Tops are processes

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: Neutral (Last changed from “bullish” on 23-May-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.

 

 

Warnings everywhere

Even as the S&P 500 reached another all-time high, numerous warnings about a market top have been appearing in my social media feed and elsewhere, starting with the elevated level of the forward P/E ratio. The S&P 500 forward P/E now stands at 21.2, which is above its 5-year average of 19.3 and 10-year average of 17.9.
 

 

 

This will not end well

Most of the warnings fall into the “this will not end well” category, which are condition indicators and not necessarily actionable trading signals.

 

One example is the warning about an extreme in market concentration. The weight of the top 10 stocks in the S&P 500 has spiked to 34%, which is the highest in its history.

 

 

Topdown Charts warned about an extreme in speculative sentiment, as measured by the assets of leveraged long and leveraged short ETFs.
 

 

Another possible contrarian data point is the departure of uber bearish strategist Marko Kolanovic from JPMorgan. Kolanovic turned disastrously bearish at the market bottom in 2022 and his target for the S&P 500 was 4200. JPMorgan announced that Kolanovic is “exploring other opportunities”.
 

From a technical perspective, different variations of the Advance-Decline Lines are forming negative divergences as they haven’t confirmed the new all-time high in the S&P 500.

 

 

While these conditions are concerning, where’s the actionable trading signal?
 

 

Too early for risk off

For traders, it’s too early to turn bearish. I see no signs of a bearish trigger. Instead, conditions appear bullish from a tactical perspective.

 

Let’s start with the relative performance of the defensive sectors, which are all flat to down compared to the S&P 500.
 

 

While concerns about market concentration and narrow leadership are very real, there are no signs of price momentum breaks in large-cap growth stocks. Even though you may be cautious or even bearish, you don’t want to stand in front of this runaway freight train.

 

 

Similarly, the NASDAQ 100 achieved a relative breakout against the S&P 500. Relative breadth indicators (bottom two panels) have also been steadily improving.
 

 

As well, Q2 earnings season is coming up. Forward 12-month EPS estimate revisions are rising strongly, indicating positive fundamental momentum.
 

 

 

Bull or bear?

We arrive at the question, should you be bullish or bearish under these conditions?

 

Investors and traders should be reminded of the technical adage, “Tops are processes, but bottoms are events”. To explain, market bottoms tend to be emotional episodes marked by panics, which tends to be a sudden event. By contrast, market tops are marked by distribution, which can be a long drawn-out process.
Technical analyst Walter Deemer once quoted veteran floor trader Edwin Stern to make my point: “When everybody is bearish, everybody is apt be wrong. When everybody is bullish, everyone may be right now and then.”

 

Here is an example. The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investor funds, has provided strong buy signals whenever it fell below its lower 26-week Bollinger Band. On the other hand, excessively high readings have not useful sell signals.
 

 

Your decision to be bullish or bearish will depend on your time horizon and risk tolerance. Investment-oriented accounts can consider reducing risk in their portfolios today. Traders, on the other hand, should take advantage of continuing positive momentum and stay bullish equities.

 

My own preference is to take a modeled approach and allow my Trend Asset Allocation Model to determine risk levels. The Trend Model remains bullish as the S&P 500 staged another upside breakout to an all-time high. Enjoy the ride, as least for now.

 

 

2 thoughts on “Tops are processes”

  1. What I keep thinking about is how we are in an unprecedented era. We have fiat currency in a world where sovereigns are buried in debt, an aging population and modern equity exchanges.
    When the UK stopped being the global power, currencies were not fiat, and when the French currency had it’s crisis, it was not global and what kind of markets did we have?
    Human nature has not changed, there will always be fear and greed, bubbles will happen and burst, but the elites will also always wish to keep the ball rolling so they will do what they can. So where are we in this?
    Is there a number beyond which central banks cannot print? I don’t think so. Who would have reasonably known that Bitcoin would go from pennies to 70k, when it is not a physical entity? Aside from a lower limit of zero for the S&P, and Bitcoin which is easy enough (nobody will charge storage fees like they did with oil when it went negative) and a liability for ever having owned stocks or BTC is unlikely, but violent revolutions did punish the educated ), there is no way to put an upper limit on this bubble.
    So the only answer is to keep an eye on prices and try to discern what they are saying.

  2. While no indicator is infallible here are some events to increase the odds of getting out close to the top:

    1. A sharp unexplained drop in a leading stock or industry. Think NVDA or the semis.
    2. A sharp increase in interest rates. The bond market has a very large drop.
    3. An unexplained rise in the dollar or a sharp drop in the same i.e. in1987 the dollar was at risk because of Baker’s statement.
    4, A surprise political event.
    5. A sudden imposition of Tariffs which is considered a hostile act by a foreign country.
    6. Spike in VIX.

    On another subject, in my last blog I mentioned gold having a breakout. The trading gods were kind to me. The story of gold has legs. US policy of imposing all sort of restrictions, grabbing assets of Russia makes every country in the world think twice of holding US Treasuries, The idea of US not paying China interest on its holdings if it invades Taiwan is not farfetched. The other feature which is not getting press is the repatriation of gold from New York and London. Some of the gold has been lent out causing additional pressure on the price of gold,

Comments are closed.