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.
Still a single macro trade
How should investors interpret the recent risk-on episode? It’s all still one big macro trade. The S&P 500 continues to be inversely correlated to the USD Index, which is mainly driven by the expectations of a less hawkish Fed. The USD Index helpfully broke down through a minor rising trend line, which is a positive sign for risk appetite.
There is no question that earnings matter and the stock market faced headwinds from disappointing earnings results from large-cap technology giants. While the Street has questioned the long-term viability of META’s business model, the challenges faced by the other FANG+ names are cyclical in nature. The primary driver of large-cap growth stock relative performance continues to be the 10-year Treasury yield.
That said, the NASDAQ TRIN spiked above 2 on Thursday, which was before the Apple and Amazon earnings reports. This is an indication of blind panic selling in large-cap growth stocks.
Setting aside the problems of Big Tech, earnings results weren’t all bad. Investors saw strong positive results from the cyclical generals, such as General Motors and General Electric, as well as other cyclically sensitive industrial stocks, all of which reported results last week.
Mid and small-cap leadership
Here are some possible positives that are likely not fully discounted by investors. Even as the S&P 500 rally began to stall under the weight of tech earnings, small and mid-cap stocks were undergoing a stealth advance. The midcap S&P 400 is already in a choppy relative uptrend against the S&P 500. The small-cap S&P 600 achieved a relative breakout, while the Russell 2000 is testing a key relative resistance zone.
In other words, market breadth is stronger than it appears on the surface.
Fading geopolitical risk
Here are some other things that could go right. I have written before about the signs of fading geopolitical risk, as measured by the relative breakout achieved by MSCI Poland.
While this is not my base case, unrest in Iran sparked by a backlash against restrictions against women could topple the government in Tehran, which would be energy bearish but risk appetite bullish. The Economist
summarized the protests in Iran this way:
Dictatorships tend to fall the way Ernest Hemingway said people go bankrupt: gradually, then suddenly. The omens can be obvious with hindsight. In 1978 Iran’s corrupt, brutal, unpopular regime was besieged by protesters and led by a sick old shah. The next year it was swept away. Today Iranian protesters are again calling for the overthrow of a corrupt, brutal regime; this time led by a sick old ayatollah, Ali Khamenei. As Ray Takeyh, a veteran Iran-watcher, put it, “History…is surely rhyming on the streets of Tehran.”
Pessimists caution that mass protests have rocked Iran’s theocracy before, notably in 2009 and 2019, and the regime has always snuffed them out by shooting, torturing and censoring. Yet there are reasons to think that this time may be different; that the foundations of the Islamic Republic really are wobbling.
The challenge for the regime is whether the security forces would obey orders to use deadly force on women, or whether entrenched interests would acquiece to such harsh levels of oppression.
Yet however much the mullahs may want to crush these unruly women, they cannot be sure that the security forces would obey an order to shoot them in the street, or that the fury that would follow mass femicide could be contained.
Previously, when faced with protests, the regime has called on its supporters to stage counter-demonstrations. This time, hardly any have shown up. And several grandees who might in the past have condemned the protests or voiced support for the regime have conspicuously failed to do so. For now, Iran’s generals say they back Mr Khamenei. But it is unclear how far they will go to support an out-of-touch 83-year-old who wants to install his second-rate son as his successor. When protests in Egypt got out of hand in 2011, the top brass elbowed aside the unpopular president (who was also grooming his son as his heir) and allowed a brief flowering of democracy before eventually seizing power. In Iran, as in Egypt, the top brass have vast, grubby business interests to protect. If they sense the supreme leader is sinking, they have no incentive to go down with him.
Moreover, the collapse of the Iranian government would deprive Russia of an ally and arms supplier, which would pressure the Kremlin to end the Russo-Ukraine war, which would be another bullish development.
The week ahead
In the wake of a slowing core PCE print of 0.5%, which was in line with expectations, compared to a downward revision of 0.5% from 0.6% in August, I reiterate Jim Paulson’s analysis of S&P 500 returns when inflation is decelerating (see How inflation is a game changer for portfolios
Tactically, the current rally may have further upside potential. The market is anticipating a 75 bps hike at the November FOMC meeting, followed by two consecutive 50 bps hikes at the next two meetings, and a terminal rate of 475-500 bps, which is already the base case scenario.
San Francisco Fed President Mary Daly has said she could support slowing rate hikes to 50 and 25 bps hikes at subsequent FOMC meetings. If the Fed were to signal such a dovish path, it would spark a further risk-on rally. The probabilities are asymmetric. At worst, the Fed will behave in line with expectations and at best it will spark a risk-on episode.
Credit Suisse pointed out that the dovish central bank surprises have recently outnumbered hawkish ones. Will the Fed continue that trend next week?
Here’s where Fed watching gets a little tricky. What ultimately matters to the market isn’t whether the Fed slows to a 50 bps hike at the December FOMC meeting, but the level of the terminal rate. Investors are seeing some very different messages from the rates market. The 2-year Treasury yield (black line), which can be a proxy for market expectations of the terminal rate, has been trending up but recently pulled back to 4.4%. The 5-year breakeven rate (red line) has trended downwards and recently steadied. Arguably, this rate signal is overly noisy because it’s based on the TIPS market, which has been dominated by the Fed and may produce a false market signal. The 5×5 year rate (blue line) has traded sideways for all of this year. Which market signal should investors believe?
In the meantime, the equity bull party is in full swing. The S&P 500 regained its 50 dma on Friday, which gives it a shot at its inverse head and shoulders measured objective of about 4120, which is also the site of its 200 dma.
Bullish traders should enjoy the party, but be aware that event risk is rising.
Disclosure: Long SPXL