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.
A dead cat bounce?
Now that the stock market has staged a relief rally, can it be characterized as just a dead cat bounce, or is it a more durable move? Arguably, the downdraft that began in January violated an uptrend. It would be difficult to believe that a market can recover to its previous highs that quickly after such technical damage.
Here are four reasons to be bullish and four to be bearish.
The bull case
Here are some reasons to be bullish. The S&P 500 intermediate-term breadth momentum oscillator just flashed a buy signal. Its RSI indicator just recycled from an oversold reading to neutral. These signals have shown a 72% success rate in the last five years.
Cyclical indicators like commodity prices and the base metals/gold ratio are strong, though the copper/gold ratio has been trading sideways. Commodity price strength isn’t attributable just to energy. The equal-weighted commodity index has made new recovery highs. This is an important cross-asset, or intermarket, relationship that should at least put a floor on stock prices.
Credit risk appetite has also been acting well. Both the junk bond and leveraged loan markets are showing few signs of stress.
Finally, sentiment readings are still depressed. Macro Charts
pointed out that S&P 500 futures speculators cut their long exposure by the fastest rate in history. Even when normalized by market cap, the selling stampede is consistent with past short-term bottoms.
also observed that leveraged Rydex bear assets skyrocketed to an off-the-charts reading last week. Major bear legs simply don’t start with sentiment readings at such extremes.
The bear case
Here is the bear case. Three of the four defensive sectors are in relative uptrends and the uptrends began before the market weakened. This is a signal that the bears still have control of the tape.
I had highlighted in the past the long-term sell signal from the negative RSI divergence of the monthly Wilshire 5000 chart. The most recent peak-to-trough drawdown was about -10%. Was that enough? If the Wilshire 5000 were to close at these levels today, MACD would turn negative (bottom panel). In the past, this has sometimes been a sign that the decline is nearly over or the start of a deeper drawdown. In all cases, it has not marked the market bottom.
How far can the market fall? This analysis of past strong advances yields some clues. The S&P 500 staged a massive rally from the March 2020 lows and the percentage of stocks above their 200 dma reached the 90% level, which represents a “good overbought” rally (shaded regions, top panel). Momentum then cooled and the percentage above their 200 dma recycled below the 90% level. There have been four other similar episodes other than the current one in the last 20 years. Two resolved in sideways markets, characterized by sideways movement in cyclical and risk appetite indicators, namely the copper/gold ratio and the equal-weighted consumer discretionary to staples ratio. And two resolved with deeper pullbacks when the cyclical and risk appetite indicators fell.
The current episode presents a mixed picture. While the copper/gold ratio has traded sideways, indicating a benign environment with normal equity risk, the equal-weighted consumer discretionary to staples ratio has fallen, indicating plunging equity risk appetite. In all past cases, pullbacks ended when the percentage of stocks above their 50 dma fell to 20% or less, which hasn’t happened yet (bottom panel). Notwithstanding the debate over the magnitude of any potential stock market weakness, the bears phase isn’t over yet.
This chart also shows how momentum has turned. People usually analyze the equity put/call as a contrarian short-term indicator, but it can also be a long-term indicator of retail sentiment and the animal spirits of the market. During a durable advance, retail investors often pile into single-stock call options to speculate on the market. The top panel shows the 50 dma of the equity call/put ratio (red line) and the 200 dma (black line). In a strong uptrend, equity call/put ratios rise, indicating strong retail participation and momentum. The equity call/put ratio began topping out in mid-2021 and they are now rolled over. The animal spirits are gone, which removes a source of equity demand.
The retreat in animal spirits is particularly bearish for speculative growth stocks. ETFs such as Cathie Wood’s ARKK are likely to be vulnerable to setbacks. The market won’t bottom until the relative performance of ARKK bottoms.
Bull or bear?
So where does that leave us? Who is right, the bulls or bears?
Actually, they both are. Bullish factors tend to have shorter time horizons, which are weeks, compared to those of bearish factors, which are 3–6 months. I interpret these conditions as the market can tactically rally further, but the intermediate-term outlook is still bearish. The current rally is a bear market rally. Expect further choppiness and volatility for the next few months with little upward progress in the major equity averages. Depending on the evolution of technical, macro, and fundamental conditions, stock prices could see further downside and undercut the recent lows.
Investment-oriented accounts are advised to maintain a neutral position in line with the asset allocation targets specified by investment policy. Traders could try to capitalize on further potential gains, but purely from a tactical perspective. If the seasonal pattern is any guide, the S&P 500 should be choppy for another week and rally into a mid-month peak.
Earnings season reporting continues and the market will undoubtedly be volatile and respond to the headline reports of the day. In addition, the CPI report on Thursday will also be a source of uncertainty.
Disclosure: Long SPXL