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 02-Jan-2024)
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 pause in momentum
Call it what you want. A breadth thrust. A momentum surge. The percentage of S&P 500 stocks surged from below 20% to over 90% in a brief two months. In the past, such episodes have usually signaled the start of bull markets. At the same time, these overbought conditions have also resolved in short-term periods of consolidation or pullbacks.
The case for a pause
The case for a pause in the uptrend is building. One factor is the failure of the Santa Clause rally, which occurs during the window starting five days before Christmas and ends two days into the new year. Historically, when the stock market fails to exhibit a positive return during this period, it portends poor returns for the rest of the year. That’s why the late Yale Hirsch coined the expression, “If Santa should fail to call, bears may come to Broad and Wall”.
While I don’t put much stock in short-run patterns as predictors of stock market returns, there are a sufficient number of traders who follow such patterns.
Ryan Detrick compiled past instances of Santa rally failures and found that they were usually followed by weak returns in January, along with subpar returns in Q1 and the rest of the year.
The current episode has also been characterized by a form of momentum failure. Stocks that had been the price momentum leaders have plummeted, as shown by the relative returns of the different price momentum ETFs. I interpret this as a sign of price exhaustion as past winners can’t sustain further upside, which is another indication that a period of consolidation and pullback is ahead.
Another headwind that the stock market faces is a decline in liquidity. In the past, financial system liquidity (blue line) has been correlated with the S&P 500 (red line).
As well, FactSet reported that Street analysts are cutting Q4 EPS estimates at a higher than average rate.
Too late to short
Tactically, it’s probably too late for traders to initiate a short position in the market. The usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator flashed a sell signal last week when its 14-day RSI recycled from overbought to neutral. However, it may be too late to short the market as the NYSE McClellan Oscillator (NYMO, bottom panel) has already fallen below the zero neutral level, which is an indication of limited downside potential.
In addition, the VIX Index spiked above its upper Bollinger Band last week, which is a short-term signal of an oversold market. While these conditions don’t constitute trading buy signals, they nevertheless indicate limited downside risk in the short run.
A three black crows market
In summary, current market conditions can be summarized by the “three black crows” candlestick pattern shown by QQQ. According to Investopedia, the three black crows pattern “consists of three consecutive long-bodied candlesticks that have opened within the real body of the previous candle and closed lower than the previous candle”, and it is indicative of a bearish trend reversal. However, the market is already oversold based on the 5-day RSI, indicating probable limited downside risk.
In conclusion, the stock market is poised for a period of consolidation or pullback after a powerful breadth thrust. I remain bullish on equities as such episodes of strong price momentum have usually led to higher prices 6–12 months ahead. In the short term, I advise against traders trying to short this market as downside risk is probably limited.
Instead, this should be regarded as a buy the dip and sell the rips choppy environment. Investment oriented accounts can consider utilizing such a strategy to enhance returns around a core set of holdings.
How does the fiscal deficit interplay with a decline in liquidity? Intuitively I believe the fiscal deficit should be bullish
I’m in the continuing bull market with a buy-the-dip but I have one concern that happened last week. Readers know I believe the junk bond spreads are the best business condition indicator. The three days BEFORE the strong jobs number, the spreads went up half of one percent, then a quarter percent and then another quarter for a total of one full percent in three days. That sudden a big liftoff happens with a financial crisis like the Silicon Bank failure or the 2008 GFC.
Short term traders don’t use junk bonds. I want to see stability return here before being confidently bullish. Who knows? Maybe there is a nasty credit event brewing that we will hear about soon. Or maybe, the GOP have gotten marching orders to shut down the government in the budget negotiations coming up in the next few weeks.
I follow $$HYIOAS, and they did pop, but are still in a downtrend. Fear though is powerful and when those spreads blow out it’s breathtaking. It’s worth keeping an eye on them.
I keep expecting issues to come out with companies needing to refinance at much higher rates in the next year or two. It’s a bit like the bankruptcy story, “slowly then all of a sudden”. The sudden part in my opinion is when your lenders realize that you are broke and shut off the tap.
So maybe spreads widening is due to refinancing woes.
The relative price return of HY vs USTs has exactly tracked the S&P 500 in the latest sell-off. That’s consistent with the early 2024 risk-off environment.
https://stockcharts.com/h-sc/ui?s=%24SPX&p=D&yr=0&mn=6&dy=0&id=p02159830978&listNum=1&a=1574659194
It should probably also be noted that the first level of support for the SP500 appears to be at the highs of the recent consolidation in Nov.-Dec and the high of July which corresponds to a value of about 4600. The next level of support which is a bit stronger is at the lows of the consolidation at approx. 4535.