Vulnerable to a setback

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 “bullish” on 29-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 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.



Mission accomplished

About two weeks ago, I highlighted the severe oversold nature of the stock market and suggested that it was poised for a relief rally. The relief rally duly arrived, and a week ago I set out a number of tripwires for traders to take profits on the tactical rally. All of the tripwires were triggered:
  • The S&P 500 exceeded the 50% retracement of the downdraft.
  • The NYSE McClellan Oscillator (NYMO) reached the zero neutral level.
  • The VIX Index reached its 20 dma. In fact, it blew through the 20 dma to breach its lower Bollinger Band, which is an overbought condition.



What’s next?



An unconvincing buy signal 

The usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) flashed a buy signal when its 14-day RSI recycled from oversold to neutral. In the last five years there were 26 buy signals, 22 were resolved bullishly and four failed. 


In this case, I am skeptical of this buy signal. Past failures occurred when the percentage of stocks above their 20 dma were at or near the 60% level, which is the case today.



These conditions are consistent with the scenario that I previously outlined where the stock market was poised for a relief rally, which has occurred, followed by further market weakness.



Further downside potential

The weekly chart of the S&P 500 outlines the bearish potential of a correction. The 5-week RSI of the index reached an overbought extreme of 90 in June. The last two times this happened, the market pulled back, rallied and weakened again to a final low. As the weekly stochastic is still on a sell signal when it recycled from overbought to neutral, this is supportive of the case for a similar pullback after the recent relief rally. Strong support can be found at the 4200–4300 zone.




Worrisome divergences

The market is exhibiting worrisome divergences that makes it vulnerable to a setback. 
The top panel of the accompanying chart shows that the NASDAQ 100 is testing a key relative resistance zone compared to the MSCI All-Country World Index (ACWI). The bottom panel shows that the relative performance of the NASDAQ 100 to the S&P 500 had been inversely correlated to 10-year Treasury yields, which makes sense because the growth stocks represented by the NASDAQ 100 have higher duration and therefore higher interest rate sensitivity. The interest rate relationship began to diverge in early 2023 when AI-related plays soared. While the gap between NASDAQ 100 to S&P 500 and 10-year yields has stabilized, the large gap between the two makes U.S. large-cap growth stocks vulnerable to a setback. As these sectors comprise over 40% of the S&P 500, any narrowing of the gap makes the S&P 500 especially vulnerable to a setback.



For a longer-term perspective, the dark line in this chart shows the NASDAQ 100 normalized for its relative performance to the S&P 500 in a rolling 52-week period. The shaded areas represent oversold episodes which represent long-term buy signals. By contrast, current conditions indicate that NASDAQ stocks are extended and vulnerable to weakness.



In conclusion, the overbought condition of the market, combined with an unconvincing show of momentum from the ITBM indicator, makes me believe the market has still unfinished business to the downside. In particular, the lack of a bullish reaction to last Thursday’s benign PCE print and non-inflationary but strong NFP report may be a sign of bullish exhaustion. The S&P 500 should find strong support in the 4200–4300 zone should the market correct from current levels.



3 thoughts on “Vulnerable to a setback

  1. Then there is the question of FOMO and things staying overbought. I agree that staying aside and waiting for the next leg down is safer, but if we break above 4634 and people start talking a new all time high then we could get FOMO.
    What makes more sense is for a drop down to strong support at 4200 or so and then the year end brings us the ATH. But being sensible is not what the market does.

    1. That makes it fun to observer the price action. Nobody gets it right all the time. But that’s OK.

      At any moment there are scary conjectures on financial TV. Because they sell on fear so if you bet against them you are likely to win, to various degree. It is also true that if you lengthen your timeframe the odds will be in your favor.

      Loosely the current situation from money flow perspective can be summarized as:

      1. Fast money is buying a group of stocks, riding the upper Bollinger band. This will continue because this month is quarter end. You can easily find these winners because they in incessant up move.
      2. Mechanical algos are buying because vix is again below 15. Price insensitive.
      3. Corporate buyback is in full force. AOC and D party’s tax on buyback has no effect. In fact these folks are also in the action. Everyone loves money. D, R, or I, no matter.
      4. Monthly flow from retirement accounts. Totally reliable, rain or shine.
      5. People betting on higher rates are selling. The potentially involves big money.
      6. People betting on seasonality are selling.
      7 People who think vix is too low are selling.
      8. People who think equities are too expensive are selling.

      You can come up with many more. It is a fun exercise and actually can give you a reasonable picture of any moment in the market. I do it this style: following Buffet and Soros principles at the same time.

      The last point today (tomorrow it is another set of conjectures which can be very different) is about generative AI. A group of people already started to doubt the potential influence. I run my own search engine and headline aggregator and see the time series going up more noticeably. A group of people are more nuanced in their articles which I pay attention to. The Internet is a very easy transition. You just move everything to the hybrid cloud or totally public cloud and you can rent/buy computing resources. Very straightforward. AI is so different because it is not a platform transition. Most companies will only see modest productivity improvement from handling those drudgery or routines. The companies who posses very deep and validated relational database will come up with something very amazing with AI algos and tools. A world which moves on the direction of more and more concentration is unfolding. Exciting, yes. Dangerous, yes. But definitely not boring. Let’s use Neil Young’s (by the way an illegal alien from Canada) words: better to burn out than to fade away. I am pretty sure he was high when he wrote the song Hey Hey My My. In fact it is very difficult to find him and his peers not high 90% of the time back in the 70s.

      1. I think that AI has been exaggerated. Remember, the economy is about people buying , making and servicing. While AI may improve productivity, we still have to deal with costs of resources, workers etc. If we get rid of many employees, then we have many unemployed.
        So even if they spend 5 trillion on chips in the next 5 years what will we get out of that? This makes me think of fiberoptics in the late 90s.
        But in the meanwhile NVDA could hit 1000, I’m not biting.

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