Day Hagan Catastrophic Stop Update December 23, 2024
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The Catastrophic Stop model declined to 60.7% from 72.9% last week due to High-Yield and Emerging Market bond breadth shifting from bullish to neutral on 12-18-2024. The Internal Composite is bullish, and the External Composite is neutral.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index.
As we all know, interest rates have been backing up. The chart below illustrates 10-year Treasury yield performance around first rate cuts. The dashed green line highlights the current period. In reviewing the chart, we noticed that other periods illustrated similar reactions, including 1974 (dark green), 1980 (yellow), and 1981 (pink).
Here are the similarities between those three periods:
1. High Inflation
1974: Inflation soared following the 1973 OPEC oil embargo, which quadrupled oil prices. This led to cost-push inflation as energy and transportation costs permeated the economy. The annual inflation rate reached approximately 11%.
1980: Inflation peaked at 13.5%, exacerbated by the second oil crisis in 1979 due to the Iranian Revolution, which disrupted global oil supplies.
1981: While inflation began to decline, it remained high at around 10.3%, as the effects of monetary tightening by the Federal Reserve under Paul Volcker were only starting to materialize.
2. Stagflation
All three years were marked by stagflation pressures, a rare combination of high inflation, high unemployment, and stagnant economic growth:
The economies struggled to grow due to high energy prices, which increased production costs and reduced consumer purchasing power.
3. Energy Crises
The oil price shocks of the 1970s played a central role in the inflation of all three years:
1974: Result of the 1973 OPEC oil embargo.
1980-1981: The second oil crisis caused by geopolitical tensions in the Middle East.
4. Monetary Policy
In response to high inflation, the Federal Reserve attempted to use tight monetary policy:
In 1974, the Fed raised interest rates but struggled to control inflation without exacerbating unemployment.
By 1980, Paul Volcker aggressively raised the federal funds rate to combat inflation, which continued into 1981. This policy eventually succeeded but initially deepened the recession.
5. Recessions
Each of these years was associated with economic downturns:
1974: The U.S. experienced a recession due to the oil embargo and the subsequent collapse in consumer and business confidence.
1980: A brief but sharp recession occurred as the Fed's rate hikes constrained economic activity.
1981: The U.S. entered another recession, extending into 1982, driven by continued high interest rates and their impact on borrowing and investment.
6. Public Sentiment and Economic Anxiety
Over these years, widespread public concern about the economy was reflected in declining consumer confidence and political pressure on policymakers.
High unemployment rates further dampened economic activity.
Figure 2: Rates continuing to rise after First Fed Rate Cuts have usually done so either in response to inflation surges or tighter monetary policies. We do not currently view either as a major problem at this juncture, with inflation pressures moderating and monetary policy less restrictive (the Fed is past peak hawkishness.)
The 26-week rate of change for Baa bond yields is in the neutral zone (up 1.4%). A move above 6% would be concerning. At this point, we are neutral on fixed income.
Figure 3: The backup in rates has been significant but so far contained.
The 10-year yield normal valuation calculation is based on measures of inflation, relative short-term rates, international fixed-income rates (bunds), and economic output vs. potential output. Normal valuation is 4.15%.
Figure 4: Fair (Normal) Value for the U.S. 10-year is calculated to be 4.15%.
Credit spreads (option-adjusted spreads) ticked slightly higher on the market pullback but are not in the danger zone.
Figure 5: Credit spreads (OAS) are still well below longer-term averages.
OAS credit spreads by equity sector are providing a similar message.
Figure 6: U.S. Sector OAS are not showing signs that a significant financial dislocation is expected
It also appears that investors have priced in a less-dovish Fed. Three months ago, the expected endpoint (in one year) for the Fed Funds rate was just under 2.9% (orange line). It has now shifted higher to just under 4.0% (dark blue line). In our view, that’s priced in a bit of pessimism. The light blue line illustrates expectations from six months ago.
Figure 7: Investors are no longer overly optimistic that a significant number of rate cuts are coming down the pike. This is a net positive for stocks and bonds.
As we head into the end of the year, I thought it would be interesting to show the results of the 2024 Cycle Composite.
Figure 8: The S&P 500 Cycle Composite for 2024 was directionally on point but missed the dips
Figure 9: Here’s the Cycle Composite for 2025. If wishes were nickels!
Lastly, short-term sentiment is heading back toward pessimism. This also is a net positive near-term.
Figure 10: Short-term sentiment is at better levels to support a Santa Claus rally
Bottom Line: We remain fully invested based on the message of the models. We acknowledge that inflationary pressures have increased slightly, global economic activity is waning (especially in manufacturing), valuations are extended, and geopolitical risks are elevated. But U.S. companies are profitable and growing, and the Fed is past peak hawkishness. Until the models shift negative, we will continue to hold the course. Note that we expect our technical indicators to turn first should the supporting backdrop deteriorate. As of this writing, the weight of the evidence continues to portray an uptrend that remains intact.
Our goal is to stay on the right side of the prevailing trend, introducing risk management when conditions deteriorate. As has been the case for all of 2024, the broader-based composite models calling U.S. economic growth, international economic growth, inflation trends, liquidity, and equity demand remain constructive. The Catastrophic Stop model is positive, and we are aligned with the message. If our models shift to bearish levels, we will raise cash.
This strategy utilizes measures of price, valuation, economic trends, monetary liquidity, and market sentiment to make objective, unemotional, rational decisions about how much capital to place at risk and where to place that capital.
If you would like to discuss any of the above or our approach to investing in more detail, please don’t hesitate to schedule a call or webinar. Please call Tyler Hagan at 941-330-1702 to arrange a convenient time.
I hope you have a wonderful week,
Sincerely,
Donald L. Hagan, CFA
Chief Investment Strategist, Partner, Co-Founder
Charts with models and return information use indices for performance testing to extend the model histories, and they should be considered hypothetical. Charts courtesy Ned Davis Research (NDR). © Copyright 2024 NDR, Inc. Further distribution is prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers, refer to www.ndr.com/vendorinfo.
Disclosures
S&P 500 Index – An unmanaged composite of 500 large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks.
S&P 500 Total Return Index – An unmanaged composite of 500 large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks. This index assumes reinvestment of dividends.
Sentiment – Market sentiment is the current attitude of investors overall regarding a company, a sector, or the financial market as a whole.
Option Adjusted Spread (OAS) - The measurement of the spread of a fixed-income security rate and the risk-free rate of return (the theoretical rate of return of an investment with zero risk), which is then adjusted to take into account an embedded option.
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