A warning from a market leadership review

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.


Dovish pivot?

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.



Marketwatch 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

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


14 thoughts on “A warning from a market leadership review

  1. We live in a time where markets make no sense.
    Does anyone feel that these are good times?
    Ukraine war, Covid still causing some issues in China, inflation and supply bottlenecks, energy crisis in Europe .
    We have seen cryptos go up like crazy over the last 10 years, now down a lot, NFTs selling for millions, used cars costing more than new ones (that one I never would have believed possible), companies like MSTR buying bitcoins en masse, Hertz rallies on announcing bankruptcy, the meme stocks.
    Irrational times, perhaps what we need is more intense bad news….pivot fuel…to spark an insane rally.
    Logically, with all the debt, rising interest rates, and inflation the market should be going down, but this makes me think of the scene in The Big Short where prices went up when they should be going down.
    So they may go up before they go down, but this does nothing to make me feel everything is rosy.

  2. This week I heard a well researched explanation of the current bullish macro American market environment by Macro Research MRB. Their research says the neutral Fed rate for the economy is in the 4.0 to 4.5% range as it was before Covid not the 2.0 to 2.5% range the Fed and other observers are using. This is because the American consumer’s balance sheet is in good condition as they have deleveraged since the GFC.

    If this is true, and I’m not saying it is, the current Fed rate projections will only cause a surprisingly small slowing of the economy accompanied by a better than expected stock market. So far, they seem to be right. They are bearish on bond since yields will need to go much higher to quell inflation than observers currently expect.

    The Canadian consumer has not deleveraged since the GFC. On the contrary, they have borrowed massively for real estate. MRB projects a very negative environment for its economy and currency in this higher than expected rate environment.

    I offer this as a well researched idea by a respected research firm.

  3. AAPL’s latest earnings were the second lowest in 5 years.
    It has retraced 78% of the drop, and of course influences the SPY.
    In august 2018 the earnings were 2.34 vs the latest 1.2, yet the share price in 2018 was around 50$ vs 172 now.
    Has the market anchored to the idea that prices always go up?
    It’s not like AAPL has a great growth opportunity and will grow revs at 50% a year.

    1. AAPL has strong, all-time high resistance at $178-180 so given that it is currently at $172.1 it may not have much further to go until it at least stalls.
      Also I think that AAPL has a lot of buybacks keeping the price up.

  4. The MRB outlook would explain why Small Cap factor is doing so abnormally well during this bear market. The other three key factors have aligned normally with Low Volatility and Growth outperforming and Value lagging but Small Cap is merrily up with the winners. It always leads us down to the eventual Recessionary Bear Market low. Its earnings are so economically sensitive. It’s strength is amazing. What’s happening?

    1. Everything depends on the labor market. If it stays strong, Fed will be scratching their collective heads and struggle to explain why. For the Fed, just say you don’t know and eat your humble pie. That’s why we should hire engineers, and not economists, to the Fed.

      Many charts and graphs in econ and finance are surprisingly (but should be not) similar to certain mechanical and electronic systems in behavior. For example, Cam’s missive yesterday showed some Beveridge curves. Beveridge curves look just like hysteresis loops in magnetism or spring systems in mechanics. When you traverse the loop the energy is lost. The magnitude is represented by the size of the area.

      The typical Beveridge curves, just like hysteresis loops, contain loop area. For an economic cycle, it traverses the B Curve in clockwise fashion. From boom to bust the bigger the loop area the greater the loss for the system, and needs more time to recover. The current B Curve does not see much of loop area, which implies our entire systems retain pretty the same energy level and capacity. What the Fed dogma insists is that we need to knock down this strong system, in any which way possible. What’s the ramification? Financial markets might show V rebound. In the economy, there might be something coming like we have never seen before.

      Can B Curve traverse in CC direction? That’s why economics is not a branch of hard science or engineering.

      1. The problem is behavioral psychology. Isaac Newton lost his fortune in the South Sea Bubble.

        1. I look at behavioral psychology in a very basic way. Fear and greed….greed is like rushing to get fruit/something to eat, but fear is about survival/not being eaten by a lion. Which is why fear is more powerful than greed, and perhaps why markets go down faster, although it’s only with downdrafts that one gets forced selling.
          So when it changes from greed to fear this is significant.

      2. The question isn’t whether the Fed is charting the right course. The question is what the Fed does next, because ultimately they’re in control.

        1. I thought the other way around. The sum of zillions of actions by investors determine the market, and the Fed follows the market.

          The yields began to go up long before the Fed took any action on the Fed Funds rate. Now, the same thing seems to be happening in the other direction. The market is saying to the Fed, not too fast. The economy is deteriorating rapidly. Will the Fed follow or continue hiking until crashing the market?

          1. One thing comes to mind. The commercials are net long and large speculators net short. What if the commercials plan to squeeze the large speculators? A short squeeze is the only scenario I can think of where a rising market can cause fear.
            David Hunter might be right, because after the squeeze is done prices collapse.

          2. This guy thinks that hedge funds will rush into equities to save their careers.

            When this turns, it will be violent to the upside. So many funds are down huge and if they don’t make it back in 2H, they’re gonna get redeemed. You can’t make it back sitting in cash. They’ll be forced to buy what’s working. Career survival will force $$ into value and energy…

            Also, the 1% tax on buybacks is effective Jan 1, 2023. Do the companies rush into buying later this year to avoid paying 1% in tax?

            I am certainly not ignoring David Hunter’s forecast. He seems genuine whether you agree with him or not. I wish he’d share a deeper look into his analysis in his interviews. It seems skin deep to me.

            He expects the melt-up to be driven primarily by the Fed pivot that the market will sense and anticipate in advance and positioning, like you pointed out here.

  5. UK inflation comes in at 10.1% – please keep in mind that many European countries adopted inflation mitigation policies like tax breaks on gasoline and other subsidies, when those expire there will be pretty dramatic MoM effects on the CPI readings of those countries. In Germany, for instance, gasoline prices are going to jump 20% due to the expiration of the tax break on September 1st.

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