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 the 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 Asset Allocation 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 a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
The latest signals of each model are as follows:
- Ultimate market timing model: Sell equities
- Trend Model signal: Neutral (upgrade)
- Trading model: Bearish
Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
A sideways pattern
Stock prices have been chopping sideways and gone nowhere in the past month. After a strong rally off the March low, the rally stalled repeatedly at the 61.8% Fibonacci retracement level while the stochastic recycled from an overbought condition. It is becoming evident that the bulls have lost control. That doesn’t mean, however, that the market is ready to go down. Instead, the sideways consolidation could continue for some time.
What’s next? Will we see further chop sideways, or have the bears seized control of the tape?
Breadth outlook: Flat to down
Breadth signals indicate a flat to down outcome. Here is the case for further sideways consolidation:
- The S&P 500 remains range-bound.
- The equal-weighted S&P 500 is holding key support.
- Both the S&P 500 and NYSE Advance-Decline Lines remain in uptrends. The market is not going to decline significantly until these breadth indicators break their rising trend lines.
Here is the bear case:
- The equal weighted S&P 500, the S&P 500 A-D Line, and the NYSE A-D Line are all rolling over.
- % Bullish is exhibiting a negative divergence.
NASDAQ breadth tells a similar story. The NASDAQ A-D Line remains in an uptrend, but % Bullish is also exhibiting a negative divergence.
The risks of narrow leadership
The market has been rising mainly on the leadership of the large cap FANG+ stocks. Even the relative performance of healthcare stocks, which should be surging during this pandemic, have faltered and turned range bound.
The market’s reliance on FANG+ names brings to mind Bob Farrell’s Rule 7. “Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.”
A bearish catalyst for Big Tech may be on the horizon. In the wake of the Trump Administration’s decision to bar American semiconductor companies from selling chips to Huawei, Chinese official media Global Times reported that Beijing is preparing retaliatory measures. Major targets include companies like Apple and Boeing.
China is ready to take a series of countermeasures against a US plan to block shipments of semiconductors to Chinese telecom firm Huawei, including putting US companies on an “unreliable entity list,” launching investigations and imposing restrictions on US companies such as Apple, and halting purchase of Boeing airplanes, a source close to the Chinese government told the Global Times…
The measures include adding related US companies to China’s “unreliable entity list,” imposing restrictions on or launching investigations into US companies like Qualcomm, Cisco and Apple according to Chinese laws like Cybersecurity Review Measures and Anti-monopoly Law, and suspending the purchases of Boeing airplanes, according to the source.
The US companies mentioned, such as Apple, Qualcomm, Cisco and Boeing, are all highly dependent on the Chinese market.
When the shooting starts in the trade war, Apple makes a big fat target. The stock is the second largest stock in the major market indices, behind Microsoft, and comprise 5.1% of the S&P 500 and 10.1% of the NASDAQ 100.
What are “smart investors” doing?
The behavior of smart investors also presents a mixed flat to down narrative. Insider buying spiked when the market hit an air pocket late last week, but sales were above purchase activity. In the past, clusters of strong insider buying have been reasonable buy signals, but high insider selling have not been actionable sell signals. I interpret these conditions as a neutral signal.
On the other hand, a quirky analysis of US senator trading activity shows a flood of recent sales. This signal was timely going in when senators bought in mid-2018, sold ahead of the COVID-19 crash, and bought afterwards/ What should we make of this sudden flood of sales?
Last week, we discussed the continuing puzzle on the sentiment model front. The weekly AAII sentiment survey shows a crowded short condition, which is contrarian bullish.
By contrast, most other sentiment models focused on short-term retail “dumb money” traders were in neutral territory.
One likely explanation is the AAII survey is capturing the sentiment of new low-information traders that have recently entered the market, attracted by zero commission trading. Indeed, online brokerage firms’ Daily Average Revenue Trades (DARTs) have surged across the board.
Further age demographic analysis shows that most of the new accounts are young millennial traders. Some analysts have also advanced the unproven hypothesis that the current lockdown environment has deprived Americans of live sports, and hyper day trading of stocks is a substitute for sports betting. In that context, the stampede into FANG+ stocks makes sense. No matter how you measure price momentum, the factor is exhibiting positive returns right now.
A recent Investopedia investor survey confirms the millennial appetite for risk, but also shows a generational bifurcation of risk appetite.
Investopedia’s latest survey of active investors reveals that the recent market turbulence has caused a broad re-thinking of risk: two-thirds of respondents state they have changed their overall investing approach, but how they’re changing appears split down the middle. Those going bigger, buying blue chips on a bargain and grabbing shares in the beaten-down airline sector tend to be Millennials, though there are some Gen Xers and Boomers in the bunch. By contrast those seeking safer havens like money market funds and high-yield savings tend to be Boomers.
The Boomers tend to be more cautious, while younger investors tilt bullish.
The new young investors are bullish, and they trade more. The Boomers are net sellers, but they are likely to trade less frequently. Who wins this tug of war?
In the end, the big money Boomers are likely to win, but not before the market sees a bearish break and the new investors capitulate. In particular, investors should pay special attention the Fed’s warning in its Financial Stability Report, which was released late Friday after the market close.
Asset prices remain vulnerable to significant declines should the pandemic worsen, the economic fallout prove more adverse or financial system strains re-emerge.
The market could trade sideways for some time as the bulls and bears battle to a stalemate, but watch for a cascade should the dam breaks.
The week ahead
Looking to the week ahead, the market tested support late last week and began a relief rally. Short-term breadth is recycling off an oversold extreme. Barring further unexpected bad news, the market should see a bullish bias early in the week.
Friday’s retail sales print was awful and below market expectations. Many of the retailers report in the coming week, and their reports could prove to be a bearish catalyst for the stock market.
The challenge for the bears is to defend the trend of lower highs in market breadth.
My inner trader initiated a short position last Wednesday, and took partial profits Thursday, but he is still short. He is likely to add to his short position on a rally. Until we see a breakout of the trading range between 2740 and 2950, my base case scenario calls for choppiness. Even the high beta to low volatility indicator, which is a measure of equity risk appetite, has been stuck in a narrow trading range.
The market’s sideways consolidation in the past month has moved the Asset Allocation Trend Model from a bearish to a neutral reading. My inner investor is cautiously positioned, but he will gradually move back to a more neutral view of risk should the choppy range-bound trading continue.
Disclosure: Long SPXU