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. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here
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 is 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.
A magazine cover buy signal?
Investors and traders who stepped up and bought into the market panic last Monday profited handsomely when stock prices staged a relief rally. Another panic opportunity may be presenting itself, this time in the energy sector.
Historically, The Economist magazine covers have been excellent contrarian market signals (see What a bond market rally could mean for your investments
). The Economist may have done it again this week with a focus on the global warming effects of heat waves in North American and floods in Germany.
Notwithstanding the public policy issues, which are beyond my pay grade, here is what it could mean for selected energy equities.
The new tobacco
One of the worse culprits of carbon emissions is coal. Coal stocks represent a relatively small part of the market, but here is how this industry has behaved in the last two years. The stocks made a saucer bottom and it is breaking upward, both on an absolute basis and relative to the S&P 500.
A more detailed analysis of global coal usage shows that OECD countries began to wean themselves off coal as an energy source at the time of the GFC. Chinese coal usage took off in the early 2000s and plateaued about 2014, while other EM coal demand continued to rise. The latest G-20 meeting ended without an agreement on the phaseout of coal powered electrical generation based on objections from China, India, and Russia.
Unfortunately, there are no easy ways to gain a diversified exposure to the industry. The only listed ETF, the VanEck Coal ETF (KOL), closed in December 2020. The lack of interest could be interpreted a contrarian buy signal.
Big Oil tests support
The oil and gas industry is another example of the “new tobacco”. The technical picture for energy stocks is not as bullish as coal. The energy sector is testing key support levels, both on an absolute basis and relative to the S&P 500. Relative breadth indicators are trying to bottom but may need some time to definitively take a position of market leadership.
The medium-term supply/demand outlook is constructive. The COVID-related inventory overhang has been worked off. As the global economy recovers, demand should pick up even as producers hesitate to commit to capex in the face of long-term climate change demand pressures.
A panic bottom and recovery
As for the stock market, conditions are setting up for a recovery from last Monday’s panic bottom. Jason Goepfert at SentimenTrader
pointed out that the “Up Volume Ratio cycled from below 15% to above 85% in back-to-back sessions on the NYSE”, which is “a buy signal that has never failed”.
Since 1962, the S&P 500 never showed a loss in the month following similar signals. These mostly occurred during momentum markets, and buyers followed through to avoid missing out on the next bull run. A few of them did end up leading to blow-off peaks, but not until month(s) later.
Technical analyst Walter Deemer observed that Monday’s downdraft represented an 89.4% downside to upside volume day, followed by an 88.0% upside volume day Tuesday and an 83.0% upside volume day on Wednesday. According to the 2002 Dow Award paper
by Paul Desmond of Lowry’s Report, consecutive 80% up volume days represent a bullish reversal buy signal after a 90% downside volume panic day.
The historical record shows that 90% Downside Days do not usually occur as a single incident on the bottom day of an important market decline, but typically occur on a number of occasions throughout a major decline, often spread apart by as much as thirty trading days…
Our 69-year record shows that declines containing two or more 90% Downside Days usually persist, on a trend basis, until investors eventually come rushing back in to snap up what they perceive to be the bargains of the decade and, in the process, produce a 90% Upside Day (in which Points Gained equal 90.0% or more of the sum of Points Gained plus Points Lost, and on which Upside Volume equals 90.0% or more of the sum of Upside plus Downside Volume). These two events – panic selling (one or more 90% Downside Days) and panic buying (a 90% Upside Day, or on rare occasions, two back-to-back 80% Upside Days) – produce very powerful probabilities that a major trend reversal has begun, and that the market’s Sweet Spot is ready to be savored.
Zweig Breadth Thrust watch
As part of the same theme of price momentum reversal, we have a potential rare Zweig Breadth Thrust buy signal setup. The ZBT buy signal is a rare momentum-based buy signal that occurs only once every few years and almost never fails. It requires the market to move from an oversold condition to an overbought reading within 10 trading days. The ZBT Indicator went oversold last Monday, and Tuesday, July 20 was day 1 of the ZBT buy signal watch. The window for flashing a buy signal ends on Monday, August 2.
This is only a trade setup. I am not holding my breath for the buy signal.
There are a number of key risks to the bullish scenario. First, the S&P 500 has rallied back to an all-time high. On the other hand, the 5 and 14-day RSIs are flashing negative divergences.
As well, credit market risk appetite is not behaving well. The relative price performance of junk bonds to their duration-equivalent Treasuries is exhibiting a minor negative divergence, which is another concern.
The week ahead
Looking to the week ahead, traders need to distinguish probable market direction based on differing time frames. I am inclined to lean bullish on a 1-2 week time horizon. Helene Meisler
conducts a weekend (unscientific) Twitter poll. Sentiment had plunged to negative double-digits the previous week, and such readings had marked tradable bottoms in the past. The latest week’s sentiment survey saw a bullish snapback, but conditions are not at a crowded long, which gives the bulls the run to run.
As well, option sentiment derived tail-risks are rising, as evidenced by the pricing of August VIX call options. I attribute this to the pricing of event risk based on what might occur at the Fed’s Jackson Hole gathering. As the market is pricing in sizable QE taper style announcements from Jackson Hole, this puts a floor on any taper trantrum risk-off episodes in the coming weeks.
In the very short-term, breadth is extremely overbought. Even if you are bullish, expect a pause or pullback early in the week.
In conclusion, coal and energy equities represent potential contrarian buying opportunities for investors. In addition, the stock market appears to have undergone a bullish reversal off a panic bottom, which should resolve in higher prices in the days and weeks ahead.