A little over a month ago, various Federal Reserve officials directed a pause and started to signal that the US central bank might have reached its terminal destination in this rate hike cycle. These statements came with the caveat that short-term rates would stay “higher for longer”, but as history shows, once the Fed is done, it has usually been a matter of months before interest rates have been cut again. The one exception might just confirm the rule: it was 2006-2007, which was the lead up to the financial crisis. (Chart 1).

Theres an old metaphor attributed to Economist Milton Friedman that refers to aggressive central banks as the “fool in the shower”. In the same way that it takes time for hot and cold water to work their way through home plumbing to an older showerhead, so it takes time for monetary policy changes to work their way through the economy. When the fool realizes that the water is too cold, they turn on the hot water. However, the hot water takes a while to arrive, so the fool simply turns the hot water up all the way, eventually scalding themself. In other words, the Fed usually doesn’t know when its hiked enough until its hiked too much, leading to negative economic outcomes that force the central bank to pivot quickly.

Markets have already begun to pivot. Since the Fed’s signaling turned dovish, important financial conditions have backed off and cleared the way for a year-end rally. The 10-yr treasury yield, the price of oil, and the US dollar are three of the most important financial conditions we monitor. After resuming strength over the summer, all three have started to loosen (Chart 2), which has provided major support for equities. Investors are turning to the past decade’s big winners of excess liquidity, mega-cap tech stocks. The S&P 500 is up ~10% from its October low and has broken out of its downtrend from the summer.

While all that seems positive, ultimately, this is all following a typical late-cycle roadmap that will inevitably lead to recession. In fact, it is very on brand for stocks to melt up into a hard landing. Typically, stocks peak within six months before the onset of a recession. (Table 1) If the recession begins in the second half of 2024, as we expect, this provides a short runway for stocks to move higher.

And It’s amazing how closely this year’s pattern for the S&P 500 has tracked its typical annual pattern. (Chart 3). If this were to continue, we may have a December to remember.

We have spoken in past commentaries about recession bells ringing for the second half of 2024, and our more pessimistic longer-term outlook for risk assets, but we believe this sets up a tactical opportunity. In the past month we have added to equity exposure following the October pullback, as we expect a final blow off rally before we inevitably position our portfolios more defensively.

Bottom Line

We do not believe this time is different, but this time is longer. A recession can be deferred (and has) but won’t be denied. A decline in bond yields, oil, and the USD from their recent highs should fuel a blow off risk rally into the end of the year, but risk assets should weaken in 2024.

Overall, our top-down asset allocation is overweight risk on a tactical timeline to take advantage of what we believe could be a year-end rally.

We will continue to monitor our portfolios as the facts change and will remain tactical as the situation evolves. We believe markets are at a point of inflection and will manage assets accordingly.

Recent Portfolio Changes

Past performance is no guarantee of future results. Performance prior to January 1, 2018 was earned on accounts managed at a predecessor firm, JAForlines Global. The person primarily responsible for achieving that performance continues to manage accounts at Donoghue Forlines in a substantially similar manner. The material contained herein as well as any attachments is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies, opportunities and, on occasion, summary reviews on various portfolio performances. The investment descriptions and other information contained in this Markets in Motion are based on data calculated by Donoghue Forlines LLC and other sources including Morningstar Direct. This summary does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities. The views expressed are current as of the date of publication and are subject to change without notice. There can be no assurance that markets, sectors or regions will perform as expected. These views are not intended as investment, legal or tax advice. Investment advice should be customized to individual investors objectives and circumstances. Legal and tax advice should be sought from qualified attorneys and tax advisers as appropriate. The calculation and presentation of performance has not been approved or reviewed by the SEC or its staff.

The Donoghue Forlines Global Tactical Allocation Portfolio composite was created July 1, 2009. The Donoghue Forlines Global Tactical Income Portfolio composite was created August 1, 2014. The Donoghue Forlines Global Tactical Growth Portfolio composite was created April 1, 2016. The Donoghue Forlines Global Tactical Conservative Portfolio composite was created January 1, 2018. The Donoghue Forlines Global Tactical Equity Portfolio composite was created January 1, 2018.

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