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 20-Nov-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.
A frothy Christmas
One sentiment indicator that’s of concern is the put/call ratio. Both the CBOE put/call and the equity-only put/call ratios are approaching the bottom of their one-standard deviation Bollinger Bands, or the froth zone. Past instances, which are marked by vertical pink lines, have tended to resolve in pullbacks.
Price momentum has been strong as stock prices surged in response to the FOMC announcement. It’s starting to look like a frothy Christmas this year.
Bearish tripwires
Let’s review the other bearish tripwires that I set out two weeks ago. The weekly stochastic (bottom panel) of the NYSE McClellan Summation Index (NYSI) is wildly overbought. Fortunately, there is no sign of a downward recycle yet. Should momentum continue to be strong, stock prices can advance for a few weeks more, but investors and traders should monitor market internals for signs of weakness.
Bitcoin prices and speculative stocks, as measured by the ARK Innovation ETF (ARKK), are correlated to each other. Bitcoin suffered a brief setback last week, but the market’s speculative juices are still flowing.
Bitcoin prices are also correlated to overall market liquidity.
This wasn’t part of my suite of bearish tripwires. But for what it’s worth, the Citi Panic/Euphoria Model is nowhere near euphoric territory that indicates a major market top.
While some indicators are raising cautionary signals, I believe the seasonal rally has more room to run. The S&P 500 just staged an upside breakout from a cup and handle pattern, which has strong bullish implications.
A review of the Commitment of Traders report shows that leveraged long speculators, which are mostly drawdown sensitive hedge funds, are not surprisingly short S&P 500 futures and they are continuing to fight this rally. The combination of strong momentum and year-end seasonality will cause pain and should force them to cover and drive prices up further.
Small caps have a tendency to outperform this time of year. The rally is exhibiting broadening market breadth, which is an indication of better participation by smaller stocks. This is another sign that strong seasonality is taking hold.
Blowoff top ahead?
It’s difficult to know how far this rally can run but current conditions may be setting up for a blowoff top at year-end or January. A point and figure analysis of the S&P 500 using a short time horizon of 30-minute ticks, 0.25% box size and 3-box reversal shows an upside measured objective of 4949. Broader parameters yield upside measured objectives in the 5800–6000 range.
Just remember that we are entering a period of strong seasonality for the S&P 500.
A possible Gamestop style risk scramble
In addition, equity market-neutral and equity long/short hedge funds were shocked last week when their funds experienced severe drawdowns in the aftermath of the FOMC announcement. Using the market-neutral ETF BTAL as a proxy for hedge fund exposures, we can see that BTAL was caught offside in probable crowded trades in several correlated factors:
- Profitability and high quality: As measured by the return spread between the S&P 500 and Russell 1000 because S&P has a stricter profitability index criteria than FTSE/Russell;
- Size: As measured by the return spread between the S&P 500 and Russell 2000; and
- Magnificent Seven over “junk stocks”: As measured by the return spread between the Russell 1000 Growth Index and the Russell 2000 Value Index.
All of these factors started turning down in early November in lockstep with BTAL performance. The downturn accelerated after the FOMC announcement when market participants began to buy low-quality small caps in a beta and short covering scramble in anticipation of a Fed-induced risk-on rebound. The returns to these factor exposures stabilized on Friday and so did BTAL returns.
Hedge funds may have been buying Russell 2000 call options as a hedge, which fed into the bullish feedback loop in the small cap index. The scramble for high beta hedges opens the door to a Gamestop-style parabolic price run in small caps and other correlated low-quality factors.
Will the short covering in these factors continue? I believe that this may be the start of a Gamestop style short covering rally. Hedge funds were caught offside in a crowded trade when low-quality names began to rally. The combination of risk manager mandated de-risking during a period of low liquidity have the potential to move prices further than anyone expects and such a rally would raise frothy sentiment to extreme levels. Just keep in mind that Bob Farrell’s Rule #4 is applicable to factor returns too: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
In conclusion, the U.S. stock market appears to be undergoing a seasonal rally into year-end and January. Warning signs of froth are starting to appear and traders should exercise caution. I believe stock prices may advance further into a possible blowoff top.
In particular, the market may be poised for a Gamestop style short covering rally in low-quality stocks. Hedge funds were caught offside in a crowded short when low-quality names began to rally. Bob Farrell’s Rule #4 is applicable to factor returns too: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”
Both my inner investor and inner trader are bullishly positioned. 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.
Disclosure: Long SPXL
On Thursday the CCC Junk bond spread fell 50 BPS. That is massive for a single day.
This is my key indicator of professional investor economic outlook. The action says the Fed pivot is VERY favorable for the economy.
I had 6 industry TWISTs on Thursday too, Tech/Financials/Healthcare/Materials/Industrials/Communications. Countries also TWISTed, S&P 500/S&P Small Cap 600/Canadian TSX and Europe. Europe had a 5.4 positive deviation TWIST which likely is the best since Napolean.
The small cap indexes actually made a low in late October 2023 from the Oct. 2022 S&P 500 bear market low. In other words, small cap had gone nowhere until recently. So, no reason to peak anytime soon.
I have written here how I thought A.I. logical/emotionless trading would be like a stock market on the Planet Vulcan with Mr. Stock’s kin. I used the example of Steve Jobs holding up the new Apple smartphone and the next day on Planet Vucan’s stock market Apple goes from $21 to $450 with nobody batting an eye. Cold calculations with instant strong movement.
It’s starting to feel like this in today’s markets. Big news = big emotionless trading moves. Thinking that these have gone emotionally too far leading to not participating while waiting for pullback doesn’t work. There is no easier entry. One has to evaluate the new factors and the change in valuation and buy or sell.
The new factor here is a very important dovish pivot by the Fed which embeds multiple rate cuts BEFORE the magic 2% inflation rate is achieved. The impact on interest rates and the economy is huge. The S&P 500 is up 2.8% from the Fed meeting with its new outlook and the Russell Small Cap is up 5.4%. Is that enough on a cold, hard, emotionless basis? Should one wait for an emotionally, easier entry point with a dip? Should one sell thinking emotional investors are too optimistic about the new Fed future? What would they do on Planet Vulcan?
Mr. Spock not Mr. Stock