How to spot the correction bottom

Posted by Cam Hui -

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 (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
  • Trading model: Neutral (Last changed from “bearish” on 03-Aug-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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 correction in an uptrend

I have been warning for several weeks that U.S. equities appeared extended even as stock prices advanced. Even though the intermediate trend was bullish, the market could pull back at any time.

 

It seems to have finally happened. The S&P 500 stalled and turned down on the news that Fitch had downgraded U.S. government debt. The ratings downgrade shouldn’t have been a risk-off trigger. U.S. Treasury paper is regarded as the default-free and risk-free asset. No one buys Treasuries based on a credit rating. In fact, the market reaction to the ratings downgrade was a steepening of the yield curve. Short Treasury yields fell while longer-term yields rose. If the market was truly rattled by the change in credit rating, yields should have risen across the board.

 

Instead, I believe the stock market had risen too far and too fast. The Fitch downgrade was just an excuse to sell and the pullback was overdue. You can tell a lot about the psychology of the market by the way it responds to news. FactSet reported that, with 84% of the S&P 500 having reported earnings, the market isn’t rewarding the shares of companies that beat EPS expectations.

 

Where’s the correction bottom?

 

 

No signs of panic

So far, the pullback has only begun, and there are few signs of panic that mark buying opportunities. The Fear & Greed Index is still at a greedy reading.

 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, rose last week, indicating increasing bullishness. Readings are above 100, which is a levered long position. I interpret this as a frothy market in need of a period of consolidation or correction.

 

 

Tactically, VIX Index term structure is not inverted, which would be a sign of fear.

 

 

The CBOE put/call ratio, has begun to normalize from an overly complacent reading. If this is a major correction, the 10 dma of the put/call ratio may have to return to its 200 dma before a durable bottom can be made. However, investors can find other signs of a short-term bottom in the absence of the major correction scenario.

 

 

 

Bottom spotting

The usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) flashed a sell signal last week when its 14-day RSI recycled from overbought to neutral. What makes this episode stand out is the sell signal occurred against a backdrop of the percentage of S&P 500 stocks bullish on P&F charts turned down from above 80% to neutral, indicating a sell signal from a severely extended condition.
 

There were only four other episodes in the last five years. In all of them, the market decline didn’t stop until the NYSE McCellan Oscillator (bottom panel) reached an oversold condition. As well, the 14-day RSI of ITBM (top panel) reached an oversold reading in three of the four occasions, and the last one was close. In the case of the major downdraft that began with the sell signal of August 2022, indicators reached an initial oversold reading and the market bounced before resuming its decline into its ultimate low.

 

 

In addition, the 5-week RSI of the S&P 500 reached an overbought extreme in June. The last two times this happened the decline wasn’t arrested until RSI reached a neutral reading of 50, which could be as low as the S&P 500’s long-term support at about 4200.
 

 

However, the pullback may not necessarily be that severe. The 5-day RSI of the S&P 500 is already oversold. Initial support can be found at the 50 dma at about 4400, with secondary support at 4200. If that support breaks, look for a test of the 200 at about 4100.

 

 

 

Still constructive

Despite the short-term dominance bearish price momentum, I am still constructive on the stock market. Market leadership has broadened out from the narrow leadership of megacap technology stocks, which is helpful to the bull case.

 

 

The relative performance of key cyclical industries is either bottoming or in a relative uptrend, both are signals of a bullish cyclical rebound.
 

 

Finally, keep an eye on the Dow Jones Transportation Average, which exhibited an inverse head and shoulders breakout. If this is indeed just a short-term correction, the index should hold above its breakout level.

 

 

In conclusion, the stock market had been undergoing an unsustainable advance and a corrective period has probably started. I believe this is just a pullback within the context of an intermediate uptrend. I offer several clues on how to spot the corrective bottom.

 

6 thoughts on “How to spot the correction bottom”

  1. Cam,
    You recently initiated and closed a short trading position within couple of days. To me it says a lot more than your call for a correction of some magnitude.
    Just saying…

  2. Personally, I feel it is premature to start searching for a bottom. Trends have a life of there own. Any Black Swan event can extend the trend. Fitch downgrading came out of the blue. What we know now is that both Tesla and Apple had sizable gap down on high volume breaking their respective uptrend trend lines. Over and above that we had weekly outside engulfing patterns in TQQQ and SOXL – a sign of an intermediate top. If the market was to correct 50% of the prior rally from March we are looking at anywhere from 10 to 20 percent depending on the Index – a sizable haircut.

  4. A small summary of what market participants and pundits are talking about these days, for our fellow students’ reference.

    1. Seasonality. Aug and Sept are slow and negative months. Aug especially for pre-election year. We don’t know how many already made the adjustment.

    2. Soft landing. Quite a few big investment houses have changed their forecast and their clients are in the process of dumping treasuries and raising equity exposure.

    3. 2Q23 reporting season. Markets have been front-running so it is no surprise that even a beat does not move prices. The biggest movements are in those heavily shorted names you probably never heard of or didn’t care about. Shorting these types of companies actually is a good strategy. Historically a new company does not have an average life span more than 10 years. And in recent decades the leftist push of equity and equality and ESG has lowered the quality of new companies even further. So if you are patient you can make nice money in shorting. Even a big one like TSLA which is purely a product of ESG policies can shrink dramatically too. If TSLA can match Toyota’s market cap over time it would be a victory.

    3Q and 4Q 2023 and 2024 EPS estimates are firming and increasing a little bit. Remember that valuation and sentiment are just preconditions. If the bond/equity reallocation can continue a slow deflation in late summer is very likely.

  5. TLT and the SPY have had a good correlation for years, until now. TLT seems about to break to the downside which suggests higher rates for longer.
    In early Jan 22, TLT broke down just a bit before the SPX, so I am keeping an eye on what TLT does. Will it break down below 90 or will it bounce off support? Pardon the pun but it seems to be at a pivotal level.
    That doesn’t mean that things cannot keep going higher. They did in 2007 when the market made an ATH in October.
    One of the problems with fundamentals or macro is that they can be way too early, which for longs means patience and better prices, but for shorts is murder. Maybe the bears are right but too early.

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