’ in our analysis.

The Crowd’s current optimism is elevated by historical standards when viewed through the lens of the Weekly Sentiment Poll, but it has not reached the euphoric levels seen in periods like 2018 as shown in the chart above. The Crowd is optimistic due to the earnings potential of AI-related companies. Conversely, the Crowd viewed through the lens of the Daily Sentiment Poll is neutral due to the inflation headwinds, tariffs, and various headline-grabbing news items such as the Iran War. Hence, when we blend the two polls, we view sentiment as between the upper end of neutral and the lower end of extreme optimism. This is an improvement from our last update when both polls were in the extreme optimism zone. Thus, we are upgrading our rating for the Crowd to a ‘yellow light’ from a ‘flashing red light’ in our previous update.

Conclusion: Maintain an Equity-Focused Strategy - FLASHING YELLOW

Viewed through three distinct lenses — a Fed on hold, a trend that is experiencing slower short-term momentum, and dampened crowd optimism - our Tactical Rules collectively signal a ‘flashing yellow light.’ Given that our collective rating of the Three Rules has not changed since the last update, we continue to believe that the market will go higher this year. Given the fluidity of economic data, earnings guidance, investor mood, and geopolitical negotiations, the Three Rules will shift in the weeks ahead. Over the next three to six months, we believe market conditions will continue to favor domestic and international equities over bonds, with yields remaining rangebound.

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.