Flashing Green Light – Excessive Optimism has Eroded, Now Bullish on Equities
SUMMARY
The Fed pauses but still on investor’s side, in our view.
The Trend remains positive but growing at a slower pace.
Crowd is now neutral as inflation worries slows optimism.
Collectively, our Three Rules improved to a ‘flashing green light’.
Since our last update of our ‘Three Tactical Rules’ on November 26, 2024, equity markets are up slightly. Despite the S&P 500 closing at a record high in late January, over the past 10 weeks the equity market has stalled as the Fed pumped the proverbial brakes on further monetary policy easing. We believe this is largely due to a stronger than anticipated labor market creating the potential for higher inflation, while the Trump administration’s potential use of tariffs could also expediate inflation. In both instances, the monetary and fiscal policies will operate with a lag, and the impact of the decisions will not be known until at least the second half of 2025, hence, we turn to our three ‘Tactical Rules’ to help guide us for the next three months. Currently, the Three Rules are a “flashing green light” which is an improvement from the “flashing yellow light” in our last update.
‘Don’t Fight the Fed’: Central Banks Still on the Investor’s Side - FLASHING GREEN
The After cutting interest rates by 100 basis points in the last three meetings of 2024, the Fed decided to hold interest rates steady at its FOMC meeting last week. Currently, the effective fed funds rate is 4.33%. The driving force behind the Fed’s decision not to lower interest rates further is due to the resilience of the US economy. The strength of the economy is allowing the Fed to have the luxury of ‘not being in a hurry’ to make a move.
We stated in our last update that the strength of the economy would cause the Fed to be “slower to lower”, and it appears that thesis is in alignment with the Fed’s current thinking. The Fed communicated late last year that the risks were balanced between inflation and employment, thus refocusing the central bank on its dual mandate of price stability and full employment rather than being singularly focused on one or the other. With core PCE at 2.8% and the unemployment rate at 4.13%, the Fed likely wants to make sure that fiscal policy based on tariffs does not derail its efforts to fight inflation before it cuts again, in our opinion. Thus, we believe that the Fed could be on hold until mid-year. Despite the Fed holding rates steady, it is not hiking rates and driving up borrowing costs, so it remains on the investor’s side, in our opinion.
Internationally, the Bank of England similarly (BOE) finds itself on hold, but with a different economic backdrop. The UK’s economy is slowing, but the central bank has not been able to fully tamp down inflation, which has led the BOE to pause rate cuts after cutting 50-basis points in the second half of 2024. Meanwhile, the European Central Bank (ECB) has cut its deposit rate by 125-basis points since last May and is approaching its 2% inflation target. While the speed of monetary policy easing is different at each of the major central banks, we believe the major central banks remain fully aligned with “Don’t Fight the Fed” and are on the investor’s side. The Bank of Japan (BOJ) is the one exception, as it is currently raising interest rates after leaving them artificially low for an extended period.
Source: Bloomberg, RiverFront. Data daily as of January 31, 2025. Chart shown for illustrative purposes. Not indicative of RiverFront portfolio performance. Index definitions are available in the disclosures.
‘Don’t Fight the Trend’: Slowing Down, but Still Going Strong - GREEN LIGHT
The trend on the S&P 500, which we define as the 200-day moving average, has slowed further since November. The slowdown can be attributed to the index trading within a 300-point range over last 10 weeks. We welcome the slower accent of the trend, as we deem it more advantageous to own stocks when returns are above the long-term average. The current condition of the trend rising at an annualized rate of 19% produces better historical odds of a positive return over the next 3 to 6 months than its prior pace of 27% in the last update. Historically, a positive trend is good for future stock returns, and we believe that this time will not be different, even with the threat of tariffs causing inflation to accelerate. Domestically our rule of “Don’t Fight the Trend” is signaling a “green light”.
International Trend: Flat for Now… but Potential for Improvement - FLASHING YELLOW
Internationally, the trend of the MSCI All Country World ex-US index has decelerated since our last update in November. The international primary trend is essentially flat and continues to decelerate faster than its domestic counterpart. Despite economic headwinds internationally, the trend will turn positive in about a week if the MSCI All Country World ex-US index can remain at its current level of 338 or higher, we believe the trend will remain positive for the next three months. A positive trend increases the probability of receiving above average returns over the next 3 to 6 months. Hence, the international trend is still signaling a “flashing yellow light”.
Beware of the Crowd at Extremes: Mixed Message Across Timeframes…but Neutral Overall - YELLOW LIGHT
We regard Crowd Sentiment as the contrary indicator of the Three Tactical Rules. 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, though we use our own analytical framework from which to draw conclusions on sentiment.
Crowd sentiment across time frames is sending two different messages currently, as NDR Daily Sentiment is neutral, while NDR Weekly Sentiment has crossed over back into the lower end of the extreme optimism zone. Historically, we have given more weight to the Weekly for this publication, despite incorporating both measures of sentiment in our overall rating. The Daily tends to be a good indicator of the investors’ ‘real time’ view of financial markets in our opinion, while the Weekly gives longer term perspective of the Crowd. In the review of Daily Sentiment, its current level of 53.33 ranks in the 52nd percentile of all occurrences in the dataset, whereas the Weekly Sentiment level of 66.24, in the chart below, ranks in the 73rd percentile of all occurrences. Hence, we view the Crowd overall as neutral because it not at an extreme and rate it as a “yellow light”.
Copyright 2025 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at ndr.com/copyright.html. For data vendor disclaimers refer to ndr.com/vendorinfo/. Past performance is no guarantee of future results. Shown for illustrative purposes.
Conclusion: The Tactical Rules Signal a Flashing Green Light - FLASHING GREEN
The tactical rules signal a “flashing green light” to us, as the trend decelerates to a more sustainable pace, and the crowd becomes more neutral after being closer to the upper limits of the extreme optimism zone. The flashing green light signal serves as affirmation that current monetary and fiscal policies are positive for the stock market over the next 3 to 6 months, despite the volatility experienced thus far this year. Hence, we remain cautiously optimistic, and the tactical rules give us the confidence to maintain the portfolio’s composition favoring stocks over bonds, with a bias towards domestic stocks over international stocks in our balanced portfolios.
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.
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