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.
Edge towards the exit
Happy New Year! I hope you are enjoying the seasonal rally, but don’t get overly complacent about the party that the bulls are throwing. Sufficient warning signs are appearing that it’s time to edge towards the exit.
Exhibit A is the relative performance of the top five sectors of the S&P 500. These sectors comprise over three-quarters of index weight and it would be impossible for the S&P 500 to rise or fall without the leadership of a majority of sectors. As the accompanying chart shows, none of the sectors are in a relative uptrend. The most bullish pattern is technology, which is trading sideways compared to the S&P 500.
Once the seasonal strength fades, what happens to the market?
Warnings everywhere
Despite the recent market strength, warnings are appearing under the hood. The most disturbing development is the long-term sell signal shown by a negative 14-month RSI divergence as the Wilshire 5000 rose to an all-time high. In the past, the MACD histogram rising from negative to positive has been a very good buy signal, and negative 14-month RSI divergences have been reasonable cautionary signals. The last negative divergence occurred in August 2018 (see Major top ahead? My inner investor turns cautious). This is a long-term signal and a market top may not be apparent for some time. The stock market continued to rise for another two months before it hit an air pocket. In the past, the lag can be as much as a year.
Other market internals are flashing intermediate-term warnings. Equity risk appetite, as measured by the relative performance of equal-weighted consumer discretionary to consumer staples, and the relative performance of high beta to low volatility stocks, are not confirming the fresh highs set by the S&P 500.
The relative performance of defensive sectors is also raising concerns. The relative returns of these sectors surged and became overextended when the S&P 500 hit an air pocket in mid-December. They have pulled back but their relative performance is improving again. This is a sign that the bears haven’t lost control of the tape.
A closer look at selected defensive sectors tells the story of lurking bears. Consumer Staples, which is a classic defensive sector, rose to fresh all-time highs and its performance compared to the S&P 500 is forming a saucer bottom. Relative breadth (bottom two panels) is also showing signs of improvement.
Healthcare is showing a similar pattern of new highs, a bottom in relative performance, and improving relative breadth.
I could go on, but you get the idea.
Temporary bullish tailwinds
In the short run, asset prices have also been supported by fresh liquidity from the Federal Reserve. According to the New York Fed, the Fed balance sheet rose by almost $140 billion month-to-date to December 21.
Wait, what? Isn’t the Fed supposed to be tapering its QE program? Didn’t the FOMC announce that it was reducing its asset purchases from $120 billion to $105 billion per month? Is this some sort of nefarious Deep State plot?
Actually, the Fed’s balance sheet faces substantial maturities between December 15 and December 31. The $140 billion in purchases was intended to offset the maturity of assets rolling off the balance sheet before year-end.
Nevertheless, the purchase of nearly $140 billion by the Fed temporarily injected a substantial amount of liquidity into the system, which should have had a bullish effect on asset prices. This effect will fade in January.
Wait for the sell signal
I interpret these conditions as the stock market is poised to weaken. Investment-oriented accounts should begin to de-risk now. Returning to the party metaphor, the celebrations are getting out of hand and the neighbors have called the police. It’s time to gather friends and relatives and prepare to leave.
I had highlighted an uncanny buy signal in mid-December. The NAAIM Exposure Index, which measures the sentiment of RIAs, had fallen below its 26-week lower Bollinger Band. Virtually all past episodes have been strong tactical buy signals with minimal S&P 500 downside risk. The last buy signal worked out perfectly. In the past, the return of the NAAIM Exposure Index back to its 26-week moving average (wma) has been a good spot to lighten long positions as the bullish momentum begins to fade, which it did last week. Readings have risen higher in the past, but risk/reward becomes less attractive at the 26 wma.
While investors should begin to lighten equity positions, traders may want to stay at the party for one more round. There may be further upside in January. Historically, the beginning of the year sees strong seasonal flows.
Tactically, S&P 500 intermediate breadth momentum reached an overbought reading. But selling now may be premature. Historically, a better sell signal occurs when this indicator recycles from overbought back to neutral.
In conclusion, investment-oriented accounts should begin to de-risk their portfolios by reducing their equity weights and lowering the beta of their equity portfolios. Short-term traders may want to stay at the bulls’ party a little longer and wait for a sell signal to turn bearish.
Disclosure: Long SPXL
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Would it be safe to say you are expecting more than a 10% garden variety selloff? Thanks.
Probably 10-20% some time in Q1. Timing uncertain.
According to Cam’s Trend Model, it goes from 80/20 allocation to 60/40 allocation for SPY/IEF respectively. Signal goes from Bullish to Neutral. I interpret this to signal a correction of 10-20%.
We may be in for a bigger drawdown (20% give or take?) based on history and declining14 months RSI (see first graph).
Divergences stand out when they work. In the first chart there was a divergence around 1996/97 but nothing happened until LTCM. But they should be a flag for caution. Maybe I look at the wrong stuff, but there are a lot of voices calling for a crash or correction. This is not euphoria, so maybe this market will keep on going…in a bumpy fashion….geez I’ve been looking out for a crash for a long time. Whatever you do, don’t short this puppy unless you like financial stretchers.
USUALLY when the trend is obvious to everyone looking at charts, because it has been going on for a while, the game has changed. Financial conditions are still very loose and real rates are still negative. So even if there is weakness, it won’t be big.
Remember that market weakness is equivalent to tightening. If that happens it will only delay the rate hikes, which is bullish. Everyone knows that GDP growth this year is not going to be robust such that Fed is working on some delicate balancing act. The coming earning report season will give us important clues going forward.
Do you see some sectors safer than others? I.e. value, growth, small caps, mid caps, real estate?
Defensive sectors (Staples, Healthcare, Utilities and Real Estate) should do ok. As I also pointed out, large cap growth FANG+ are also the new defensives.
Thanks ‘!