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: Neutral
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.
Technical analysts recently became excited when the percentage of S&P 500 stocks above their 50 dma surged from below 5% at the June low to over 90% in mid-August. In the past, such strong price momentum has always signaled the start of a new equity bull.
Since then, the S&P 500 fizzled at its 200 dma. Markets further took a risk-off tone when the Fed and other central bankers signaled their determination to raise interest rates and warned about pain ahead. The reversal has been so dramatic that the percentage of S&P 500 stocks above their 20 dma has retreated to under 10%.
If it’s any consolation, the intermediate technical outlook is still bullish for equities.
Buy signal still intact
Rob Hanna at Quantifiable Edges
studied the history of failed breadth thrusts. He found that historical returns are strong even in cases when the market suffered an initial drop.
Jason Goepfert at SentimenTrader
studied historical analogs to the recent breadth thrust market action and concluded:
- The 50-day rally off the June low is comparable to other long-term bottoms.
- A price analog shows that the highest-correlated 50-day patterns all showed one-year gains.
- Shorter-term returns were inconsistent, with several giving back most or all of the initial rally.
- The highest-correlated rallies tended to peak where we did now but showed long-term gains.
Lessons from market history
Some lessons from market history are revealing. A study of past market bottoms since 2000 shows that recovery from a breadth wipeout (bottom panel), as measured by the percentage of S&P 500 stocks above their 50 dma rising from below 5% to over 90%, has always been bullish. Other market bottoms have been characterized by low-quality rallies, a rebound in the cyclically sensitive copper/gold ratio, and strength in the consumer discretionary to consumer staples ratio as an indicator of risk appetite. In addition to the recent breadth thrust, all three of those factors are confirming the latest bullish impulse.
What about the Fed? A key risk to the bull case is the Fed’s “whatever it takes” determination to bring inflation back to its 2% target. A study of the Zweig Breadth Thrust tells the story of the interaction of breadth thrusts and Fed policy. There have been only six ZBT buy signals since Marty Zweig wrote about his model in 1986. The market has been higher a year later in all instances. In two cases, the market chopped around and re-tested its lows during periods when the Fed was raising rates. While it’s difficult to make any definitive forecasts based a study where n=2, the re-tests occurred 2-4 months after the initial ZBT buy signal.
Fast forward to 2022, the 30-year long Treasury bond could be giving investors a message. In the past, the peak in the long 30-year Treasury yield has been either coincident or slightly led the peak in the Fed Funds rate. The long bond yield appears to be trying to top out. Past episodes have tended to be bullish for risk assets such as equities.
Former Fed economist Claudia Sahm
outlined how inflation could resolve itself in a relatively benign manner. Economic weakness in Europe and China helps the US to bring down inflation.
Who benefits from Europe going into recession? We do. The United States, as the largest economy in the world, the largest producer of oil and natural gas, and with one of the strongest recoveries, should be able to weather the storm in Europe. Their hardship will sharply lower their demand and help bring our inflation down.
Yes, the lockdowns and production stoppages in China will reduce the available goods for us to buy. But remember, inflation comes down with more supply and/or less demand. We are not the only ones who buy electronics and cars. If demand in the European Union, the second-largest economy, China, third-largest, and others, slows dramatically, that’s less competition for goods and less inflation for us.
USD strength is importing disinflation and exporting inflation to America’s trading partners.
The stronger dollar pushes down our inflation. Imports are cheaper now for us from basically everywhere. Usually, the “pass-through” of import prices to the overall CPI is considered small. But import prices are falling markedly—both with the stronger dollar and easing supply chain disruptions—and will show up to some degree. Moreover, new research from the New York Fed by Mary Amiti, Sebastian Heise, Fatih Karahan, and Ayşegül Şahin suggests that the import price “pass-through” in the United States has been larger since the pandemic began.
Short-term pain ahead
Tactically, equity bulls are likely to face further pain. The market is very oversold, but fear levels are inconsistent with major market bottoms.
The NYSE and NASDAQ McClellan Oscillators (NYMO and NAMO) are exhibiting deep oversold readings, which could see the market bounce, but any rally is unlikely to be unsustainable.
That’s because sentiment indicators did not reach washout and capitulation levels. Investors Intelligence sentiment has recovered from a crowded short condition and readings are only mildly bearish.
A 10-year history of the CBOE put/call ratio and equity put/call ratio shows a pattern of slowly rising put/call ratios until readings reach a crescendo. I conclude from this that the market needs to either re-test or stage a near re-test of the June lows.
The term structure of the VIX isn’t even inverted, which would be an indication of panic.
The VIX Index appears to be exhibiting a 50-day cycle, and the projected peak for the VIX is above 34 on September 20, 2022, which coincidentally is one day before the next FOMC meeting. Stay tuned.
To underscore my point about the unsustainability of a bounce, here are all the instances in the past 10 years when NYMO became as oversold as it did recently.
There were four cases during the 2012-2013 period. None of them exhibited extreme fear as measured by the inversion of the VIX curve. All relief rallies resolved with lower lows soon afterwards.
There was one instance of an oversold NYMO in 2015. The VIX curve inverted. The market staged a relief rally but came back to re-test the old low.
There were four episodes during the 2018-2020 period. The VIX curve inverted in all cases, indicating panic. Only the Christmas Eve Panic of 2018 resolved in a V-shape bottom. All others, including the COVID Crash, saw the market decline soon after a rally.
In summary, there were nine NYMO extreme oversold episodes in the last 10 years. Eight of the nine resolved in further declines after bounces.
In conclusion, the bullish implications of the breadth thrust are still alive. If history is any guide, stock prices should be higher by next summer after some short-term sloppiness. The key risk to this forecast is the Fed will continue to tighten into a recession and deliberately tank stock prices to fight inflation.