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.
About that AAII sentiment…
It’s confirmed. The AAII weekly sentiment data was not a blip. While bullish sentiment advanced slightly from the previous week, it remains weak and the bull-bear spread is still below -20, which is a contrarian buy signal. While bullish sentiment did crater, bearish sentiment did not spike to levels indicating panic.
A similar set of circumstances was found in the Investors Intelligence survey. The %bulls skidded badly, but %bears fell too, though not as much as %bulls. The bull-bear spread consequently turned negative, which is interpreted as a contrarian buy signal.
While conventional sentiment analysis would conclude that these represent tactical buy signals, I beg to differ. This time is different, and here’s why.
Conflicting sentiment signals
Even though the AAII and II sentiment surveys show strong buy signals, a number of other sentiment models tell a different story.
The NAAIM Exposure Index, which is a survey of RIAs who manage individual investor funds, is neutral. As a reminder, a breach of the lower 26-week Bollinger Band of the NAAIM Exposure Index has been an excellent buy signal (vertical lines).
A detailed analysis of the NAAIM data shows the survey exposures at the first, middle, and third quartile breaks, as well as the maximum and minimum equity exposures. The minimum exposure of 16% means that there were no respondents who were short the market as they were several weeks ago. These results are inconsistent with a picture of investors who are panicked over the stock market’s outlook.
A similar lack of fear can be found in the options market. If investors are afraid of a sudden drop in stock prices, they tend to buy put option protection and drive up the price of puts compared to calls. The SKEW Index measures the relative pricing of out-of-the-money calls to puts. A high SKEW indicates the perception of high tail-risk while a low SKEW indicates complacency. Current readings are neutral to low. More importantly, the 10-day change in SKEW recently fell by -10%. Historically, such episodes have been reasonably good trading sell signals. In the last five years, there were 18 such signals. 11 resolved in a bearish manner (pink vertical lines) and seven bullishly (grey lines).
The bears are in control
Tactically, the bears are in control of the tape. Defensive sectors are all in relative uptrends.
Equity risk appetite factors are exhibiting negative divergences against the S&P 500. In particular, speculative growth stocks, as represented by the ARK Innovation ETF, broke a relative support level after holding up well for about a month.
highlighted the spike in both new highs and lows and concluded that such a conditions has always resolved in a bear market. His observation is similar to one of the underlying elements of the Hindenburg Omen, where both new highs and new lows rise together indicating a bifurcated market (see Another Omen warning
As well, Cross Border Capital
pointed out that Fed liquidity injections had dropped dramatically last week, though the drop may be a data blip. Historically, the S&P 500 has been highly correlated with market liquidity.
If the decline in Fed liquidity injections is concerning, the more ominous sign is that quantitative tightening has only started. The Fed’s balance sheet fell a measly $10 billion in the week, which amounts to a roundoff error in a balance sheet of $8.97 trillion.
An oversold market
In conclusion, I interpret the AAII and II sentiment readings as the bulls have capitulated but the bears haven’t and there is unfinished business to the downside. Despite my intermediate bearish outlook, the market weakness late in the week left the stock market oversold, though sentiment indicators are still mixed. The VIX Index spiked above its upper Bollinger Band, which is a sign of a short-term oversold condition. As recent history shows, oversold markets can become even more oversold.
As well, the Zweig Breadth Thrust Indicator reached an oversold level on Friday. As a reminder, Zweig Breadth Thrust buy signals are triggered when the ZBT Indicator moves from oversold to overbought in 10 trading days. Such conditions are rare and I am not holding my breath for the signal. Nevertheless, it does indicate that prices are stretched to the downside.
Investment-oriented accounts should be positioned cautiously and take advantage of rallies to raise cash. Trading accounts should be aware that the market is short-term oversold and poised for a relief rally in the context of a downtrend.