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 prices. 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 be 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.
Head and shoulders intact
The head and shoulders breakdown of the S&P 500 remains intact. The index surged to test neckline resistance last week when Powell took a three-quarter rate hike off the table, but the bears regained the upper hand the next day.
How much should you trust the head and shoulders breakdown and its downside measured objective of about 3830? The 5-week RSI is already oversold. How much more downside is left?
Here are the bull and bear cases.
Let’s start with the bull case. This may sound like beating a dead horse, but AAII weekly sentiment is still very bearish, which is contrarian bullish. The survey cutoff was on Tuesday, which was the day before the FOMC ramp. While bullishness had risen and bearishness retreated, the bull-bear spread is still flashing a buy signal at -26. Bearish sentiment is still historically high at 52.9.
The CBOE put/call ratio is elevated, which is a sign of heightened fear. The put/call ratio remained above 1 at 1.05 on the day of the FOMC market surge, indicating skepticism of the advance.
Thursday’s bearish turnaround after Wednesday’s surge was enough for CNBC to broadcast a “Markets in Turmoil” special program, which has been regarded as a contrarian bullish signal.
helpfully compiled the instances of “Markets in Turmoil” programs since 2010 and he found that the one-year forward returns had a perfect track record, though he added that the period was “limited to a buy-the-dip bull run where corrections have been short-lived”. Based on Bilello’s data set, I made a shorter-term study of the strategy, with the caveat that there was a large cluster starting from February 24, 2020, that didn’t end until June 4, 2020. There were a total of 97 signals during the study period but only 14 non-overlapping signals. Based on the first occurrence of a “Markets in Turmoil” program, the sweet spot for buying the S&P 500 is about 4-5 days, with a median outperformance of 1.2% to 1.3%. The chart below depicts the profit curve if you had held the S&P 500 for five days after the signal.
Even though market breadth was negative, the market exhibited breadth improvements as a series of higher lows and higher highs.
The bears will argue that there is plenty to be concerned about. Even though breadth shows signs of improvement, readings are not oversold enough to indicate a long-term market bottom.
Other breadth indicators, such as the Advance-Decline Lines are weak. A survey of different versions of A-D Lines shows that most of them are in downtrends.
Even though sentiment appears excessively bearish, the term structure of the VIX Index isn’t inverted, indicating fear and panic haven’t fully appeared just yet.
Equally disturbing is the behavior of insiders. Mark Hulbert
observed that this group of “smart investors” are selling into the downdraft.
In April, insiders aggressively picked up the pace of selling. Nejat Seyhun, a finance professor at the University of Michigan and one of academia’s leading experts on interpreting the behavior of insiders, says this is perhaps the most bearish thing insiders can do. That’s because they normally are contrarians, selling more as the market rises and increasing the pace of buying as the market declines.
When insiders sell into a market decline, Seyhun reasons, it means they don’t believe their companies’ shares will be significantly higher any time soon.
Lastly, if you think that Jerome Powell’s remark that the Fed isn’t considering a three-quarter point rate hike is dovish, it’s not. The Fed is keeping to a measured pace of tightening. The knee-jerk market reaction overlooked the announcement that the Fed is conducting quantitative tightening (QT) and reducing its balance sheet. An analysis
of returns during QE and QT shows that while QT is not necessarily negative for the stock market, volatility is considerably higher compared to QE periods.
Catch a falling knife?
So where does that leave us? The bull and bear debate is really a debate of differing time horizons. The bullish factors are mainly short-term in nature, while bearish factors tend to be more intermediate term. My base case scenario calls for a short-term bottom and a bear market rally of unknown magnitude, followed by a greater decline into an ultimate low in the coming months.
The S&P 500 is undergoing a third possible double bottom as its exhibits a positive RSI divergence this year. Should a rally materialize, the initial upside objective would be a test of the falling trend line in the 4300-4350 zone, with secondary resistance at the 50 dma of about 4370.
Key dates to watch in the coming week are the Russia Victory Day on May 9 for signs of a possible escalation, and the CPI report on May 11 for signs of expectations changes in the trajectory of monetary policy. Stay tuned.
Disclosure: Long SPXL