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 that 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: Buy equities
- Trend Model signal: Bullish
- 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.
Still scaling the heights
The S&P 500 remains in an uptrend on the weekly chart. After pulling back and successfully testing the lower bound of a rising megaphone trend line three weeks ago, the index rose to test resistance as defined by the upper megaphone trend line.
Should the market break out to the upside, it would represent a blow-off top of unknown magnitude. On the other hand, bulls should be warned that the market is exhibiting a negative divergence on the 5-week RSI. Should the market break the lower megaphone trend line, the experience of the past four years suggests a pullback in the 6-12% range.
Does this market action represent the start of a renewed bull or the last gasp of a dying bull? Here is what I am watching.
Earnings, earnings, earnings!
Keith Lerner at Truist Advisory Services observed that the S&P 500 has been rising since last June, but the market’s forward P/E ratio has been steady. This indicates that forward EPS estimates have been rising in line with stock prices, which is constructive for the bull case. What he neglected to mention is that the 10-year Treasury yield has risen about 0.5% during the same period, which makes fixed-income instruments more competitive with equities. In order for stock prices to rise, EPS estimates need to rise at the same pace or more than the stock index. Otherwise, the strength of the TINA (There Is No Alternative to stocks) investment theme will fade.
To the relief of the bulls, earnings estimates have been rising. The EPS and sales beat rates of the Q4 earnings season have been ahead of historical averages.
However, there is some question as to how much of the Q4 earnings beats have been priced in. For the first half of earnings season, the market was not rewarding earnings beats but the situation turned around in the last week. Bespoke
reported that stock prices had been falling in reaction to earnings reports but improved sharply in the week ending February 9, 2021. The one-day price reaction to earnings report for that week was a positive 1.34%, which was considerably better than the earlier periods.
Sentiment: Elevated but off the boil
Sentiment model conditions are still excessively bullish but they are mostly off the boil. The Fear & Greed Index is recovering after falling, but readings are still in neutral territory and not excessively bullish.
AAII sentiment has also recycled back to net bullish, but conditions are not extreme enough to be alarming. In any case, overly bullish AAII sentiment has not shown itself to be a timely sell signal in the past.
One area of concern arises out of the NAAIM Exposure Index
, which is a survey of RIAs managing client funds. The latest survey shows that the most bearish respondents are 80% long the market, which is astounding.
pointed out that while these readings are concerning, they have not constituted actionable sell signals in the past.
In addition, the surge in penny stock and option trading volume along with a collapse in SPY volume has a bubbly feel of a stampede of inexperienced small retail traders. One investment professional reported
, “Schwab is receiving so many requests to turn on options trading that their usual 24-48 hour application turnaround is now 7-10 days.” Bubbles can persist for a long time but bubbly conditions don’t constitute immediate sell signals.
These sentiment conditions as worrisome. The market can pull back at any time, but conditions are not excessive enough to preclude additional price gains.
Market internals: A second wind
A glance at the market internals of the top five sectors shows the bulls getting a second wind. These sectors represent about 75% of S&P 500 index weight, and it would be impossible for the market to advance or decline without the participation of a majority of these sectors. The relative performance of the Big Tech sectors (technology, communication services, and selected consumer discretionary stocks) are all turning up, along with financial stocks.
In addition, the performance of the high-octane and speculative stocks, as proxied by ARK Innovation ETF, is beating the market.
On the other hand, leadership is narrowing, and that’s a concern from a longer-term perspective. The percentage of stocks beating the S&P 500 has dropped to historic lows.
A similar pattern of narrow leadership can be also observed globally.
Waiting for resolution
Where does that leave us? The bulls can point to renewed bullish technical conditions that are supportive of additional gains. Sentiment conditions, while elevated, can rise further before reaching crowded long readings.
The bears can highlight selected technical warnings, such as the negative divergence on the 5-week RSI and narrowing leadership. In addition, the combination of SPAC mania and retail meme trading are characteristics of a speculative top that does not end well (see Rip the bandaid off now, or later?
I interpret these conditions as a market that is extended and can correct at any time. However. the market can grind higher in the short-term. Investment-oriented accounts should raise some cash and reduce some risk at these levels. Traders should wait for definitive signs of either an upside breakout of the megaphone, which would indicate a bullish blow-off top, or a breakdown below megaphone support, which signals a correction, before acting.