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.
Something for everyone
During the recent bull and bear debate, Nautilus Research provided some historical analogs for both bulls and bears. Depending on what camp you are in, Nautilus had a market template for you.
I have been in the bear camp ever since this rally began (see Lessons from a study of past major bottoms
). As the S&P 500 rally stalled and pulled back at the 200 dma, here are six reasons why the advance was likely a bear market rally and not the signal that a new bull had begun.
A short covering rally
The rally off the June low was mainly a short covering rally as sentiment and positioning were stretched at historic extremes. While the S&P 500 has risen 15% from its June low, the Goldman Sachs Basket of most shorted stock basket was up over 45% at its peak and the performance of the basket has dramatically pulled back. While short covering rallies can be bullish indicators of positive price momentum, the market needs additional catalysts to push prices higher once the fast money has covered its short positions.
When the S&P 500 was rejected at its 200 dma resistance, momentum began to turn down. The 14-day RSI recycled from an overbought condition, which is a tactical sell signal. The index has reached its first Fibonacci retracement level and may see some near term strength early next week.
A similar pattern can be seen in the weekly chart as the 5-week RSI recycled from an overbought reading.
New bull markets are generally characterized by a change in leadership. Investors have seen no signs of the emergence of any new leadership. In fact, the same old large-cap growth leadership is still leading the way as the relative performance of the NASDAQ 100 remains sensitive to the 10-year Treasury yield.
On the other hand, speculative growth stocks have cratered and its price pattern is following the script of growth stocks in the aftermath of the dot-com bust.
The script hasn’t fully played out yet. A new bull won’t emerge until new leadership appears.
In all likelihood, the US economy is headed into a recession by Q1 2023. Earnings estimates are falling. Jeff Weginer at WisdomTree observed that S&P 500 EPS growth is inversely correlated to credit conditions, as measured by the loan officer survey. Once earnings estimates decline, valuation support for stock prices will weaken.
A hawkish Fed
The Federal Reserve has made it clear that its north star is fighting inflation. In his Jackson Hole speech
, Powell affirmed the Fed’s “responsibility to deliver price stability is unconditional”. He admitted that monetary is a crude tool because it can only affect demand and not supply, but he implicitly accept that the economy could fall into recession as the Fed tightens monetary policy.
It is also true, in my view, that the current high inflation in the United States is the product of strong demand and constrained supply, and that the Fed’s tools work principally on aggregate demand. None of this diminishes the Federal Reserve’s responsibility to carry out our assigned task of achieving price stability. There is clearly a job to do in moderating demand to better align with supply. We are committed to doing that job.
He acknowledged that higher rates will cause some pain, but invoked the short-term pain for long-term gain mantra. In other words, the Fed will tolerate a recession in order to control inflation.
While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
Powell warned, “We must keep at it until the job is done”.
History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting. The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.
With the inflation rate running close to a 40-year high and the unemployment rate at half-century lows, the Fed will stay hawkish for a considerable period. Ryan Detrick
highlighted analysis from Strategas that in the past eight cycles, the Fed kept raising rates until the Fed Funds rate exceeded CPI.
Even if we use the most optimistic assumptions by substituting core CPI for headline CPI and assumethat the transitory nature of goods inflation subsides, core CPI is likely to decelerate to only about 4% by early 2023. But sticky price CPI is stubbornly high and accelerating. This indicates that the Fed Funds rate will continue to rise to 4% or more before the Fed is done, which is well above current market expectations.
Tactically, a number of seasonality studies indicate that September is a poor month for stock returns. September is especially negative during midterm election years.
also found that history shows September to be a particularly negative month. He could find no explanation and chalked it up to a market mystery.
As well, the Fed is scheduled to double the pace of its quantitative tightening to $95 billion per month starting in September. Investors should be prepared for the possible negative effects of a withdrawal of liquidity from the financial system.
In conclusion, while there appear to be some superficial reasons to support the case for the start of a bull market, an analysis of market internals, valuation, and monetary policy backdrop indicates that the bear market isn’t over. Investors should watch for a re-test of the June lows and make a decision then about downside risk based on sentiment, technical conditions, and insider behavior.
Disclosure: Long SPXU