Prelude to a correction

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.

 

Glass half  full?

Is the glass half full or half empty? Is breadth back?
 

The S&P 500 continues to test a key resistance level. While the equal-weighted S&P 500 rose to an all-time high, the small-cap Russell 2000 is struggling below its all-time high.
 

Long-term bullish

Let’s start with the good news. There are few signs of a long-term cyclical top. The S&P 500 just made a monthly closing all-time high in a well-defined uptrend after staging a convincing upside breakout at 4800 in early 2024.
 

As well, both the S&P 500 Advance-Decline Line and the NYSE Advance-Decline Line made fresh all-time highs. Market tops don’t look like that.
 

Negative divergences everywhere

An analysis of breadth and price momentum tells a slightly different story. On one hand, the percentage of stocks above their 200 dma (top panel) rose above 75%, which is a sign of positive price momentum. On the other hand, the measure never reached 90%, which is the characteristic of a “good overbought” condition and an extended advance. In addition, both the percentage of stocks above their 200 dma and 50 dma (bottom panel) exhibited a series of lower highs, which are negative divergences and warnings of an imminent market stall.
 

The daily chart is exhibiting similar negative divergences as the S&P 500 tests overhead resistance. The 14-day RSI and NASDAQ 52-week highs-lows are also showing signs of flagging momentum, though the NYSE 52-week highs-lows equaled its recent high on Friday.
 

Risk appetite indicators are turning down. The ratio of high beta to low volatility stocks is and the ratio of consumer discretionary to consumer staples are rolling over.
 

The market’s negative reaction to NVIDIA’s earnings beat underlines the failure of the high octane of the Magnificent Seven’s leadership. Even as the S&P 500 tested overhead resistance, the Magnificent Seven ETF (MAGS) is well below its highs and is struggling below its 50 dma.
 

More ominously, the relative performance of defensive sectors is turning up. Not only have they all made rounded saucer-shaped relative bottoms, defensive sectors are all leading the market even as the S&P 500 traded sideways (shaded areas).
 

Putting it all together, these are all warnings that the market is due for a pullback and correction. I pointed out last week that election year seasonality tends to see weakness in September and October, and the current market structure confirms that view. While I don’t know what the trigger for a correction might be, investors should be prepared for a period of short-term weakness and a possible buying opportunity in October.