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.
In need of a washout
While I am a long-term equity bull, sentiment models are extremely stretched in this market and in desperate need of a reset. The latest BoA Global Fund Manager survey shows that institutional risk appetite is at historically high levels.
Retail risk appetite is even more stretched. The CBOE equity put/call ratio (CPCE), which tends to measure retail sentiment, is extremely low indicating excessive bullishness. By contrast, the index put/call ratio (CPCI), which measures institutional hedging activity, has been rising indicating cautiousness. Such high spreads between CPCE and CPCI have resolved themselves with market pullbacks in the past.
This is insane! When’s the sentiment reset?
The end of the retail frenzy?
In many ways, you can tell that we are nearing the end of the retail trading frenzy when Congress holds hearings into the GameStop Affair. Bloomberg TV also took steps to educate its viewers on WallStreetBets lingo.
also featured the profile of a 25 year-old security guard who took out a $20,000 loan to play GameStop and lost. These are all typical signs of a mania that’s nearing its end.
The bear case
Here are some bearish factors to consider. The 10-year Treasury yield has taken off like a rocket and even rose through a rising trend line.
Ally strategist Callie Cox
found that “Quick jumps in the 10-year yield tend to freak out stocks, but stocks tend to do well in the 12 months after….because big jumps in yield often happen at the tail end of recessions or early on in economic recoveries”, which describe current circumstances well.
As well, simultaneous high correlations between the S&P 500, the VIX Index, and VVIX, which is the volatility of the VIX, have tended to resolve with pullbacks in the 3-5% range in the past.
The weekly S&P 500 chart is exhibiting a negative 5-week RSI divergence. But this is not an immediate and actionable sell signal. These divergences can persist for several weeks before they resolve themselves.
Earnings Season: What’s priced in?
Another concern is the market’s reaction to Q4 earnings season. According to FactSet, 79% of the S&P 500 has reported, and both the EPS and sales beat rates are well above their historical averages. In response, analysts are revising their EPS estimates upwards. These developments should be equity bullish. As the historical record shows, earnings estimates have moved coincidentally with stock prices.
The disturbing development is the market response to positive earnings surprises. Stocks have not reacted well to earnings beats, which calls into question what the market has already priced in. In the past, the market either pull back or experience difficulty advancing under similar conditions.
The bull case
On the other hand, the bulls can make the case that the path of least resistance is up. Despite a combination of frothy sentiment and extreme positioning, market internals do not support the case for a pullback. Most technical indicators are confirming the signs of market strength.
The relative performance of the top five sectors to the S&P 500 shows few signs of broad technical breakdowns. The top five sectors comprise 75% of index weight and it is impossible for the market to move up or down significantly without the participation of a majority.
Equity risk appetite, as measured by the ratio of high beta to low volatility stocks, and the equal-weighted ratio of consumer discretionary to consumer staples, is not showing any negative divergences.
Credit market risk appetite is also not showing any bearish divergences either.
Foreign exchange (FX) risk appetite presents a mixed picture. The USD Index has been inversely correlated with the S&P 500 in the last year and it is flashing a minor warning. However, the AUDJPY exchange rate, which is a risk-on indicator, is flashing a bullish signal.
Waiting for the break
Tactically, the market can continue to grind upwards, but it can also break down and correct at any time. I pointed out in my last post (see No reasons to be bearish?) that significant downside breaks need a bearish trigger and story. Despite the presence of technical warnings, no bearish narrative has taken hold.
In the absence of a negative fundamental story that spooks the markets, the best the bears can hope for is a 3-5% pullback, but no sentiment reset. Market psychology has become so overdone that the healthiest scenario is a brief scare and correction to wash out the weak hands. So far, that hasn’t happened.
Looking to the longer-term, the big picture market structure favors a sustained advance. The percentage of S&P 500 stocks above the 200-day moving average recently exceeded 90%. This is the sign of a “good overbought” momentum advance that can last for months.
The market just needs a sentiment reset and correction for the bull trend to continue.