Here comes the sentiment flush

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.

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: Bearish (Last changed from “neutral” on 15-Mar-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.

Last week, I pointed out that the S&P 500 violated an uptrend that began in November. The violation resolved with the index is testing initial support at the 50 dma at about 5110. Secondary support can be found at the upside gap in the wake of the last NVIDIA earnings report at roughly 5000 and strong support at the breakout level at about 4800.

The decline may not be done. The stochastic recycled from overbought to neutral, which is a tactical sell signal, but hasn’t quite yet reached an oversold level. I am inclined to look for an oversold reading before turning more constructive on stock prices after a major trend break.

The AAII bull-bear spread has come off the boil, but readings are still bullish. AAII bears are still low, indicating a lack of panic.
 

 

The AAII sentiment readings were taken earlier in the week before fears of an Iran-Israeli war rattled the markets. The Fear & Greed Index, which is updated in real-time, is only in the neutral zone after retreating from an excessively bullish condition.
 

 

The Topdown Charts analysis of leveraged ETF trading as a sign of sentiment tells a similar story of a retreat from excessive bullishness, but readings are not bearish enough to be contrarian bullish.
 

 

 

Nearing a bottom

That said, technical indicators are nearing extreme oversold conditions consistent with a tactical bottom. The Zweig Breadth Thrust Indicator reached an oversold level, which tends to be signals short-term bottoms, though the signals can be slightly early. There were 17 such signals in the last three years, and the market continued to decline for a few days after the initial signal in seven instances.
 

 

Three of the five components of my Bottom Spotting Model flashed buy signals on Friday. Historically, two or more simultaneous buy signals have been good indicators of short-term bottoms. Similar to the ZBT Indicator, this model has a tendency to be slightly early and I would look for the actual bottom early in the coming week. The three buy signals are:

1. The VIX spiking above its upper Bollinger Band, indicating an oversold condition;
2. The NYSE McClellan Oscillator falling below -50, another oversold condition; and
3. TRIN spiking above 2, which is a sign of price-insensitive selling, which is indicative of risk manager induced selling.

 

 

 

Fade the inflation scare

Last week’s market weakness was first sparked by a stronger-than-expected CPI report which resolved in upside cup and handle breakouts in Treasury yields across the entire yield curve. As well, market expectations of the first Fed rate cut were pushed out from June to September. Higher yields will undoubtedly create some headwinds for stock prices.
 

 

I am inclined to fade the inflation fears. Barring an all-out Middle East War that spikes oil prices for a prolonged period of time, the economy is not about to experience a 1970s-style runaway inflation. The one-year change in oil prices is barely positive at 3.5%.

 

The Atlanta Fed’s Wage Growth Tracker shows that wage growth has decelerated to 4.7%. While that figure is well above the Fed’s 2% inflation target, the trajectory of labour market compensation does not point to a 1970s-style wage growth spiral.
 

 

Much of the elevated inflation readings in CPI can be attributed to shelter and owners’ equivalent rent (OER). CPI would be below the Fed’s 2% target if we were to substitute real-time estimate of rent for OER.
 

 

As earnings estimates are still rising, the economic environment is steady growth with uneven disinflationary progress toward the Fed’s 2% target. This should be bullish for stock prices, though bond prices would depend on how inflation evolves in the coming months.
 

 

Lastly, the IMF recently published a note warning about slowing global productivity. The U.S. appears to be one of the few exceptions, experiencing above-trend productivity growth. What’s not to like?
 

 

In conclusion, my analysis of market internals concludes that the decline is nearly done. Sentiment is not sufficiently panicked to be contrarian bullish. Technical conditions are oversold but can become more oversold. I interpret these conditions as a stock market that’s undergoing final flush before an intermediate-term bottom is formed. I believe any pullback should be temporary and shallow in nature. The macro backdrop is long-term equity bullish.

My inner investor continues to be bullishly positioned in accordance with the readings of the Trend Asset Allocation Model. My inner trader should have covered his short position in the S&P 500 on Friday, but he was tied up for most of the day. The usual disclaimers apply to my trading positions.