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: 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.
The S&P 500 rallied strongly early in the week but gave up most of its gains as time passed. Friday’s hot NFP report cratered stock prices and the index traced out a bearish island reversal, which is clearly visible on the hourly chart. The good news is the S&P 500 has nearly reached the measured downside target of its reversal pattern. In addition, the last hour was characterized by a morning star doji candle, which is a possible reversal pattern that needs to be confirmed by market strength Monday morning.
Possible inverted hammer reversal candlestick patterns can also be seen in the NASDAQ Composite weekly chart and the S&P 500 weekly chart. The bullish backdrops are enhanced by the presence of positive RSI divergences. Both reversal setups will need to be confirmed by market strength next week.
The bullish rewards of a reversal could be considerable. Portfolio manager Steve Deppe
found that the stock prices surged the following week when the S&P 500 closed over -4% off its weekly high each of the last four weeks (caution, n=3).
Reasons to buy
Notwithstanding the bullish results from silly small sample studies, technical conditions are supportive of the bull case. First, the relative performance of defensive sectors look dismal, except for Healthcare. Two out of four sectors are testing relative support and one, real estate, is breaking down relative to the S&P 500. It should also be noted that weak relative strength in defensive sectors began even before the stock market staged its rally.
Another positive signal comes from cross-asset analysis. Credit market risk appetite is perking up. Both the relative price performance of high-yield and leveraged loans compared to their duration-equivalent Treasuries is exhibiting positive divergences against the S&P 500.
Equity risk appetite indicators are bullish to neutral. The relative ratio of high beta to low volatility is showing a minor positive divergence, while the equal-weighted consumer discretionary to staples ratio is tracking the performance of the S&P 500.
Despite the surge in stock prices early in the week, the NYSE Summation Index (NYSI) oversold and very near an extreme condition. The market simply doesn’t crash with NYSI readings at these levels. At a minimum, this should put a floor on stock prices should the market weaken.
Positioning is at an extreme and supportive of high prices. Bloomberg
reported that fund flows into the short ETF is a record, indicating that retail investors have piled in. A separate Bloomberg article
revealed that fund flow reports show investors poured the most money into cash in the past week since April 2020.
Tactically, hedge funds are short and poised to cover. Charlie McElligott at Nomura observed that CTAs have begun to cover their equity shorts from a crowded short condition. Any catalyst that sparks gains in the market could start a melt-up stampede.
In addition, the 10 dma of the equity put/call ratio is at or near levels where the market has bottomed out in the last 10 years. Fear levels are nearing a crescendo.
Upbeat earnings season
As we approach Q3 earnings season, FactSet reported that the pace of positive guidance has improved sequentially from last quarter and negative guidance declined. Moreover, the number of companies giving positive guidance is above its 5-year average. The game of guiding lower to beat results for Q3 is done. We should see a decent series of positive earnings surprises in the coming weeks.
The theme of an upbeat Q3 is confirmed on a top-down basis by the Atlanta Fed’s GDPNow nowcast, which soared to 2.9% and shows no immediate signs of a recession.
Despite the sunny near-term outlook, investors can expect some storm clouds on the horizon. Using the official definition of -20% from their highs as the definition of a bear market, about 40% of global markets are in bear markets. As Europe is almost certainly in recession, China is teetering on one, and the US is almost certainly going to see one in 2023, these readings are inconsistent with a durable bottom. Stocks have more work to do on the downside.
The recent risk appetite environment has mainly been driven by the bond market, as the stock market has really gone along for the ride. The MOVE Index, which measures the volatility of bonds, is exhibiting a significant divergence from the VIX Index. This bear market is unlikely to end until the two converge. Watch for the VIX to rise in the coming months.
In conclusion, I am constructive on the stock market for the next few weeks, perhaps as far as to year-end. These conditions are consistent with the pattern of positive seasonality that begins about now. However, investors need to be prepared for turbulence once any short-term rally peters out. This is a bear market, and don’t mistake a bear market rally for the start of a fresh bull.
Disclosure: Long SPXL