All clear? - MMM v5-38

This week the Federal Reserve is expected to do what they first hinted at 11 months ago – to cut interest rates. They have already declared "mission accomplished" in their inflation fight. The market is programmed to initially celebrate any sign of Fed policy easing. On paper it makes sense. If interest rates are lower, borrowing costs go down, which should make it easier on businesses and consumers, which should stimulate economic growth.

The problem is, history tells us more often than not, when the Fed cuts interest rates, more often than not the economy STILL goes into a recession (or it had already started). There have been a handful of times where the Fed cut rates to "normalize" rates after an inflation fight or when growth is slowing down faster than they are comfortable.

Morningstar took a look at the past 4 rate cutting cycles. It was a mixed bag.

Goldman Sachs went further, looking at all rate cutting cycles going back to 1980. Using hindsight, they identified what the economic environment was at the start of the cycle. The results are drastically different.

This means what is more important is whether or not the economy is just going through a 'growth scare' that will be solved by lower interest rates, or if like most of the time throughout the Fed's history, if the economy is already on its way to a recession. Last week we walked through our economic model where we showed all indicators except the stock market are either 'neutral' or declining. In aggregate, it isn't quite enough to push our model to 'bearish', but it's close to moving that direction.

Based on last week's action, the stock market has already given the 'all clear' signal with stocks posting their best week of the year so far. This leaves us in a difficult position. Even if growth doesn't slow, stock valuations are at levels rarely experienced. In both 2000 & 2007, stocks were also at historically high valuations when the Fed started cutting rates. We know how that ended.

For our clients we will do what we always do – focus on the data and make adjustments based on our models, not our opinions or 'hopes'.

Market Charts

The mega-cap S&P 500 ended the week essentially back to all-time highs.

In theory if the economy is 'fine', cutting rates should be huge for small cap stocks.

Turning to bonds, what nobody seems to be addressing is HOW the yield curve 'normalizes'. We keep hearing how in theory, it's a good time to own bonds, but is it? To 'normalize' we need to see short-term rates go well below long-term rates. With long-term rates already coming down, how much lower will the Fed have to force short-term rates to return to a more normal environment? What if they cause inflation by cutting rates too much? We know what happened to longer-term bonds the last time the Fed let inflation get out of control (the lost 22%).

Again, just because 'everybody' is confident of what happens when the Fed cuts rates, the outcome will depend on what happens inside the economy and nobody knows what that will be.

Long-term rates have already been cut by 1.3% since last fall. How much more does the market believe they will be cut?

SEM Model Positioning

-Tactical High Yield had a partial buy signal on 5/6/24, reversing some of the sells on 4/16 & 17/2024 - the other portion of the signal remains on a sell as high yields continue to oscillate.

-Dynamic Models are 'neutral' as of 6/7/24, reversing the half 'bearish' signal from 5/3/2024. 7/8/24 - interest rate model flipped from partially bearish to partially bullish (lower long-term rates).

-Strategic Trend Models went on a buy 11/27/2023;  7/8/24 – small and mid-cap positions eliminated with latest Core Rotation System update – money shifted to Large Cap Value (Dividend Growth) & International Funds

SEM deploys 3 distinct approaches – Tactical, Dynamic, and Strategic. These systems have been described as 'daily, monthly, quarterly' given how often they may make adjustments. Here is where they each stand.

Tactical (daily): On 5/6/24 about half of the signals in our high yield models switched to a buy. The other half remains in money market funds. The money market funds we are currently invested in are yielding between 4.8-5.3% annually.

Dynamic (monthly): The economic model was 'neutral' since February. In early May the model moved slightly negative, but reversed back to 'neutral' in June. This means 'benchmark' positions – 20% dividend stocks in Dynamic Income and 20% small cap stocks in Dynamic Aggressive Growth. The interest rate model is slightly 'bullish'.

Strategic (quarterly)*: BOTH Trend Systems reversed back to a buy on 11/27/2023

The core rotation is adjusted quarterly. On August 17 it rotated out of mid-cap growth and into small cap value. It also sold some large cap value to buy some large cap blend and growth. The large cap purchases were in actively managed funds with more diversification than the S&P 500 (banking on the market broadening out beyond the top 5-10 stocks.) On January 8 it rotated completely out of small cap value and mid-cap growth to purchase another broad (more diversified) large cap blend fund along with a Dividend Growth fund.

The * in quarterly is for the trend models. These models are watched daily but they trade infrequently based on readings of where each believe we are in the cycle. The trend systems can be susceptible to "whipsaws" as we saw with the recent sell and buy signals at the end of October and November. The goal of the systems is to miss major downturns in the market. Risks are high when the market has been stampeding higher as it has for most of 2023. This means sometimes selling too soon. As we saw with the recent trade, the systems can quickly reverse if they are wrong.

Overall, this is how our various models stack up based on the last allocation change:

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