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: Sell 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.
A bullish turnaround
The S&P 500 turned up last week after a test of the May lows while exhibiting a 5-day RSI divergence. The rally was convincing as the index rallied through a falling trend line and the daily MACD indicator turned positive.
One of the most anticipated relief rallies is here. How far can the stock market run?
Buy signals everywhere
Last week’s market action sparked buy signals everywhere. NYSE breadth on Wednesday was an 83% volume upside day, Thursday was an 87% upside day, and Friday was another 87% upside day. Two consecutive 80% upside days are unusual. Three consecutive ones are extremely rare. A study by Paul Desmond
of Lowry’s Reports found that back-to-back 80% upside days were breadth thrust signals indicating “the completion of the major reversal pattern[s]”.
On occasion, back-to-back 80% Upside Days (such as August 1 and August 2, 1996) have occurred instead of a single 90% Upside Day to signal the completion of the major reversal pattern. Back-to-back 80% Upside Days are relatively rare except for these reversals from a major market low.
The historical record shows that while three consecutive 80% upside days tended to be bullish, there were exceptions. Stock prices topped out after such a signal in 1981 and fell to a lower low in 2008. In other case, the market consolidated sideways.
Nevertheless, price momentum has become very strong. The NYSE McClellan Oscillator has reached levels consistent with a “good overbought” advance, indicating further upside potential.
Credit market risk appetite is also starting to show some life. The relative performances of high yield and leveraged loans relative to their duration-equivalent Treasury prices are exhibiting some minor positive divergences from the S&P 500.
AAII weekly sentiment is still excessively bearish, which is contrarian bullish.
Sentiment models are supportive of further gains. Last week, we saw bear claws on the cover of Barron’s. This week, Bloomberg BusinessWeek’s cover is another contrarian magazine cover indicator that’s supportive of the bull case.
From a global perspective, the percentage of countries above their 50 dma rose from zero the previous week to 10% last week, indicating a recycle off an oversold extreme.
The performance of MSCI Poland is turning up, which is a sign that geopolitical risk is fading.
When should traders sell?
What’s the upside potential of this rally? The most straightforward way of estimating upside potential is to find potential areas of resistance. Arguably, the S&P 500 is already testing a resistance zone. Further resistance can be found at the first Fibonacci retracement level of about 4185, with secondary resistance at the 50 dma at about 4280, which also roughly corresponds to the area at the falling trend line..
Another way of estimating upside potential is to monitor the evolution of trading signals. The NAAIM Exposure Index, which measures the sentiment of RIAs, flashed two consecutive buy signals by falling below its 26-week Bollinger Band. This indicator has been excellent at calling short-term bottoms. Upside momentum often fades when NAAIM rises to its 26-week moving average.
Also, keep an eye on the VIX. Trading tops often form when the VIX Index falls below its Bollinger Band.
Despite last week’s show of strength by the bulls, my base case scenario calls for a bear market rally within a bear trend. The relative performances of defensive sectors are still in uptrends, indicating that the bears still have control of the tape.
Enjoy the rally, but don’t overstay the party.
Disclosure: Long SPXL