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: Bearish (downgrade)
- 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 relief rally
A week ago, I highlighted an observation by Bill Luby
that a recycle of the VIX Index below 30 after a prolonged period above that level is historically bullish. Now that the VIX has fallen below 30, how far can the rally run?
The S&P 500 tested support while exhibiting a series of positive RSI and rallied on the hopes of a Russia-Ukraine peace accord. The advance continued even in the face of a hawkish FOMC message. The index violated a falling trend line, which is a positive development.
Despite the strong historical statistics, don’t be too bullish. The relief rally looks like a bear market rally within a downtrend.
Time to turn cautious
My Trend Asset Allocation Model has downgraded its signal from neutral to bearish. It’s time to acknowledge that this is a bear market. The model applies trend following principles to global stock and commodity prices to create a composite signal. The model is pointing to recessionary, or near recessionary conditions.
The Ultimate Market Timing Model remains bullish. As a reminder, this model only turns bearish when the trend model is bearish, which it is, and my Recession Watch indicators
flash the warning sign of a recession, which it hasn’t yet. The combination of the two is rare, which explains the low level of model turnover. This is confirmed by the latest update from New Deal democrat
, who maintains a set of coincident, short-leading, and long-leading indicators. He reported that his long-leading indicators have moved into neutral, with the caveat that war-related disruptions could plunge the economy into recession [emphasis added].
There are two separate dynamics operating on the economic indicators. One dynamic is a typical cyclical one of the Fed reacting to high inflation and low unemployment by raising rates, now that it has been convinced that inflation has not been “transitory.” The second dynamic is Russia’s invasion of Ukraine, and the world’s reaction to it.
The first dynamic is primarily acting on the long leading indicators. Thus we see bond yields rising, and yield spreads tightening. In fact, several portions of the yield curve inverted Thursday and at least intraday Friday (most notably the 5 minus 3 year spread which briefly turned negative Friday, before closing ever so slightly positive). This dynamic is also why mortgage rates are negative, and at least partially why credit conditions have tightened.
As a result, the long leading forecast has turned neutral. A recession is possible one year from now, but not that likely yet…
The global economic reverberations of the Russian invasion of Ukraine, and the reactions to it, by way of sanctions, global oil supply, and also by businesses severing ties with Russia, is an exogenous event, just as the pandemic was in 2020. And just as with the pandemic in 2020, it could cause a recession without the normal procession of cyclical effects through the economy. But it is “transitory” in the sense that if and when the conflict resolves, the normal cyclical procession will reassert itself. Those cyclical processes, the other side of the pincer, continue to point towards a stall roughly at the beginning of next year.
In the US, the S&P 500 has exhibited a dark cross, where the 50 dma falls below its 200 dma. Moreover, the broadly-based Value Line Geometric Index is in a well-defined downtrend and violated support.
Across the Atlantic, the Euro STOXX 50 has taken the brunt of the Russia-Ukraine war fears. Even though the FTSE 100 is acting a bit better, the mid-cap FTSE 250, which is more sensitive to the UK economy, is in a downtrend.
In Asia, China and Hong Kong have tanked, though a recent announcement of market-friendly measures has sparked a turnaround. Nevertheless, the market structure of the major Asian markets are all screaming “downtrend”.
Commodity prices are strong, but I pointed out last week (see Not your father’s commodity bull
) that price strength is attributable to supply shortages and not excess demand. Such conditions are not reflective of strong cyclical strength but will resolve in demand destruction, which is bearish for the global economy. Indeed, the cyclically sensitive copper/gold ratio confirms this assessment by trading sideways.
A bear market rally
Bull markets don’t go straight up and bear markets don’t go straight down. Short-term sentiment is supportive of a bear market rally, which can be brief but vicious. The AAII bull-bear spread remains at a buy signal, which is tactically bullish.
A key technical test
Last week’s bounce presents a key technical test for the S&P 500. Since December, the S&P 500 has reacted to oversold conditions with sharp 2-4 day rallies, followed by further weakness to either test the previous lows or more new lows. The main differences this time are the violation of the falling downtrend line and the positive RSI divergence. Much will depend on whether the market can follow through with more strength in the coming week.
The market is also enjoying a momentum tailwind. The S&P 500 exhibited four consecutive days when it was up 1% or more last week. Such episodes are rare but they have historically resolved with a bullish bias, though the sample size is very small (n=4).
The bullish island reversals exhibited by both the Euro STOXX 50 (FEZ) and MSCI China (MCHI) are additional inter-market signs that a strong bear market rally is underway.
In the short run, the part of the US market with the most upside potential is large-cap growth. Macro Charts
pointed out that the NASDAQ 100 is exhibiting a strong breadth thrust after a deeply oversold condition, which is very bullish.
I agree with the bullish assessment on the NASDAQ 100. The index violated a falling downtrend after exhibiting a series of positive RSI divergences. Relative breadth against the S&P 500 has been strong (bottom panel), indicating positive underlying relative strength. Watch for overhead resistance at the 50% Fibonacci retracement level as a possible profit target, but recognize that there is also a risk of momentum failure.
Even ARK Innovation (ARKK), which represents speculative growth stocks, underwent a bullish island reversal, though its downtrend remains intact. If the rally continues, watch how the ETF performs near its trend line resistance.
In conclusion, the stock market is undergoing a relief rally in the context of an intermediate-term downtrend. It’s difficult to know exactly how far the rally can run. Investment-oriented accounts should take advantage of market strength to rebalance to a position of minimum risk. Traders who are long should use a stop-loss to define their risk.
Disclosure: Long TQQQ