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
- Trading model: Neutral
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 bifurcated market
As the S&P 500 struggles to hold its 50 dma, an unusual condition is occurring in the US equity market. The intermediate-term technical outlook is decidedly bearish, but the survey sentiment has reached a crowded short condition, which is contrarian bullish. This week, I offer some canaries in the coalmine as a way to resolve the wildly differing views of the market.
Crowded short sentiment
I was shocked to see a complete collapse in the weekly AAII bullish sentiment which took the bull-bear spread to -32.6, a reading last seen in 2011 at the height of the Greek Crisis. While bearish sentiment did not surge to 2011 levels, they are nevertheless elevated.
A similar sentiment extreme was also evident in the Investors Intelligence survey, which did see a historically high level of bearishness.
The level of bearishness was also confirmed by the CNBC All-American Survey, which found that 28% of respondents who invested in the stock market believe that it’s a good time to invest in stocks, compared to 48% who don’t. These readings have deteriorated since the last time the survey was conducted in December.
One drawback of survey-based sentiment is it asks respondents what they think and does not indicate what they’re doing with their money. Option-based sentiment, which measures dollars-and-cents sentiment, is nowhere near a bearish extreme. The term structure of the VIX is far from inverted, which indicates fear.
I was also surprised by the results of Helene Meisler’s (unscientific) weekly Twitter sentiment poll
, which came in at zero net bull-bear reading. Survey sentiment has usually turned bearish when stock prices turn soft in the previous week. I interpret these conditions as the market has further room to fall.
The most worrisome development is bearishness of intermediate-term market internals. The usually reliable S&P 500 Intermediate-Term Breadth Momentum Oscillator (ITBM) recently flashed a sell signal. The ITBM’s sell signals were correct about two-thirds of the time in the last five years (red=bearish outcomes, grey=bullish).
In addition, a warning was also sounded by the Hindenburg Omen. The Hindenburg Omen depends on three conditions:
- An established uptrend;
- Elevated new highs and new lows, indicating indecision; and
- A bearish momentum break.
The Omen does not turn bearish until we see a cluster of signals within a short period of time, which has not happened yet.
The canaries in the coalmine
How should investors and traders react to these widely differing market interpretations? I rely on the pairs trades that I identified in the past two weeks, which I call my canaries in the market coalmine.
As a reminder, the pairs have a number of factor exposures to be aware of:
- Long price momentum;
- Long commodity producers and short either importers at a country level or cyclicals at an industry level; and
- Slight negative beta, which may be a product of the price momentum factor.
Here is a report card of the country and regional pairs identified two weeks ago (see How the commodity tail wags the stock market dog
), where the horizontal lines indicate the publication date price levels. Three of the four pairs are profitable and the remaining unprofitable pair, long Brazil/short frontier markets, remains in a relative uptrend. I see no reason to exit any of these positions.
As long as the majority of these pairs remain in relative uptrends, my bearish outlook remains intact. Nevertheless, survey sentiment readings present a risk for short-term bear market rallies.
An ESG mean-reverting pair
As all of the pairs introduced have a positive price momentum exposure, I am introducing a new pair trade with a mean-reverting feature which has the added bonus of allowing investors to passively beat the gold mining index on a long-term basis. Moreover, the approach should be compliant on most ESG metrics.
Making a directional call on gold prices has been difficult. In the past, gold was highly correlated with TIPS but they have each gone in their own direction in the past year. The divergence can be partly explained by the rise in a geopolitical risk premium. Investors can find a better way to profit by trading a gold/gold mining stock pair.
To explain, a gold mine can be modeled as a series of annual call options with the strike price set at the cost of production. To estimate the value of the mine, just multiply the value of the option by the projected ounces of production and sum the value of the options over the expected life of the mine, and adding in an inflation factor to production costs every year. An investor can model the value of a gold mining company by summing the value of its mines. As most gold miners tend to be mainly financed with equity, valuation is relatively simple using this technique.
There are some limitations to this modeling approach. It will not capture the upside potential from new discoveries. On the other hand, it will sidestep the risk of labor strife and production problems such as mine fires and floods. Moreover, an investment approach that owns either physical or paper gold compared to the messiness of owning gold mines should be ESG compliant.
I produced a research report in 2006 in a previous life using this technique that compared the value of the gold mining index to the model value and the fit was remarkably good. The report is available here
(see page 6).
Here is the problem for the gold miners. Cash costs for the gold mining industry were $261/ounce. They have skyrocketed since then as old deposits became depleted and they were replaced by new mines with higher costs. Imagine if you bought a long-term call option with an exercise price of X, but discovered that, some time later, X had risen without your knowledge. The value of your call option would have fallen in response. That’s the long-term problem with owning gold mining stocks.
The chart below shows the long GLD/short GDX pair. The pair is trading at a support zone that stretches back to 2016. While the ratio has been lower in the distant past, the lower values can be explained in the context of a much lower cash cost regime, which can be modeled as a lower strike price.
This is a mean-reverting pair trade worthy of consideration. In addition, investors can take advantage of this relationship to outperform any gold mining stock index over the long term.
In conclusion, intermediate-term technical indicators remain bearish but survey-based sentiment indicates crowded short conditions, which is contrarian bullish. As long as my pairs trading factors remain in uptrends, I am inclined to remain cautious on the equity outlook.
As a consequence, my inner investor is cautiously positioned and underweight equities relative to benchmark. Subscribers received an email alert on Thursday that my inner trader had covered his short position and stepped to the sidelines until there is greater clarity on the short-term outlook.
Disclosure: Long SLY/Short IWM