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: Neutral
- 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.
Estimating downside risk
Last week, I highlighted a sell signal from the intermediate-term breadth momentum oscillator (ITBM). The 14-day RSI of ITBM had recycled from an overbought condition, which was a sell signal for the stock market. In the past, ITBM sell signals have resolved with 5-10% drawdowns and the market bottomed with the ITBM RSI fell to an oversold or near oversold condition.
The S&P 500 fell -5.8% since the sell signal and RSI is oversold. Does this indicate a short-term bottom, or is this the start of a major bear leg?
The bull case
Here are the bull and bear cases. The market is oversold and due for a relief rally. The percentage of S&P 500 stocks above their 10-day moving averages (dma) has reached levels consistent with short-term bottoms.
As well, the Zweig Breadth Thrust Indicator has fallen into oversold territory (grey bars). As a reminder, a ZBT buy signal occurs when the indicator rises from an oversold to overbought condition within 10 trading days. These signals are extremely rare (red dotted line) and I am not anticipating such a buy signal. Nevertheless, a ZBT Indicator oversold condition has usually marked short-term bottoms in the past.
Two of the four components of my bottom spotting model have flashed buy signals. In the past, such episodes have signaled tradable bottoms with reasonable accuracy. The VIX Index spiked above its upper Bollinger Band, indicating oversold conditions, and the NYSE McClellan Oscillator (NYMO) has also fallen to oversold levels. Only the term structure of the VIX hasn’t inverted and TRIN hasn’t risen above 2, which are indicators of short-term panic.
While market-based sentiment indicators such as the VIX term structure and TRIN have not signaled fear, survey-based indicators have. Mark Hulbert
revealed that his newsletter sample of NASDAQ market timers had become sufficiently bearish to flash a contrarian buy signal. Sentiment is more bearish than it was at the March 2020 bottom.
Indeed, the normalized ratio of the NASDAQ 100 to S&P 500 has reached historically important oversold conditions that NASDAQ stocks are likely to see low relative downside risk at current levels.
That said, Hulbert also his regular sample of market timers are not bearish enough to be in the lowest decile reading to flash a contrarian buy signal, though readings are close.
Similarly, the latest AAII weekly survey shows a spike in bearish sentiment and a bull-bear spread of -25.7. In the past, bull-bear sentiment spreads below -20 have marked low-risk long entry zones for equity investors.
The bear case
While sentiment models are showing a retreat in bullishness, some models indicate a stubborn lack of bearishness. This could be interpreted as the market due for a short-term bounce, but a durable bottom isn’t in sight just yet.
For example, the Investors Intelligence survey shows the bull-bear spread in retreat, but a lack of a spike in bearishness. This could be interpreted as an oversold market, but the absence of panic and washout translates to greater intermediate-term downside risk.
conducts a weekly unscieintific poll every weekend. To my surprise, the bulls slightly edged the bears despite last week’s carnage in stock prices. Sentiment may still be too complacent and traders are not panicked enough yet.
Similarly, while the VIX Index had risen above its upper Bollinger Band, indicating an oversold market, the width of the Bollinger Band remains relatively narrow and not wide enough to be consistent with intermediate-term bottoms.
Other market internals are also problematic. Indicators of equity risk appetite are exhibiting negative divergences, which is disturbing for the bulls.
The relative performances of defensive sectors are all forming saucer-shaped bottoms, indicating that the bears have gained control of the tape.
What to watch
How can we resolve this bull and bear debate? First, recognize that the market is stretched to the downside and a short-term relief rally can happen at any time. Much will depend on how the market behaves after the bounce.
Here is what I am watching. The percentage of S&P 500 stocks has fallen through the 50-60% zone that defines up and downtrends. If the market were to rally, can this indicator regain the 60% level?
Support and breadth indicators can also be useful guides. The S&P 500 is testing its 200 dma, which should act as a support level. As well, the weakness in the S&P 500 is overstating index weakness. The equal-weighted S&P 500, which represents the average stock in the index, has been outperforming its float-weighted counterpart since early December, which is constructive.
In conclusion, the stock market is sufficiently oversold that a relief rally is likely in the short run. However, stock prices remain vulnerable to intermediate-term downside risk. Subscribers received an email alert that my inner trader had bought an S&P 500 position as a short-term trade.
Traders and investors should monitor the development of market internals should the rally materialize. The FOMC meeting in the coming week could prove to be a catalyst for volatility and greater clarity on market direction.
Disclosure: Long SPXL