In search of the next bearish catalyst

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: Bullish

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.


Another leg down?

Here is some good news and bad news. The good news is that the S&P 500 tested its 50-day moving average (dma) while exhibiting a positive 5-day RSI divergence. That’s bullish, right?



The bad news is the same pattern occurred during the COVID Crash of 2020. Even though RSI showed a series of higher lows and higher highs, the market continued to fall after a brief relief rally.


The moral of this story is that RSI divergences can be more persistent than you expect. Will history repeat itself? Will the market experience another leg down?



Similarities and differences

Here is what is similar and different between 2020 and today.The market is severely oversold today. All of my market bottom models have flashed buy signals in the past week. But oversold markets can become even more oversold, which is exactly what happened during the COVID Crash of 2020.



As the market became oversold in 2020, selling was sparked by further bad news. Global markets were suddenly faced with an exogenous shock. A pandemic had gripped the world. While initial models had penciled in a SARS-like outcome, the reality was actually far worse. There were no treatments. China reacted by shutting down its economy. The global economy was collapsing.


Here is what’s different today. The markets were surprised by the appearance of a new variant and a hawkish pivot from the Federal Reserve. The markets are already oversold. What’s the next shoe to drop that could spark another down leg?


Omicron running out of control? The latest mRNA technology allows pharmaceutical companies to re-program vaccines quickly. In the worst case, a new vaccine could be available within 3-4 months, depending on testing and the regulatory approval process.


Government shutdown? House and Senate leaders came to an agreement to continue to fund the US government until February. Crisis averted.


A hawkish Fed? The yield curve flattened in the wake of the November Jobs report, indicating that the market believes economic growth is decelerating and a probable Fed policy mistake.



I know I am tempting fate by asking this question. What’s the worst thing that could happen? The market is already oversold. Oversold markets become more oversold from existential bearish catalysts such as a Russia Crisis, a Lehman collapse that threatens the global financial system, or an unexpected pandemic that shuts down the global economy. What else could go wrong?


Otherwise, this market weakness is just a temporary panic and a buying opportunity.



Poised for a rally

Last week, I observed that the market was oversold, but upon further investigation, sentiment was still complacent. Most traders expected the market to rally after the Black Friday downdraft.


This week, the market became even more oversold. Ed Clissold of Ned Davis Research observed that 7.0% of S&P 500 stocks were above their 10 dma, which is below the 7.7% oversold threshold level. Forward returns have historically been strong after similar signals.



More importantly, evidence of panic is appearing in the markets. The markets are extremely jittery. The Bollinger Band of the VIX Index has spiked above 90. While similar readings have not marked exact market bottoms in the past, they do indicate a heightened state of anxiety.



The put/call ratio has risen to levels consistent with fear.



As well, insider buying is starting to look constructive, though this indicator is an inexact market timing tool.



Another constructive sign is selling pressure may be abating on NYSE stocks. NYSE new lows peaked on November 30, just before the S&P 500 tested its 50 dma. However, NASDAQ new lows are still expanding, which is still bearish. Viewed through a style lens, this is bullish for value (NYSE) over growth (NASDAQ).



In short, the stock market is sufficiently oversold and washed out that a meaningful relief rally is imminent.



Looking for opportunity

Under a relief rally scenario, where are the greatest opportunities?


The most straightforward way to benefit would be to buy S&P 500 exposure in anticipation of a rebound. A most speculative way to participate would be small-cap stocks. Small-caps are washed out and hated. The small-cap indices staged a failed upside breakout and they are approaching the bottom of their trading range that has been in place for most of this year. Watch for additional selling pressure in the next few weeks as investors harvest tax losses for 2021. Buy them in anticipation of a year-end relief rally into early January.



Mark Hulbert recently cited a study showing that December tax-loss sale candidates usually turn into January winners. This Santa Claus effect begins just after Christmas and lasts into the new year.



Notwithstanding the tax-loss selling scenario, portfolio manager Steve Deppe conducted a historical study of the Russell 2000 when the index reached an all-time high weekly close followed by a three-week losing streak. While the sample size is small (n=8), the index has never closed lower a month later.



In conclusion, the stock market is oversold and there are signs of capitulation. Barring another major negative shock, the market is poised for a relief rally into year-end and possibly January. Small-caps are washed out and could prove to be a worthwhile speculative buy as a way of taking advantage of the Santa Claus rally seasonal pattern.



Disclosure: Long SPXL


21 thoughts on “In search of the next bearish catalyst

  1. The worst that could happen? Probably unknowable at this point.

    What concerns me about the Omicron variant is not the variant itself, but what it portends for future variants. For instance, will we continue to see exponential increases in mutations as the virus evolves? If so, will it begin to outpace our ability to respond with effective vaccines?

    The panic response to Omicron probably stems more from the realization that we are far from achieving any kind of ‘handle’ on the pandemic – normal life isn’t necessarily around the corner the way it may have appeared last summer. There may be permanent changes in behavior with impacts on businesses and economic activity yet to be determined.

    1. Rx, that’s an interesting observation. I thought the folks in the developed world are actually rather complacent. It’s only a matter of re-programming mRNA vaccines to produce new ones in 3-4 months, as Cam stated in this missive.

      What makes you think the investors are worried about the future mutations?

      1. “For instance, will we continue to see exponential increases in mutations as the virus evolves”?
        My response: Yes, unless we can vaccinate globally, quickly. “Exponential speed” is less than factually accurate.
        “If so, will it begin to outpace our ability to respond with effective vaccines”?
        Yes. We have known this for the last few decades. The last time this movie played out was with the AIDS crisis. As AIDS became “endemic,” funding for such labs was withdrawn and many such researchers struggled and the labs shut down. This is how we work in the US.
        RNA viruses like SARS-COV2 or HIV (unlike DNA viruses), make less than perfect copies of themselves, as they replicate. EACH such imperfect copy has the potential for a mutant strain. Human ability to counter such mutations is extremely limited.
        If you have an interest in this field, I would suggest checking out Laurie Garrett’s encyclopedic, Pulitzer Prize winning book titled The coming pandemic.

      2. “It’s only a matter of re-programming mRNA vaccines to produce new ones in 3-4 months, as Cam stated in this missive”.

        Sanjay: in the mean time, the virus is mutating! ” It mutates, every second, with every replication, and after several cycles, “deviates” from the parent copy. Omicron, has show very rapid mutations as it grew unchecked in immunosuppressed population. Such immune compromised populations provide excellent fodder for the virus to grow unchecked. Africa has only 7% immunization. South Africa is around 23%.
        Yes, one can program these vaccines but unless we vaccinate the entire globe, we will not get durable relief from this pandemic.
        Not every replication will create a “mutation”. That is not what I am saying, but there is the potential. Omicron variant is a good example. “Founder effect” ensured that delta became the dominant strain, and Omicron has the “potential” to displace delta variant. Time will tell. If Omicron is less virulent (but more transmissible), it may displace delta and may be a silver lining. Again, this is not a prediction.
        We saw this movie with AIDS (HIV virus). M strain of HIV became “founder” in North America, and is not the same as HIV virus in African AIDS patients. Hope this helps. Welcome to the dark world of RNA viruses, which we have barely scratched the surface of.

        1. There is the math of contagion, and virulence. They are not necessarily correlated thank God. Obviously anything that spreads faster will gain market share so to speak. Virulence is different. A lot of corona viruses are harmless, so hopefully there is a mean which is more benign that mutations might target. There are also issues of susceptible populations, that once these are done the overall impact is less.
          Most likely this will end up like the flu…there was that disastrous one in 1918, but most don’t wreak havoc.
          So there will be bad strains of covid, but hopefully with partial immunity etc things will be less severe.
          I worry more about them doing experiments in labs….but that won’t stop either

        2. The data so far seems to suggest that Omicron is more transmissible but less virulent. We’ll see how it evolves.

          Thanks for suggesting the book. It was written almost 3 decades ago. Is this still relevant?

    2. The boosters seem to offer good protection against Delta, so odds are that there will be some protection against Omicron. There will always be pandemics.
      The question is if we will be wise enough to make less vulnerable and fragile societies….I fear not.
      Most likely we will learn to live with it. I don’t expect lockdowns unless Omicron escapes vaccines…at present I think if the boosters offer 90%+ protection from severe disease, the question will be “Do we lockdown our economy to protect those who refused a freely available vaccine?” My guess on that is no.

  2. All traders are confident they’ll be able to safeguard their accounts ahead of the next crash. For the most part, that’s not what I’ve observed. In retrospect, it’s easy to recognize shots across the bow – in real time, it’s not that simple. Many traders will sit through the first -5%, convinced it’s a pullback. When markets subsequently gap down let’s say another -2-3%, they freeze. Not wanting to take the additional hit, they wait for a bounce – one that never comes. Another -3%, and the thinking is that it’s too late to sell – until the indexes pull back another -5% – but then it’s really too late to sell – until it pulls back another -10%.

    1. RX, well said, and that is exactly what has gone through my mind. I am trying to learn not to let this thought process enter my mind.

  3. from what I’ve seen so far, initial Omicron data implies this virus is evolving as most do… as viruses mutate over time, they usually become more benign… faster spreading but less deadly. This is where evolutionary pressure pushes it. “Faster spreading” is good for business, killing the host is “bad for business”. We should know if this is the case for Omicron shortly.

    1. I don’t think it’s that simple. In a long term stable state, evolving into a less virulent but more transmissible variant may be a common evolutionary strategy but would involve evolutionary selection on both the virus and the victims (i.e. survival of the fittest). Omicron being new can be more virulent and more transmissible at the same time.

  4. In response to Sanjay- I generally assume that my concerns are shared by many if not most other traders (or even the general population) – and I’m not only disappointed but also worried that a ‘return to normal’ keeps getting pushed back. Maybe permanently. Of course, that’s only my opinion at this point in time, and things can and will change. Hopefully, once we have herd immunity things will in fact return to normal.

    HIV certainly changed human behavior more or less permanently as it transitioned from the gay community to the substance abuse community and inevitably to the world at large. Safe sex practices and needle exchange programs are here to stay – until perhaps an effective vaccine changes the game. Is social distancing (at least in terms of working from home and avoidance/a decline in attendance at crowded venues) here to stay? Is Zuckerberg moving his company to where the puck will be – in the metaverse?

    1. We should always entertain the opposing viewpoint.

      In this case, what if Omicron is the catalyst that ends the pandemic? The variant that spreads faster and thus becomes the dominant strain – yet causes milder disease. Thus hastening the process of herd immunity at minimal cost in terms of hospitalizations and lives lost.

        1. This is what Marko Kolanovic of JPM stated last week when everyone is still in a state of confusion. Marco made tons of calculation/simulation last year when original Wuhan virus was in rampage and came up with timelines which almost exactly matched what actually happened thereafter. Of course US government did not ask his opinions. He is a nobody to the bureaucrats.

          But quite a few people made a killing in stock market because of him. Marco is a very rare math genius trained in physics. Everything he published went thru rigorous math analysis. And he knows the right math or a combination of them for each particular analysis, unlike a lot of average wannabe quants.

          If you have a chance to review his math analysis works you will be impressed. I am very impressed.

  5. Heads of vaccine drug makers are saying the current vaccine is not likely to be as effective as on Delta and they will know in three weeks or so. We don’t know how fast it will spread but we know it’s spreading like wildfire in South Africa.

    So, between now and three weeks from now, we are guessing. I don’t see the value of guessing. If a coin is in the air and I guess right by picking heads, what does that mean. Even if I know this coin gives a 10% edge to heads and I bet my life savings on it, is that a rational risk to take?

    So even betting on a more likely scientifically based outcome is not rational in my way of thinking.

    If I bet the new virus is not a problem and I’m right, the market might add 10 or 15% to the current high index prices. If it is a nasty outcome, markets could plunge a lot more.

    Also, one has to think about one’s situation. Do you need another 15% or does a 30% drop change your life very negatively. This is where the rubber meets the road.

    1. All positions off here. Early? No doubt. But selling early has recently been the only way I’m able to lock in gains.

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