Exhausted bears, tiring bulls

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: Bullish (Last changed from “neutral” on 17-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.

 

 

Bearish capitulation

Last week, I suggested that the current market environment “argues for a buy the dip and sell the rip posture in trading”. When the S&P 500 fell a miniscule -1.8% on an peak-to-trough intraday basis, my models were registering signs of bearish exhaustion, which was a sign to buy the dip.
 

How could a -1.8% intraday drawdown spark such oversold extremes? One inter-market clue came from Asia, where Chinese and Hong Kong stocks cratered on bad news out of China. The Hang Seng Index skidded -4.1% on Wednesday to a new 52-week low, and there wasn’t a single advancing issue.
 

 

Jason Goepfert of SentimenTrader found that such episodes tended to resolve bullishly. It was therefore no surprise that the Hong Kong market rebounded the next day, and so did the S&P 500.
 

 

Back in the U.S., two of the components of my bottom spotting model flashed buy signals, and a third came within a hair of one. Historically, tradable bottoms have occurred whenever two or more components registered buy signals. The bullish components are the VIX Index, which spiked about its upper Bollinger Band indicating an oversold market; the NYSE McClellan Oscillator (NYMO), which fell to oversold levels; and TRIN, which rose to 1.95 Wednesday, which was just short of the 2.0 threshold that’s indicative of price-insensitive margin clerk and risk manager induced selling.
 

 

Hopefully, you bought the dip.
 

 

Fade the rally

The S&P 500 is tracing out a strongly bullish cup and handle breakout, which is an intermediate bullish pattern, but the short-term bull case is far from clear. That’s because the index is exhibiting a severe negative divergence on its 5-week RSI as it approaches its all-time high. While this doesn’t necessarily preclude further strength, the longevity of any bull move over the next few weeks may be in doubt.
 

 

In addition to the negative RSI divergence, I am concerned about the evidence of narrowing breadth and weakening bond prices, which were correlated to stock prices for much of their recent rally.
 

 

 

But respect the bounce

That said, it’s too early to short the market. Bears should respect the momentum of the price bounce. The NYSE McClellan Oscillator (NYMO) recycled from an oversold condition. Past episodes have seen NYMO recover to at least neutral before the relief rally petered out. While this is only a guesstimate, a typical bounce could see the S&P 500 reach slightly above 4900 before topping out.
 

 

As well, the Fear & Greed Index is elevated but not extreme, indicating further upside potential.
 

 

I remain long-term bullish. The monthly MACD of the NYSE Composite turned positive, which is a buy signal with a strong track record.
 

 

 

Sources of risk

Investors face several sources of risk in the coming weeks. Fed Governor Christopher Waller virtually single-handedly pushed back against market expectations of a March rate cut. Waller made it clear that while rate cuts are coming into view, market expectations of the timing and pace of rate cuts are overdone.
 

Recent Fed decisions have shown themselves to follow market expectations. If policymakers disagree with the market consensus, it has shown a pattern of coordinated speeches from Fed speakers to correct the market’s views. Already, the odds of a March cut fell from over 70% to about 55% today and the consensus timing of a first cut has been delayed to May.

 

As the Fed has entered the blackout period before the next FOMC meeting, investors won’t get any more official guidance until the meeting on January 31. However, the Fed could give unofficial guidance through leaks to the press if it felt that expectations are too out of line with its likely policy path.
 

 

As well, the coming two weeks will see the heaviest pace of company reports from Q4 earnings season. Investors face a higher than usual risk of earnings disappointment, as the pace of negative EPS guidance is elevated compared to historical averages.
 

 

In particular, most of the megacap growth stocks, which are mostly in the technology sector, are reporting in the coming two weeks. The risk is most of the negative guidance is coming from the technology sector.
 

 

The recent advance was driven almost entirely by P/E expansion of valuation that’s above its 5- and 10-year averages. The S&P 500 forward P/E ratio stands at 19.5. Earnings expectations need to grow in order for this rally to continue.
 

 

In conclusion, I believe that short-term outlook for stock prices may be limited, though I am bullish longer term. While the bulls may have temporarily gained the upper hand, many risks remain. The recent episode of price weakness was relatively shallow, and I don’t expect any change. Traders should continue to adopt a strategy of buying the dips and selling the rips.

 

My inner investor is bullishly positioned. My inner trader went long the S&P 500 last Wednesday but he has his finger on the sell button. 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