Making sense of the H&S breakdown

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.



Bull case

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.



Charlie Bilello 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.




Bear case

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


40 thoughts on “Making sense of the H&S breakdown

  1. It sure feels as if the financial media has everyone convinced we’re headed straight down.

    A huge wall of worry. Remember March 2020? We were all convinced the markets were headed straight down then as well.

    1. True enough, it’s a little worrisome when everyone is on one side of the ship. However the Fed doesn’t have the markets back this time around. Hard to see a bull catalyst. Sometimes the consensus is right.

      1. Agree. Even I can’t come up with a bull catalyst. But neither could I come up with one in March 2020. It was the market that predicted the development of a vaccine within the next eight months when experts were warning it would take much longer.

  2. Cam, I have a couple of questions/comments. First off I have always thought the CBOE P/C ratio was a reflection of the smart traders, not the public. The long term average P/C for this statistic exceeds 0.93. Am I wrong about this ?
    Second, I have found that numbers for bull markets must be compared to numbers for other bull markets, and vise versa, otherwise we mislead ourselves. What did the weekly sentiment for AAII look like during the last bear market, are those numbers available ?

  3. Regarding May 9 Victory Day Celebrations in Moscow, I think Putin will try to find a way out by claiming victory in Mariupol.
    US at this point can’t let Ukraine lose. So much money and war materials have been sent. So many top politicians have visited Ukraine. Not after what happened in Afghanistan.
    Russia is short of war materials. A general mobilization is likely to be a failure. Continuing the war risks losing to NATO not to Ukraine.
    My bet is on Russia finding a way out. To regroup maybe.
    And that would be a powerful catalyst for a rally.

    1. Russia short on raw materials, general mobilization… How do you come up with such stuff? Really. Check the numbers. Russia is using in Ukraine only part of its active duty military and they are not even all engaged in the fighting. A lot of the ground fighting in Donbass is carried out by the militia. Russia has already won the war. The only question now is how Ukraine will be divided.

      I listened to Putin’s speech, in Russian (I’m not Russian). No claims of victory. But he made some interesting claims about the situation that led to the invasion.

  4. This will have important consequences for the Fed Funds Rates and the stock and bond markets.
    “We expect inflation to peak this summer between 6%-7% and to recede to 3%-4% next year with no recession. … We may have spotted the first signs of peaking inflation already, in lower three-month than y/y rises of several price and wage measures.” – @yardeni

    1. Probably the likely outcome. yoy rates approach small numbers and fluctuate abound them. But the real numbers settle at higher plateaus. And an adjustment period follows when everything is re-priced to reach local equilibria. But for most folks, purchasing power is still lower unless your income rises proportionally.

      Humans are highly adaptable. So many ways to cope. WW2 era victory gardens come to mind. Every space counts if you have the will.

  5. Futures red across the board.

    Weighing in with real time thoughts, as always.

    (a) I’m just a few years away from hanging it up. Thus the current overweight in bonds – which if anything have recently underperformed stocks. So that’s an unexpected surprise. But we all know that life is filled with unexpected surprises.

    (b) 40% bonds. 25% equities. 65% cash. You wouldn’t think that would be a bad asset allocation in a bear market – but I have to deal with the fact that inflation is killing bonds.

    (c) Zooming out to the bigger picture – I’m probably OK with current holdings despite the fact that most paper assets (with the exception of cash) are out of favor. Bond funds + stocks represent ~24% of my net worth right now. The remainder lies in a mix of home equity + cash + a so-called virtual pension plan + a few I bonds.

    (d) What if all bond funds/ stock funds sink by another 50%? Well, that’s the kind of thinking I engage in from time to time. I would probably extend my career for a while longer – and very thankful to have that option. Do I expect financial assets to sink another 50%? No. If anything, I expect my bond funds/VT to appreciate markedly over the next 6-12 months.

    So it comes down to juggling a mix of ST/LT perspectives with the benefit of a lifetime of investment experiences – in the capital markets, the real estate market, and not least with my own mistakes in managing income generation and wealth accumulation. I may cut exposure a bit if/as bond/stock prices decline further, but I’m actually quite comfortable doing nothing. It’s always the optimistic scenario that wins out in life.

    1. Bonds holding up – although the pattern has been for traders to later sell them into the close.

    2. Unfortunately, I still sense no panic – and not really sure what it would take to instill any.

    3. I would agree with Helene Meisler that that too many traders are calling for an oversold rally – we’ll have to wait for them to give up on that scenario.

    4. Bonds catching a bid! Hope to see them regain their status as a safe haven.

  6. What worries me is a depression, not a recession. The reason why that worries me is because of all the debt. It’s one thing to create demand destruction by raising rates, but debt will continue the process. This can be self reinforcing. But what is consistent is that sovereigns try to save themselves and increasing the burden of their debts is not the way to do it, but how much further down does this elevator shaft go?

    1. Inflation and deflation are relative. Imagine a deflationary world, but one where your disposable income decreases faster than the deflation due to debt. Then even if prices are dropping, they are becoming less affordable. It’s the opposite of rising prices when there is free money.

  7. Just how bad is this market?

    I happened to check in with a colleague during lunch who is the most conservative investor I know. When I last checked in sometime last year, she was talking about a VALIC fixed income/interest fund that guaranteed 1.7% annually.

    So I expected to congratulate her on earning a positive return in 2022.

    Not the case. Turns out that most of her retirement money is in a target date fund (2020). The fund currently lists an asset allocation of 51% bonds/ 43% stocks/ 6% cash. The fund is down -12.7 ytd as of today’s close.

    She’s still working. But the majority of fund investors are undoubtedly retired. A -12.7% return in four months from a fund that is 50% invested in bonds/cash is not what they signed up for.

    1. As bad as it was today, my takeaways are bullish.

      (a) We’ve seen a great deal of liquidation.

      (b) If investors experienced frustration last week, then I believe it began to transition into despair today.

      (c) Might we be headed much lower from here? Sure. But odds are we head higher first.

      I’m bullish on both stocks and bonds here. It may be a +2% rally or a +10% rally – no way to know ahead of time. If we close another -1%+ lower on Tuesday, then I’m wrong. But I like the odds.

    2. Major reversal points are never announced ahead of time. There are guideposts – but they can be early. Sometimes all we can do is position ourselves in a way that matches our risk tolerance.

  8. It is always humbling to walk into one of this gaps up or down if you are on the wrong side, such as the one from last Friday. This is often done to shake out the traders.
    SPX gap downs from lower ATR band values are often filled in days, but no guarantees.
    We had one gap down from 1/21/22 filled 1/24/22
    another on 2/23/22 filled 2/24/22
    another 4/8/22 filled 4/20/22; this one took a while
    But dont’ overstay the reprieve. Often gap fills brings reversals and the trend is still down currently.

    Gap downs from relative high ATR bands positions such as the one from 1/14/22 came very close to being filled on 3/29/22, but didn’t.

    1. Another gap down from 4/25/22 filled 4/28/22. This one seems to be the area when many traders began to talk about talking a long position. So these are the common trading patterns that market makers favor.

  9. Maximum pain. Maximum frustration. It’s amazing how often the worst path I can imagine is exactly the one the market takes.

  10. Stock and bond prices lifting on essentially no news, which may be a sign that sellers are done.

    On the other hand, the CPI release could easily snuff out any bullish wave.

    1. +8.6%.

      Anyone who opened positions premarket being shaken out right now. But then what?

    2. (a) The overnight spike in futures attempted to price in a low CPI – and forced sidelined traders to chase.

      (b) The negative reaction effectively threw them overboard – but also presented more cautious sideliners a buying opp.

      (c) However, they would have had to act fast. And being cautious, it’s unlikely they would have opened positions. More likely a sigh of relief.

      (d) So are we now ready for liftoff?

    3. Bonds will lead stocks IMO.

      The bullish catalyst we’re all looking for may be as simple as: declining yields.

        1. fwiw. Tepper announced yesterday that’s he’s covered his QQQ short and buying SPY. He’s not necessarily a perfect tell, but combined with all of the other buy signals right now it indicates to me this is not a time to sell. The market will not make it easy – but in general the harder it is, the more durable the rally.

Comments are closed.