S&P 500 breakout or fake-out?

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: Neutral (Last changed from “bullish” on 26-Jul-2024)
• Trading model: Neutral (Last changed from “bearish” on 18-Sep-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 difficult decision

Technical analysts face a difficult decision. The stock market is exhibiting strong positive price momentum, but in the face of a seasonally weak period for stocks.

On one hand, the S&P 500 just staged an upside breakout from a cup and handle formation, which is a highly bullish pattern.
 

On the other hand, stock prices tend to weaken into late October in an election year.
 

Should traders be bullish or bearish?

Momentum begets momentum

Here is a historical study to consider. The S&P 500 exhibited a 7-day winning streak within 1% of an all-time high. Forward returns are highly bullish. Momentum begets more momentum.
 

 

Sentiment readings aren’t excessively frothy. Put/call ratios are showing neutral readings, indicating that the bulls have more to run.
 

 

The NAAIM Exposure Index, which measures the sentiment of RIAs who manage individual investors’ funds, is relatively low by historical standards.
 

 

 

Reasons for caution

On the other hand, there are reasons for caution. The market adopted a risk-on tone after the Fed decision because it embraced the soft-landing scenario. As long as growth holds up while interest rates fall, stock prices should rise. Some events could upset that narrative. The more obvious economic ones are the PCE report in the coming week and the Payroll report the week after. As well, some bearish exogeneous events are also lurking.

Election years are famous for October surprises. While some surprises are political earthquakes that affect the election but don’t move the needle for financial markets, here are three that doesn’t seem to be on the radar screen of many investment strategists. These “October Surprise” factors are consistent with a seasonal spike in equity volatility.
 

The first is the possibility of a government shutdown if there is no stopgap bill on or before September 30. The Republican-controlled House failed to pass its own bill to avert a shutdown by attaching the SAVE Act, which mandates proof of citizenship to vote, to the bill. Trump has thrown his political weight behind the SAVE Act and urged Republican lawmakers to avoid passing a spending bill without it. A shutdown would seriously embarrass the Republicans in the upcoming election. While previous shutdowns haven’t always created havoc on Wall Street, they have the potential to rattle markets should they drag on.

Another is the looming possibility of an East Coast port strike, which would be negative for the Democrats. If the International Longshoremen’s Association (ILA) can’t come to terms with the U.S. Maritime Alliance (USMX) and goes on strike, many businesses could miss the key Black Friday, Cyber Monday peak sales period and that would send shudders through the economy. The union is already prepared for a strike to begin October 1, and such a strike would shut down the East Coast and Gulf Coast port. Shipments could be re-routed by air freight, which would be expensive, or to the West Coast, which would snarl traffic in a manner reminiscent of the shipment bottlenecks of the COVID era. If a strike were to occur, it would put the Biden Administration in a difficult position. It could intervene to break the strike, but politically costly ahead of an election.

As well, geopolitical tensions may heat up in the near future. It appears that Israel is preparing for an incursion into Lebanon to confront Hezbollah. This raises the possibility of a spike in oil prices, which had been quite tame.

 

From a technical perspective, the upside breakout from the cup and handle may be a little shaky. The good news is the S&P 500 staged an upside breakout from a cup and handle pattern. The bad is the breakout was accomplished first with a doji candlestick, which indicates indecision about direction, followed by a hanging man candlestick, which is a bearish reversal pattern.
 

 

Even as the S&P 500 reached a fresh all-time high, the 14-day RSI showed a negative divergence.

The equal-weighted S&P 500, which has been stronger than the float-weighted index, shows a similar pattern of negative RSI divergence.
 

Weather vs. climate

Travelers to a new land should be aware of the climate and weather of the place they visit. In Finance Land, seasonality determines the climate and the combination of fundamental, technical and macro factors determine the day-to-day weather.

 

In the very short term, the weather is bullish, but stock prices are ultimately determined by the growth and interest rate outlook. In the face of challenging seasonality, stock market direction will depend on economic reports like PCE and Payroll, and possible “October surprises”, such a government shutdown, port strike, and geopolitical risk.

If the investment outlook were to turn stormy, watch for the 70% level on percentage bullish on point and figure. Momentum tends to be positive above that level, while a recycle below 70% would be a bearish signal that a corrective phase has begun.