Comparing the S&P 500 today to the October bottom

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: Bullish (Last changed from “neutral” on 22-Sep-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter 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.

 

 

How much downside risk from here?

The recent downdraft in stock prices left many indicators in severely oversold territory. But how oversold, as oversold markets have been known to fall further. I compare the current technical conditions to the market bottom of October 2022.

 

Consider, for example, the Zweig Breadth Thrust Indicator. The ZBT buy signal is triggered when the ZBT Indicator moves from oversold to overbought within 10 trading days, which is a rare display of price momentum. Nevertheless, investors can use the ZBT Indicator as a short-term trading signal to spot entry points on the long side. As the accompanying chart shows, oversold conditions on this indicator always resolved in a short-term bounce, with no guarantee of a sustainable rally. The market did become oversold on this indicator last week, but levels were not as severe as the October bottom. In fact, the October bottom was a complex bottom, with the market becoming initially oversold, rallied, fell to another oversold condition, rallied again and weakened to the final bottom. The bottom was signaled by a positive divergence in the ZBT Indicator. None of that is in evidence today.
 

 

If we were to define the October low readings as the floor, does that mean the market has more downside potential?
 

 

Sufficiently oversold?

Here is what I am watching. Our Bottom Spotting Model is made up of five components. Historically, any two components that are triggered have been enough to signal tradable bottoms.
 

  1. The VIX Index spikes above its upper Bollinger Band;
  2. The term structure of the VIX inverts, as measured by the ratio of the 3-month to 1-month VIX;
  3. The NYSE McClellan Oscillator falls below -50, an oversold condition;
  4. TRIN spikes above 2, which indicates price-insensitive selling, or a “margin clerk market”; and
  5. The intermediate-term overbought/oversold model, which is the ratio of the percentage of stocks above their 50 dma to percentage above their 150 dma, falls below 0.5, which is an oversold condition.

 

 

All five components flashed buy signals during the October bottom, but only three have triggered buy signals today.

 

Take how sentiment models are behaving. The AAII bull-bear spread is -13 today, compared to -40 at the height of the October low panic. AAII bears spiked to as high as 60 in October, compared to 41 today.
 

 

On the other hand, the current 10 dma of the equity put/call ratio is comparable to the levels seen at the October lows, though readings did spike in December.
 

 

The CNN Fear & Greed Index is also at similar levels as the October 2022 bottom and tactical bottom in March 2023.
 

 

I am also seeing similar insider buying activity today as in October. While insider purchases (blue line) are exceeding sales (red line) in both instances, I prefer to see spikes in insider buying, rather than falling insider sales as a more convincing trading signal. Nevertheless, any past instances of purchases exceeding sales
 

 

 

A correction in an uptrend

Even though oversold readings are not severe as seen during the October low, the market is sufficiently washed out for a tradable relief rally. I interpret the difference in conditions as a correction in an uptrend, as illustrated by Investors Intelligence sentiment data. Willie Delwiche of Hi Mount Research observed that further deterioration in the II bull-bear spread would take sentiment into bear market territory. You need bulls to have a bull market.
 

 

Here’s another condition that leads to the belief that the latest episode of market weakness is just a correction and not the start of a major bearish episode. The relative performance of defensive sectors has been weak during this latest pullback. By comparison, the relative performance of these sectors was much strong in the downdraft that culminated in the October bottom.
 

 

As today’s technical and sentiment readings are consistent with a short-term bottom, current conditions appear to be a correction in an uptrend. Both investment-oriented and trading accounts should be bullishly positioned for an equity rally in the coming weeks and months.

 

My inner trader remains tactically long the S&P 500. The usual disclaimers 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.