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 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 those email alerts is shown here.
Subscribers can access the latest signal in real-time here.
Waiting for the Big Event
The US election is just around the corner, and there isn’t much more to say. I have been monitoring the evolution of SPY implied volatility (IV), and this chart represents the final snapshot before the election. Since I began keeping track in September, IV has spiked at the time of the election and remained elevated into 2021, indicating a high level of anxiety over the results, and the possibility of a contested outcome. It was only recently that contested election anxiety has faded, and IV began to normalize just after the initial spike.
The IV of other asset classes are following a similar pattern to stocks, as represented by SPY. Gold (GLD) and long bond (TLT) IV both surges at election time, and slowly fall afterward.
The upcoming week should provide greater clarity of macro developments. While the actual outcomes are difficult to predict, investors can engage in some scenario planning so that they can be prepared.
First, I would like to point out that this level of anxiety of not unusual. BNP Paribas found that implied volatility – realized volatility also spiked before the election in 2016.
Here is what to watch for on Election Night. As the level of advance and mail-in voting has been very high, not all states will be able to complete most of their counts on Election Night. Pennsylvania, a key swing state, does not begin to process mail-in ballots at 7am on Election Day, and state officials have stated that they may not be able to report a full count until Friday. I refer readers to the analysis last week (see How the Election held the market hostage
). Two key battleground states that are expected to report their results in a timely manner are North Carolina and Florida. FiveThirtyEight has a useful tool (link here
) to monitor the odds on Election Night. Both those states are must-wins for Trump. If he loses either of those states, it will be a long night for the President.
The next question is which party gains control of the Senate? The following graphic shows the likely fiscal effects of different scenarios. The most bullish outcome is a Blue Wave, with a Biden Presidency and Democratic Senate, while the most bearish is a Biden win, coupled with a Republican Senate.
New pandemic waves
In addition to election jitters, market concerns are also rising over the appearance of a second pandemic wave in Europe, and a third one in the US. The Financial Times
reported that a new mutation has appeared in Spain, and the new variant is spreading across Europe. France and Germany announced lockdowns last week, joining a host of other European governments.
Here is the glass-half-full version of the analysis. Lockdowns in Europe are constructive. because case counts fall shortly after they begin. Several vaccine Phase III trials are scheduled to report in the next 4-6 weeks, which are hopeful signs for 2021. However, vaccine approval is not assured, and even if one or more vaccines are approved, production and deployment may not be smooth. Investors have to consider the best and worst-case scenarios of vaccine development.
Lastly, the trajectory of equity prices depends on the earnings outlook. So far, the Q3 earnings season has been a success. Both EPS and sales beat rates are above their historical averages, and EPS revisions are positive.
In fact, earnings sentiment is positive across all regions.
However, some of the market’s reaction to earnings reports are disconcerting. Earnings misses are badly punished, but beats are not being rewarded.
The near-term path of equity prices depends on how the macro outlook develops. The market is nearing an important crossroads, and we should get greater clarity in the coming week. Bill Luby of VIX and More
found that the VIX Index historically rises into an election, and declines afterward.
Analysis from Jeff Hirsch of election year seasonal patterns indicates that no matter who wins, November and December have been strong on average. If history is any guide, investors should view the recent market weakness as a buying opportunity, but averages can hide a lot of variation.
Investors can only engage in scenario planning, and stay prepared.
Looking to the week ahead, the market is entering the new month in a severely oversold condition. We now have an exacta buy signal from my Trifiect Bottom Spotting Model. As a reminder, the Trifecta Model consists of the following three uncorrelated bottom spotting components:
- Inverted VIX term structure indicating fear (Yes)
- TRIN > 2, indicating a “margin clerk” market involving price-insensitive selling (No)
- Intermediate-term overbought/oversold indicator of stocks above their 50 dma/stocks above their 150 dma < 0.50 (Yes)
In addition, the NASDAQ 100 is behaving remarkably well despite the poor performance of Big Tech stocks that beat earnings expectations but fell last week. The NASDAQ 100 remains in an uptrend relative to the S&P 500.
My inner investor is neutrally positioned at the asset allocation weight specified by his investment policy. Were it not for the looming event risk on the horizon, my inner trader would be inclined to take a shot at going long here.