Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on research outlined in our post Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.
The latest signals of each model are as follows:
- Ultimate market timing model: Buy equities
- Trend Model signal: Risk-on
- Trading model: Bullish
Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.
Value meets Growth and Momentum
No, I am not turning bearish on stocks despite the title of this post. However, the value side of my inner investor is starting to get a little nervous. The market has risen to a level that can be described as either fair value or slightly overvalued. In addition, the behavior of “smart” investors like insiders are also raising cautionary flags that serve as early warning signs of limited upside potential.
On the other hand, the US economy is undergoing a growth revival, which is helpful for higher stock prices. In addition, the market is experiencing powerful momentum in the form of a FOMO (Fear of Missing Out) rally that’s still in its early stages. The irrational exuberance scenario that I postulated two weeks ago (see How to get in on the ground floor of a market bubble) is becoming my base case. Under those circumstances, stock prices can rise further than anyone expects.
My preliminary conclusion is we are seeing the late stages of a market blow-off that will ultimately mark the top of the bull market that began in March 2009. We are in the 7th or 8th inning* of this bull and there are still gains to be made, but longer term investors should start to begin to exercise some caution.
* For readers unfamiliar with baseball, a normal game lasts 9 innings. If the score is tied after the 9th inning, then extra innings are played until a winner is determined.
The bull case
Let’s start with the bull case for stocks. I have been saying for several weeks that we are seeing the start of a growth surprise and that trend continues. Last week, we saw the latest Manufacturing PMI beat expectations and tell a story of an industrial growth revival.
Last week, we also saw more progress in initial jobless claims which also beat expectations. Last week’s release is particularly useful as it coincides with the survey period for the July Jobs Report.
We also saw a number of key metrics being released for housing last week, which is important as the sector is a leading indicator of economic growth – it’s virtually impossible to have a recession without housing and construction turning down. Housing starts and existing home sales both beat expectations, reflecting solid prospects for continued economic growth (click on links to comments from Bill McBride of Calculated Risk).
In fact, macro momentum was so strong last week that there were very few important indicators that missed expectations.
A solid earnings season
If we were to analyze the market from a bottom-up basis, the growth picture appears just as positive. The latest Earnings Season update from John Butters of Factset shows that both the EPS and sales beat rates are coming in slightly ahead of historical averages. More importantly, the Street is revising EPS upwards at a solid rate (chart annotations are mine).
From a growth investor’s viewpoint, these are all bullish signs.
FOMO rally = Momentum
Even as the market undergoes a growth surprise, the BoAML Fund Manager Survey (FMS), which is primarily a survey of global institutional fund managers, is suggestive that a FOMO stampede is just starting. Remember – institutions represent big and slow money and their moves tend to be slow but powerful.
The FMS shows that global institutions are still relatively defensively oriented. Cash levels are high.
Overall portfolio risk is well below average.
Equity allocations at about neutral (the lower than average portfolio risk can be explained by high cash levels).
Growth expectations are falling, despite emerging evidence of a US growth surprise.
Equity weights in the US has moved from an underweight to a slight overweight position in June, though readings are not excessively high. Managers are allocating more funds into US equities as the evidence of a growth surge emerges. The combination of an defensive portfolio orientation and positive US growth characteristics suggests that the shift into US equities leads me to believe that funds flows into the US market has a lot more room to run.
This buying stampede has created a price momentum tsunami. CNBC highlighted analysis from Ari Wald of Oppenheimer showing past instances of momentum breadth surges have led to much higher prices.
In short, funds were caught off-side and too defensively positioned. Now they`re buying anything that moves. As the chart below of high beta stocks vs. low volatility stocks shows, a FOMO rally has a long way to run before sentiment can be characterized as irrational exuberance.
Despite the bullish signals from Growth and Momentum, a number of cautionary signs are restraining me from getting wildly bullish. I wrote before that the combination of above average valuation (as measured by Morningstar’s fair value estimate) and insider selling (Barron’s) could pose bullish headwinds (see How worried should investors be about insider selling?).
Those conditions are appearing again. We are seeing mild (3%) overvaluation and several weeks of of insider selling. While this is not a perfect market timing signal, it does suggest that stock prices lack valuation support.
I would warn that this model is not designed for trading, but investing. During the episode in late 2014 and early 2015 when such a combination of condition existed, the signal persisted for several months and the market ground upwards before it corrected (chart from How worried should investors be about insider selling?).
Another risk that I have also pointed out in the past raised concerns about how a rising US Dollar squeezes the margins of large cap US multi-national companies. While the USD remains fairly flat on a YoY basis, the recent rally of the USD Index has moved it to test downtrend technical resistance. An upside breakout could be a signal of further strength, which would eventually pose headwinds for US equity fundamentals.
Another cause for concern the direction of bond yields. The chart below (via Ed Yardeni) shows the Citigroup Economic Surprise Index, which measures whether macro-economic releases are beating or missing expectations (red line), and the 10-year UST yield (blue line). These two indicators have tracked each other quite closely in the past. While ESI has surged in the past few weeks, 10-year yields have barely moved. How long before yields rise to catch up with ESI?
If Treasury yields were to rise, it would change the risk-reward relationship between stocks and bonds in the favor of bonds and put downward pressure on stock prices.
The ESI-bond yield relationship also begs the question of the Federal Reserve’s reaction function to higher growth, better employment and stabilizing markets. When will it resume its path of interest rate normalization? How many rate hikes will we see in 2016?
We should get better clarity when the FOMC releases its statement next week. The FOMC statement is expected to set the tone for the bond market and the USD, which could have profound implications for equity prices for the reasons I mentioned above.
The bull market in the late innings
For now, any Fed induced slowdown or recession is well in the future. Nevertheless, these are risks bear watching in the face of a mature economic cycle and mature late-stage stock market bull.
When I put it all together, the stock market is caught between a battle between Value. whose signals tend to be early, and Growth and Momentum. As the latter two factors can be very powerful in the late phase of a bull, this combination suggests that the bull market that began in 2009 can still have more room to run. If I had to make a guess about an SPX target, a rough estimate of 2400-2500 would be where this market ultimately tops out – and that figure is consistent with the upside target on a point and figure chart.
As for the question of the timing of a market peak, we can get some clues from this Morgan Stanley analysis of the the high yield credit cycle (via Value Walk). Based on this analysis, we might see the top of the cycle about a year from now. By contrast, an analysis using the Presidential Cycle would see a cyclical market top in early 2017. So a rough guess would see the time frame for a market top in 6-12 months.
The bull market isn’t dead, but it`s aging. It is now starting the manic phase where price is overshooting fair value. I am now paying more attention to technical analysis to watch for the signs of a top.
The week ahead
I don’t have much to add to my mid-week tactical market comment (see When will the bulls take a breather?). Bullish momentum appears to be waning. Even perennially bullish strategist Tom Lee at Fundstrat has turned tactically cautious. He pointed out that equity volatility (VIX) has fallen below bond volatility and such episodes have historically seen an average SPX loss of -1.3% in the next 20 trading days 68% of the time.
In addition, the latest Commitment of Traders data shows crowded long positions by futures speculators in the NASDAQ 100, S+P 400 and the Dow. The combination of these readings all point to limited upside potential in the near-term.
Though the stock market can continue to grind upwards and make marginal new highs, the more likely outcome is a 1-2 week period of sideways consolidation or minor pullback.
Even though he is getting a little nervous, my inner investor remains bullish and fully invested. My inner trader remains in cash after coming back from vacation. Next week will see potential volatility in the form of the heavyweight AAPL earnings report and the FOMC meeting. My inner trader is inclined to believe that the prudent course of action is to stay on the sidelines. He is waiting for signs that the market’s overbought condition has been alleviated before making a commitment to the long side.
Disclosure: No trading positions