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: Buy equities
- Trend Model signal: Bullish
- Trading model: Bearish
Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @email@example.com. 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.
Can’t have a bull market without the bulls
Ever since I turned bullish on equities (see What the bull case looks like), I am seeing signs of a revival in sentiment. Contrarian sentiment analysis is useful, but if you believe this is the start of a new bull, sentiment needs to steadily improve. You can’t have a bull market without a steady revival of bullish sentiment. Indeed, the 4-week moving average of AAII bulls-bears and the NAAIM Exposure Index, which measure the sentiment of RIAs managing individual client funds, have bottomed turned up.
Similarly, the TD Ameritrade IMX, which measures the equity exposure of the firm’s clients, have also been making a bottom.
As well, Bloomberg reported money managers have cut their bearish equity exposures and they are now positioned more in line with historic norms. Readings are not extreme. The stock market can rise further if there are positive catalysts.
Willie Delwiche pointed out that recoveries after a prolonged bout of bearishness, which he measured as the number of weeks AAII bulls were below AAII bears, tend to be bullish.
Other signs of a bullish revival can be seen in factor analysis and the technical structure of the market. A review of four major factors reveals the following:
- Underlying strength in small caps.
- A revival of value against growth, notwithstanding the recent growth rebound.
- High quality dominance in H2 2022, followed by a reversal in 2023.
- Uneven returns to price momentum.
Recessionary market bottoms are often characterized by a dash for junk, which are the characteristics seen in small cap strength and low quality rally of 2023. The value/growth reversal appears to be a secular change in leadership that can be seen when market leadership changes from bull to bear.
Cross Border Capital pointed out that the global liquidity cycle is bottoming. Rising liquidity should be positive for stock prices.
In addition, the broadly based Wilshire 5000 is on the verge of flashing a long-term buy signal. In the past, this model has served well to delineate bull and bear markets. A bullish signal occurs when the MACD histogram turns from negative to positive, which should occur within the next few months should the market advance continue. A sell signal occurs when the 14-month RSI exhibits a negative divergence.
The bull case faces several risks. The first is valuation. The S&P 500 forward P/E is elevated by historical standards. That doesn’t mean the market can’t advance from current levels, but a gain of 15-20% would put valuation into extreme bubbly territory.
Other risks can be characterized as tail risks, which are relatively low probability events with high impact. The Economist highlighted Pakistan as a sovereign default candidate. A Pakistani default has the potential to ripple through the Chinese financial system because of the debts incurred from the Belt and Road Initiative. Such a default could cause a disorderly unwind that unduly affects China’s financial system.
Moreover, Zeynep Tufekci highlighted bird flu as another pandemic threat to global health in a NY Times OpEd. First, mammal to mammal transmission has been documented in the latest bird flu variant.
Alarmingly, it was recently reported that a mutant H5N1 strain was not only infecting minks at a fur farm in Spain but also most likely spreading among them, unprecedented among mammals. Even worse, the mink’s upper respiratory tract is exceptionally well suited to act as a conduit to humans, Thomas Peacock, a virologist who has studied avian influenza, told me.
More importantly, the latest H5N1 bird flu strain exposes vulnerabilities in the vaccine supply chain. Vaccines production depend mainly on egg production, but the hens that lay the eggs could be devastated by (you guessed it) bird flu.
Worryingly, all but one of the approved vaccines are produced by incubating each dose in an egg. The U.S. government keeps hundreds of thousands of chickens in secret farms with bodyguards. (It’s true!) But the bodyguards are presumably there to fend off terror attacks, not a virus. Relying on chickens to produce vaccines against a virus that has a 90 percent to 100 percent fatality rate among poultry has the makings of the most unfunny which-came-first, the-chicken-or-the-egg riddle.
The only company with an F.D.A.-approved non-egg-based H5N1 vaccine expects to be able to produce 150 million doses within six months of the declaration of a pandemic. But there are seven billion people in the world.
In the short-term, the market appears to be extended. The 14-day RSI reached an overbought level and retreated last week. Such events have usually resolved in either pullbacks or sideways consolidations in the past.
As well, the 10 dma of the put/call ratio has normalized from panic levels to readings indicating growing bullishness. While this doesn’t mean that the market will crash from here, it is a cautionary signal and a sign of rising headwinds for stock prices.
Another short-term risk factor can be seen in the development of Fed liquidity, which consists of quantitative tightening, less changes in the TGA and RRP. Fed liquidity has been highly correlated with the S&P 500 and a negative divergence is appearing between the two.
In conclusion, the signs of a bullish revival are becoming more evident in both the sentiment and technical data. However, valuation risk is elevated. The market is also extended in the short run and may be in need of a corrective or consolidation period.
My inner investor is bullishly positioned. My inner trader is tactically short the market in anticipation of near-term weakness. The usual caveats apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXU