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. 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.
A History Lesson from 2011
The last time the U.S. faced a serious debt ceiling impasse was 2011. The S&P 500 skidded -8.2% in the weeks leading up to x-date, or the estimated day that the U.S. Treasury would run out of funds. Both sides came to an agreement two days before x-date, and the market fell further after the deal.
While history doesn’t repeat itself but rhymes, we fear that some analysts have learned the wrong lesson from 2011. The post-deal market weakness was mainly attributable to the Greek Crisis in which the very existence of the euro currency was threatened. It’s unclear how much of that sell-off can be traced to a “buy the rumour, sell the news” reaction to a debt ceiling deal.
This time is indeed different. Here’s why.
Here is what’s different this time compared to 2011. In 2011, the eurozone was experiencing an existential crisis. Today, the Euro STOXX 50 has staged a relative breakout and most European markets have also done the same.
As well, the Fed and the U.S. Treasury now have contingency plans in place to stabilize markets in the event of a default (see How the market could break up to a blow-off top
). While a default will still be disruptive, it may not immediately turn out to be like falling off a cliff, but taking a significant stumble.
What’s the same
Here’s what’s the same as 2011. Sentiment readings are very similar. Institutional risk appetite, as measured by the monthly BoA Global Fund Manager Survey, is very similar to the levels seen during the 2011 Greek Crisis.
Retail sentiment, as measured by the weekly AAII survey, shows a slightly greater level of net bullishness, but otherwise conditions are broadly similar.
If U.S. lawmakers step back from the brink, the Treasury Department’s response to the lifting of the debt ceiling should be the same. Expect Treasury to flood the market with paper, which would drain liquidity from the financial system. Historically, equity prices have been correlated with liquidity conditions.
In the event the debt ceiling is raised, Treasury is expected to issue a flood of new paper. In addition, it will reverse the drawdown of the Treasury General Account (TGA), which is its account held at the Fed. Both measures will have the effect of reducing liquidity.
In conclusion, I continue to be surprised by how well stock prices have held up in the face of the combination of a banking crisis and U.S. default fears, suggesting that market participants are too bearish, which is contrarian bullish. A definitive breach of S&P 500 resistance at 4180-4200 could see the index surge to the next resistance level at 4300-4310.
A study of the last debt ceiling crisis in 2011 leads me to believe that, in the event of a default, risky asset prices will initially crater in a disorderly fashion but stabilize soon afterward. Should the White House and Republican lawmakers come to a debt ceiling deal, expect a reflex risk-on rally, followed by a decline as liquidity conditions create headwinds for stock prices.