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 bsoe 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: Bearish
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.
Fun with Japanese candlesticks
Last week’s market action in the S&P 500 was a classic lesson in the usefulness of Japanese candlesticks. I wrote last weekend that the market was oversold and due for a rebound. The S&P 500 cooperated on Monday by exhibiting a hammer candle
, in which the market tanks but rallied to a level equal to or above the open. Hammer candles are indications of capitulation selling and a possible short-term bottom, but the pattern needs to be confirmed by continued strength the next day. The bottom was confirmed Tuesday when the index advanced and regained the 50 dma.
The second candlestick lesson came on Wednesday, when the S&P 500 showed a doji
, when the open and closing levels are about the same. Doji candles are signs of indecision and possible reversals but must be confirmed the next day. The S&P 500 duly weakened Thursday and stabilized Friday ahead of the long weekend. All of this is occurring as the S&P 500 forms a triangle, which suggests that a big move is just around the corner.
In short, it was a master class in trading Japanese candlestick patterns. Not all candlesticks resolve in textbook manners, but they did last week.
Reasons to be bearish
Now that the bearish reversal is in place, the path of least resistance is down. The intermediate-term breadth momentum oscillator (ITBM) flashed a sell signal when its 14-day RSI recycled from overbought to neutral. In the past, these sell signals have been effective about three-quarters of the time.
My cautious outlook is supported by negative divergences in equity risk appetite indicators. In particular, speculative risk appetite for high-beta story growth stocks is tanking (bottom panel), which is bearish.
Breadth indicators are wobbly again. The NYSE Advance-Decline Line has been unable to regain its upside breakout level. Net NYSE highs-lows are negative again. The percentage of S&P 500 stocks above their 50 dma has deteriorated to the critical 50-60% zone that separates bullish and bearish trends.
Determining downside risk is always a difficult exercise. In the past, ITBM sell signals have resolved with pullbacks in the 5-10% range. In this case, a test of the 200 dma, which stands at about 4420 and represents about a 7% drawdown, is a reasonable guesstimate. However, the sell signal presented by the negative 14-month RSI divergence of the Wilshire 5000 has typically ended with corrections of up to 20%.
The earning season wildcard
A 20% pullback would involve a major bearish catalyst. A possible source of volatility is the Q4 earnings season. So far, consensus EPS estimates have been steadily rising.
With December headline CPI at 7.0% and headline PPI at 9.7%, one of the key questions for investors is whether companies can pass through increased costs.
What about the effect of the Omicron wave? As an example, Bloomberg
reported that lululemon revealed Omicron had dented its sales. Was LULU an exception or the start of a trend?
The company best known for its yoga pants said that it started the holiday season strongly. But then it suffered from several effects of omicron, including staffing shortages and reduced operating hours in certain locations. Even before the latest variant, consumer-facing companies were grappling with supply-chain snarl ups and not having enough workers. If these pressures continue, Lululemon won’t be the last to highlight the consequences.
So far, companies with strong brands, such as Nike Inc., and with scale, such as Walmart Inc. and Target Corp., have been able to withstand the supply-chain challenges, while weaker firms have struggled to stay afloat. Last week, Bed Bath & Beyond Inc., which is in the midst of a turnaround plan, cut its sales and profit forecast.
Expectations are elevated, but companies have tended to manage expectations so they’ll surprise Street estimates. The very preliminary results are disconcerting. Four large financials reported Friday morning. JPMorgan beat on earnings and sales expecations. Blackrock beat on earnings but slightly missed on sales. Citigroup missed on both. Wells Fargo beat on both. Of the four stocks, only Wells Fargo advanced.
The geopolitical wildcard
The other major source of market risk is geopolitical instability over Ukraine. US-Russia talks on the issue broke up with the Russian side characterizing the discussions at a “dead end”. Russian troops have been massing on the Ukrainian border and the muddy season is ending soon. The window for an invasion will open as soon as the ground firms.
A discussion of whether an invasion is justified is beyond my pay grade, but Adam Tooze
of Columbia University recently outlined the challenges the West faces with Russia. Simply put, economic sanctions are not a very useful levers for two reasons. First, Russia has a strong foreign exchange reserve position.
Hovering between $400 and $600 billion they are amongst the largest in the world, after those of China, Japan and Switzerland.
This is what gives Putin his freedom of strategic maneuver. Crucially, foreign exchange reserves give the regime the capacity to withstand sanctions on the rest of the economy. They can be used to slow a run on the rouble. They can also be used to offset any currency mismatch on private sector balance sheets. As large as a government’s foreign exchange reserves may be, it will be of little help if private debts are in foreign currency. Russia’s private dollar liabilities were painfully exposed in 2008 and 2014, but have since been restructured and restrained.
As well, Russia is too big to effectively sanction. More importantly, it will continue to accumulate reserves as long as oil prices stay above $44 a barrel.
Russia is a strategic petrostate in a double sense. It is too big a part of global energy markets to permit Iran-style sanctions against Russian energy sales. Russia accounts for about 40 percent of Europe’s gas imports. Comprehensive sanctions would be too destabilizing to global energy markets and that would blow back on the United States in a significant way. China could not standby and allow it to happen. Furthermore, Moscow, unlike some major oil and gas exporters, has proven capable of accumulating a substantial share of the fossil fuel proceeds…
Putin’s regime has managed this whilst operating a conservative fiscal and monetary policy. Currently, the Russian budget is set to balance at an oil price of only $44. That enables the accumulation of considerable reserves.
Even as the Ukrainian story occupies the front page, an equally important geopolitical development that is on back pages is the recent crisis in Kazakhstan. From the Kremlin’s point of view, Kazakhstan represents a vital Russian interest for a number of reasons. First, it has an enormous border with the Russian Federation. About 20% of the population are ethnic Russian and political instability will create a refugee crisis for Russia. As well, several Soviet-era space launch sites that are still being used by Russia are located in Kazakhstan and the country is a major producer of uranium.
While Kazakhstan’s independence from the Soviet Union was relatively smooth economically, it has been ranked as one of the top countries for corruption. It is, therefore, no surprise that NGOs such as George Soro’s Open Society Foundation and the US-based National Endowment for Democracy (NED) funded democracy movements in the country. However, the NED has the unfortunate history of being spun out of the CIA during the Reagan years because it was felt that the CIA should not be seen as directly supporting pro-democracy movements in other countries. In the past, the NED has supported “color revolutions” in former Soviet republics, which has cast suspicion on the organization, especially to a former KGB officer like Vladimir Putin.
The Russians recently sent about 2,000 paratroopers to stabilize the situation in Kazakhstan when mass protests erupted over fuel price increases and the troops began withdrawing last week after accomplishing their mission. Nevertheless, Putin could view the Kazakh protests as covert American intervention in a former Soviet republic that is of vital interest to Moscow, which raises the temperature of the Ukraine situation.
I don’t want to over emphasize Russia’s role in the world. Russian GDP is roughly the same size as Italy’s. However, geopolitical tail-risk is probably higher than the market is discounting and an invasion could spark a major risk-off episode in the markets.
In conclusion, the tone of the market is turning bearish. Technical internals are deteriorating and my base case scenario calls for a 5-10% pullback in the coming weeks. A downdraft of 20% represents an outlier case but would need a major bearish catalyst such as severe earnings disappointments or the emergence of geopolitical risk.
Disclosure: Long SPXU