Why You Should Fear Fed Rate Cuts
BY MICHAEL SALVATORE, EDITOR, TRADESMITH DAILY
In This Digest:
- Fed rate cuts aren’t doing what they’re supposed to do
- The bearish logic behind this week’s expected cuts
- More warning signs for stocks under the hood
- The best Quantum-rated sector is utterly hated
- This standout stock is one to own in any kind of market
The Fed is in a bit of a pickle…
Last December, the central bank released its Summary of Economic Projections for 2025.
One key element was the “dot plot,” which projects where each Fed member expects short-term rates to be at the end of the year. And on that plot, a slim majority of Fed governors thought rates would be between 3.75% and 4% by the end of 2025.
Now, traders are pricing in a 90% chance that the Fed will take rates even lower than that tomorrow, to a range of 3.5% to 3.75%.
It seems like a small miss. But it shows how challenging it’s been to forecast the economy this year.
Tariffs have disrupted about 10% of global trade.
The jobs market has cooled, with the unemployment rate ticking up from 4.1% to 4.4% from June to September.
And since September, when the Fed started cutting short-term rates this year, the 10-year Treasury yield has jumped over 100 basis points. (A basis point is 1/100th of a percent.)
The Fed doesn’t control long-term rates – the market does. That’s a problem because the 10-year yield feeds into mortgage rates, a major pain point for homebuyers.
If you borrow $500,000 at 6.3% instead of 2.6%, you pay an extra $1,093 a month in interest… and an extra $393,539 in interest over the full course of the loan.
This hampers the Fed’s ability to tackle the big political problem of the day: the cost-of-living crisis.
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In short, rate cuts aren’t doing what they’re supposed to do…
Most investors expect rate cuts to boost stock prices, unlock the mortgage market, drive up spending, and keep the economy running hot – a magic wand, in other words.
But it’s up in the air if any those things will happen.
However, there’s one thing that hashappened consistently whenever the Fed starts cutting after a rate-hiking cycle… and you won’t like it. Going back to 1989, the economy has gone into recession every time.
See the chart of short-term rates below with recessions shaded in gray.
Recessions followed rate-cutting cycles in 1991, 2001, 2007, and 2020:
The Fed’s job is to keep the economy in balance. When it’s heating up, the Fed raises rates to cool it down. When it’s cooling, it drops rates to try to heat it up again.
Like it or not, rate cuts are a warning sign. They show that the Fed is worried about a slowing economy… and by extension, a falling stock market.
This time may be different. The Fed may have discovered how to walk the tightrope, keeping the economy right where it should be and avoiding a recession.
But it hasn’t been able to do that successfully in 35 years. So we see no reason why we should bet on it being successful now.
TradeStops is the ultimate recession blocker…
Our company was founded to help regular investors manage their risk and avoid the kind of costly losses that come with bear markets and recessions.
Our flagship software, TradeStops, was built for this express purpose.
It uses the historical volatility of a stock, index, or ETF to determine at what price you should sell it. This helps you get out of your positions before a bear market strikes.
Take the S&P 500, for example.
In 2020, the short-lived COVID recession saw the S&P 500 drop 50% in less than three months. But TradeSmith CEO Keith Kaplan and anyone who heeded his advice sidestepped most of the carnage, thanks to TradeStops.
Take a look at this chart of the S&P 500 from back then…
The S&P 500 flashed its Red Zone signal on Feb. 27, a 12% drop from the previous high. That was right before the index plunged from 3,100 all the way down to 2,200 points in a month – a 29% drop:
You can see the shift from Green Zone, to Yellow, to Red along the bottom of the chart.
It flashed back into the Green Zone on March 27, just days after the market bottomed. And it allowed you to ride the S&P 500 higher until it crossed into the Red Zone again on May 23, 2022… locking in a 58.3% gain before the 2022 bear market.
That’s just the most recent example. TradeStops would also have saved you from the worst of the losses in the 2008 bear market.
TradeStops would have recommended exiting the S&P 500 on November 21, 2007, before a 51% plunge.
It would have also gotten you back into stocks in August 2009, with the Green Zone persisting all the way through to August 2015 – locking in a 97% gain:
It would even have helped you escape most of the pain of the dot-com bust at the turn of the millennium.
As you can see, the Red Zone flashed a warning on Dec. 18, 2000, before a 39% plunge in the S&P 500 that bottomed in September 2002. Then it got you back into stocks in June 2003, riding them 45% higher through the housing bubble:
We aren’t seeing the same “crash alert” in stocks right now…
As of today, the S&P 500 is still in the Green Zone on its long-term Health indicator.
Our system would flash a warning if the S&P 500 closed below 6,132 points – a roughly 10% drop from where it’s trading today. That’s the Red Zone level right now.
But there are other warning signs under the surface.
You see, we don’t just track whether the indexes themselves are in the Red Zone. We track each of the stocks within the index, too.
And right now, despite the S&P 500 pushing higher by 10%, the number of Red Zone stocks has crept up from 22% in August to 31% today.
We saw a similar thing happen in mid-2007, with the number of Red Zone stocks rising from 25% to a peak of 55% before the top in October of that year.
This bearish pattern may signal pain ahead in 2026. So stay tuned for more on whether our indicators shift into the Red Zone.
Moments like that are too important to keep to ourselves. So whether you’re one of our top-tier Platinum members who pays to receive everything we publish or you’ve never paid a penny for our research, you can rest easy that we’ll be sounding the alarm in these pages when our system says it’s time to get out.
Before we wrap up for today, an anomaly in our quant data…
In my daily scan of our analytics platform, TradeSmith Finance, something curious caught my eye on Monday.
I was looking at a module we recently added, showing the average Quantum Score for all the key market sectors.
Jason Bodner created the Quantum Edge system to find those needles in the haystack – the less than 1% of stocks – that exhibit elite fundamental strength and technical strength, including Big Money flowing in from institutional investors on Wall Street.
Formerly a senior derivatives trader on Wall Street, Jason’s job was to pair up big institutional buyers with sellers. And in seeing hundreds of multimillion-dollar trades pass through his hands, he found that combination made all the difference for his trades.
He took both these factors and quantified them into the Quantum Score. The higher the score, the better the stock.
Our backtest from 1990 through 2023 found that holding the top Quantum Score stocks on a six-month rotation resulted in outperformance of more than 5x the S&P 500.
Take a look at which sector has the best average Quantum Score of the bunch. I guarantee it’s not what you expect:
The Energy sector, represented by the SPDR S&P 500 Energy ETF (XLE), has the best average Quantum Score of the group – at 68.4 – and the second-best average Fundamental score – at 71.9 – behind only Technology.
The context here is the energy sector has been stagnant for the past few years. XLE is only slightly higher today than it was back in June 2022. Measured from the 2022 bear market bottom, the S&P 500 has left it in the dust.
But measured from five years ago at the start of 2021 – not long after oil prices went negative due to a demand shock – XLE has outperformed. It’s up 173% since then, more than double the return of the S&P 500:
Energy is a core part of any portfolio. It can be volatile, but few other sectors can boast the level of necessity that energy can. Without energy, there simply are no technology, consumer discretionary, utilities, or really any market sector. It’s the lifeblood of the economy.
That’s a good thing, because energy is also the cheapest major sector based on forward earnings… and one of the market’s richest sources of dividends.
If you don’t have any energy stocks in your portfolio, now is a good time to add some. In another bout of volatility, energy may hold its weight just as it did in 2022.
Valero Energy (VLO) is a good stock to take a closer look at. It boasts one of the highest Quantum Scores of the group at 91.1, with a strong fundamental score of 85.0 and superior technicals ranking at 95.4.
Stocks like these are what a great portfolio is made of – in good times and bad. And if history even rhymes with past Fed cutting cycles, you’ll want robust stocks like this in your pocket.
To building wealth beyond measure,
Michael Salvatore
Editor, TradeSmith Daily
RJ Hamster 