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: 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.
Another test of the 2022 lows
Here we go again. The S&P 500 tested its 2022 lows on Friday while exhibiting a positive 5-day RSI divergence. Selected sentiment readings are at off-the-charts levels. Both the bond and stock markets are poised for a relief rally, and the FOMC meeting Wednesday could be the catalyst.
A historic sentiment extreme
I recently expressed doubts over the weekly AAII sentiment survey readings, but the latest survey results now finally confirmed a contrarian bullish conclusion. For the third consecutive week, the bull-bear spread remains below -20. Not only has bullish sentiment collapsed in the latest week, but also bearish sentiment spiked to a nearly off-the-charts reading, indicating unbridled panic. Both the bull-bear spread and bearish sentiment have not been this bearish other than the bear market low in 1990 and the generational equity market low in February 2009.
In addition, equity fund flows have tanked to levels last seen during the 2020 COVID Crash, the 2011 Greek Crisis, the 2008 Lehman Crisis, and other major market panic lows.
At a minimum, this is a setup for a tactical stock market rally, though I remain unconvinced that investors have seen the actual low for this market cycle. As we look ahead to the FOMC meeting in the coming week, the market is also setting up for a bond market rally with important implications for stock market leadership.
Stocks vs. bonds
Stock and bond prices have undergone the unusual condition of falling together in 2022. Both stock and bond sentiment are exhibiting excessively bearish readings. A review of the technical and sentiment backdrop leads me to believe that bond prices have greater intermediate upside potential than stocks.
Let’s begin with the equity market outlook. While the AAII sentiment readings appear contrarian bullish, other sentiment models are not confirming similar extremes. The CNN Business Fear & Greed Index
is fearful, but conditions are not at panic-driven lows seen in the recent past.
Similarly, the NAAIM Exposure Index, which measures the sentiment of RIAs managing individual investor funds, retreated last week. While readings are below average, indicating minor levels of bearishness, they are nowhere near conditions seen in past washout lows.
To be sure, all four components of my bottom spotting model flashed buy signals within a few days of each other last week.
From an intermediate-term perspective, the S&P 500 has definitively violated neckline of a head and shoulders pattern. This suggests that any relief rally will encounter overhead resistance at about 4310.
From a long-term technical perspective, the percentage of S&P 500 stocks above their 200 dma reached a “good overbought” condition of over 90% in 2020 and recycled below in mid-2021 (top panel). Historically, such declines don’t end until the percentage of S&P 500 above their 50 dma fall to 20% or less (bottom panel). Investors have yet to see that capitulation low.
From a valuation perspective, the S&P 500 is trading at a forward P/E of 18.1, which is constructive. I pointed out recent (see US equity investors are playing with fire
) that the last two times the 10-year Treasury yield traded at current levels, the forward P/E ranged from 13.5 to 16, which represents further downside potential from current levels.
In addition, we have not seen the clusters of insider buying that exceed sales that usually mark major market bottoms.
As a reminder, this is the pattern of insider activity during the COVID Crash bottom.
What about bonds?
Turning to the bond market, Ed Clissold of Ned Davis Research observed that bond market sentiment is excessively bearish.
The blogger Macro Charts also confirmed that the 10-year Treasury Note’s Daily Sentiment Index is at a bearish extreme, though DSI can be an inexact timing indicator.
As the market looks ahead to the May FOMC meeting, investors are faced with the unusual condition where the Fed Funds rate has barely budged but the 2-year Treasury yield has skyrocketed in anticipation of a fast tightening cycle.
The market is anticipating a half-point hike in May, followed by a three-quarter point hike in June, and a half-point hike in July, which represent extremely hawkish expectations. In all likelihood, a three-quarter point hike in July may be overly aggressive and any hint of a steady course of half-point moves would be enough to spark a bond market rally.
Watching for confirmation
From a technical perspective, the 7-10 Year Treasury ETF (IEF) appears to be trying to form a bottom, but we have seen similar false starts in the recent past.
Here is what I am watching. If the bond market were to stage a rally from bearish sentiment extremes, watch for confirmation from changes in equity market leadership from inflation hedge groups to interest-sensitive issues.
In addition, falling bond yields would translate into better relative performance for high duration quality large-cap growth stocks such as the NASDAQ 100.
In conclusion, extremes in bearish sentiment in both stocks and bonds are setting up for tactical rallies in both asset classes. Short-term stock market readings are extremely oversold and major downdrafts simply don’t begin under such conditions. My base case scenario calls for better intermediate upside potential from the bond market. The upcoming FOMC meeting is a potential catalyst for the rally.
Strap in and brace yourself.
Disclosure: Long SPXL