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
- Trading model: Neutral
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.
Subscribers can access the latest signal in real-time here.
I have been writing about bearish setups for several weeks. In particular, risk appetite indicates have been sounding warnings. For example, the ratio of equal weighted consumer discretionary to consumer staples stocks, equal weighted to minimize the dominant weight of AMZN in the consumer discretionary sector, have been trading sideways and not buying into the equity rally.
As well, credit market risk appetite, as measured by the relative performance of high yield (junk) bonds and leveraged loans to their duration equivalent Treasuries, are also not buying into the equity risk-on narrative.
The divergence between the VIX Index and the TED spread, which is one of the credit market’s indication of risk appetite, is another worrisome sign.
In the short run, none of this matters. Here is what traders should really be paying attention to.
Big Tech dominance
I wrote about how Big Tech stocks are dominating market action (see A Potemkin Village market?). Indeed, the Big Tech sectors (technology, communication services, and consumer discretionary/Amazon) comprise roughly half of S&P 500 index weight. It would be virtually impossible for the market to move without the significant participation of these top sectors. So far, technology has been in a well-defined relative uptrend, consumer discretionary stocks have been strong on a relative basis, and communication services relative strength has been moving up in a choppy pattern.
The NASDAQ 100 remains in an uptrend, though breadth indicators are sounding negative divergence warnings. Until the NASDAQ 100 breaks its trend line, it would be premature to turn bearish despite the widespread warnings.
Macro speed bumps
There are also warnings from a top-down macro perspective. Disposable income had been held up in this recession by fiscal support.
The expiry of the $600 per week supplemental unemployment insurance at the end of July has caused UI outlays from Treasury to fall off a cliff. Undoubtedly that will show up in falling confidence and retail sales in the near future.
Banks are responding predictably by tightening credit standards. We have the makings of an old-fashioned credit crunch, which will crater economic growth in the absence of further significant fiscal and monetary policy support.
The narrative for the economy is turning from bounce back rebound to a stall. Historically, the stock market has encountered headwinds when growth expectations disappoint, as measured by the Citi Economic Surprise Index (ESI).
Here is a close-up look at ESI, which is showing signs of topping out.
This trend of stalling ESI is evident globally. Here is Eurozone ESI.
Here is China ESI.
Pennies in front of a steamroller
In the short run, none of this matters until the major market indices, and the NASDAQ 100 in particular, experience breaks to the rising trend lines. Short term momentum remains positive as the percentage of stocks in the S&P 500 above their 5 dma is exhibiting a series of higher lows.
A similar pattern can be found for the NASDAQ 100.
In conclusion, the negative divergence concerns that I raised in the past few weeks are still valid. However, nothing matters until we see trend line breaks, especially in the NASDAQ. Traders could try to buy dips in this environment. However, intermediate term downside risk is considerable, and buying here would be akin to picking up pennies in front of a steamroller.