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: Neutral
- Trading model: Bearish
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.
The stock market has taken on a giddy tone in the wake of the tamer than expected inflation reports. The S&P 500 has staged an upside breakout through a key 50% Fibonacci retracement level, which according to some chartists, could be the signal for the all-clear and a resumption of the bull market.
reported that technical analyst Jonathan Krinsky interpreted the upside breakout with guarded optimism:
“Since 1950 there has never been a bear market rally that exceeded the 50% retracement and then gone on to make new cycle lows,” said Jonathan Krinsky, chief market technician at BTIG, in a note earlier this month…
Krinsky, meanwhile, cautioned that previous 50% retracements in 1974, 2004, and 2009 all saw decent shakeouts shortly after clearing that threshold.
“Further, as the market has cheered ‘peak inflation’, we are now seeing a quiet resurgence in many commodities, and bonds continue to weaken,” he wrote Thursday.
My review of market internals shows narrowing leadership which is a warning that the current rally is unsustainable.
A leadership review
My market leadership review begins at the global level, which shows strong US leadership and flat to falling relative strength in all other regions. Europe and China are lagging the MSCI All-Country World Index (ACWI). Japan is trading sideways, and EM xChina appears to be trying to bottom on a relative basis.
A more detailed analysis of EM xChina shows that two of the top three countries in the index are in relative downtrends and only one, India, is in a relative uptrend.
In other words, the US and India are holding up the world.
Narrow US leadership
Relative performance analysis of the top five sectors of the S&P 500 also shows narrow leadership. The top five sectors comprise over 70% of index weight and it would be difficult for the S&P 500 to rise or fall without the participation of a majority. Sector relative performance shows that technology and consumer discretionary stocks are leading the market up in the last two months, with healthcare and communication services the laggards. Financial stocks are flat to down compared to the index. However, the equal-weighted consumer discretionary sector, which lessens the effects of the heavyweights AMZN and TSLA, has been flat against the index. In short, the leadership in the S&P 500 amounts to technology and large-cap NASDAQ 100 names like AMZN and TSLA.
A review of the relative performance of defensive sectors is equally revealing. Two defensive sectors, healthcare and consumer staples, are holding relative support and the other two, real estate and utilities, are trading in a sideways range. The relative strength shown by these sectors is an indication that the bears haven’t fully lost control of the tape.
In summary, the global market advance is being led by a handful of US technology stocks and, to a lesser extent, India. The narrowness of breadth amounts to a warning to investors.
Other warnings about stock market strength are emerging. Even as the WSJ
declared that a new bull market had begun for the NASDAQ Composite when it rallied 20% from June’s bottom, Mark Hulbert
disagreed and sounded a word of caution.
On the contrary, there have been a number of occasions during past bear markets in which the Nasdaq Composite index rallied by far more than 20%. There were three such rallies during the bear market that accompanied the bursting of the late 1990s internet bubble, for example. The most explosive of them occurred between early April and late May of 2001, during which this benchmark rallied more than 40%. I doubt that any investor who lived through the bursting of the internet bubble would look back and consider that rally to have been a new bull market.
It’s not just the volatile Nasdaq that has the ability to rally explosively during bear markets. The same is true for the more sedate, blue-chip dominated Dow Jones Industrial Average. There are three bear markets in the calendar maintained by Ned Davis Research in which the Dow also rallied more than 20%. The most spectacular of those rallies occurred over a five-week stretch in late 1931, when the Dow gained 35.1%. That rally occurred during some of the darkest days of the Great Depression, and once again I doubt any market historian would consider it to have been a bull market.
John Butters at FactSet
pointed out that S&P 500 earnings growth is becoming challenging. Q2 earnings growth was actually negative if the energy sector is excluded. Viewed in this context, the recent expansion in the S&P 500 forward P/E ratio raises valuation risk for the market.
The Energy sector is also the largest contributor to earnings growth for the S&P 500 for Q2 2022. The sector is reporting an aggregate year-over-year increase in earnings of $47.7 billion, while the S&P 500 overall is reporting an aggregate year-over-year increase in earnings of $31.1 billion. In fact, if the Energy sector is excluded, the S&P 500 would be reporting a year-over-year decline in earnings of 3.7% rather than a year-over-year increase in earnings of 6.7%.
Equity risk appetite factors are showing growing negative divergences. The relative performance of equal-weighted consumer discretionary to consumer staples is already lagging the S&P 500, and the gap with the high beta to low volatility baskets is starting to grow. Speculative growth stocks, as measured by ARK Innovation ETF, is still struggling with relative resistance and hasn’t achieved an upside relative breakout. View in isolation, these divergences are not actionable sell signals, but they are concerning when viewed in conjunction with the other warnings.
Subscribers received an email alert Friday that the VVIX, which is the volatility of the VIX Index, had flashed a short-term sell signal. In the past, a spike in the 5-day correlation between the S&P 500 and VVIX tended to resolve bearishly. There were 21 similar signals in the past five years. The market was flat or up in six cases (grey vertical lines) and fell in 15 (pink vertical lines).
My inner investor remains neutrally positioned at the asset weights specified by his investment policy. My inner trader just went short the market based on the spike in correlation between the S&P 500 and VVIX. Historically, the results of the sell signal should be known almost immediately and the trade will be stopped out if the market continues to advance in next few days. Good traders play the odds, but they also practise risk control.
Disclosure: Long SPXU