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 11-Oct-2024)
- Trading model: Bullish (Last changed from “neutral” on 15-Oct-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 Trump Trade update
Just ahead of the U.S. election, here is an update on the polls and the Trump trade. The polls show a very tight race. As a matter of perspective, here is a sensitivity analysis of what would happen if the polling errors were the same as they were in 2020 and 2022.
My view is that the election has been a referendum on Trump. Trump has always had a base support of about 40% of the electorate. Against that, the Democrats have their base and a coalition of never-Trumper Republicans. Opinions on both sides have been substantially dug in. What really matters in the end is the effectiveness of each side’s “get out the vote” efforts.
As a reminder, each of following charts of Trump factors is designed so that a rising line denotes rising favourability for a Trump victory.
- Trump Media & Technology Group: It’s a proxy for Trump enthusiasm as it’s the holding company for Truth Social, Trump’s social media vehicle.
- Domestic Revenue Stock ETF vs. S&P 500: One of Trump’s main platforms is to use tariffs to bring manufacturing back to the U.S.
- Inflation Expectations: Trump’s tariff policies are expected to be inflationary.
- Poland vs. Euro STOXX 50: Poland has been a surprise growth engine in the EU, but it neighbours Ukraine and the relative performance of its market is a measure of Ukrainian anxiety.
- Gasoline Price: Gasoline can be thought of as an anti-incumbent trade. Rising prices depress consumer sentiment and it’s negative for the incumbent.
Each has its idiosyncrasies. Even though Trump factors have taken a last-minute wobble, the general trend in the Trump trade has been up.
The bull case
Broadly speaking, Trump’s major policy initiatives are:
- Raising tariffs on imports to encourage foreign companies to establish manufacturing in the U.S.;
- Restricting and reversing unauthorized immigration; and
- Extending the TCJA Trump tax cuts.
Regardless of who controls Congress, Trump can implement the first two without authorization from Congress. The third, tax cuts, would be subject to negotiation with legislators, and the odds of a Republican sweep are currently much higher than a Democratic sweep, especially in light of the Democrats’ weak position in the Senate races.
I wrote last week about the bull case under a Trump White House. As a reminder, higher deficits are bullish for stocks, even though they are negative for the fiscal picture. Moreover, Trump has proposed corporate tax cuts, which will raise profit margins.
A study by the nonpartisan Committee for a Responsible Federal Budget found that the proposals of both candidates would add to the deficit beyond the current baseline under almost all scenarios, but the Trump plan would raise the deficit far more than the Harris plan. Not included in the Committee’s projections are some of Trump’s latest trial balloons, such as deductibility of car loans, the elimination of double taxation for Americans living abroad, as well as the tax cuts for veterans, police officers and others who serve. These higher deficits would be in 0excess of a projected $22 trillion in budget deficits under a baseline scenario over the coming decade if Congress does nothing.
The Committee also projects significant fiscal stimulus under the Trump plan of slightly above $10 trillion over the next decade under a central tendency scenario.
These factors should be the basis of substantial fiscal stimulus, which should be bullish for stock prices.
In addition, a Trump victory could represent a “party now, pay later” moment for European equities. Robin Brooks reported that the consensus from European-based attendees at the recent IMF and World Bank meetings in Washington, D.C. that an end to the Russo-Ukraine War, even if it involved forced Ukrainian capitulation, would represent an end to uncertainty, and therefore bullish for the EU. The longer-term risk, however, is the disintegration of European security and a possible Ukrainian refugee crisis that swamps Europe.
EM crisis ahead?
While an equity bull is my base-case scenario, investors should be aware of the volatility risk should Trump win the White House.
For starters, what about an emerging market currency crisis? Remember what happened during the Russia Crisis or the Asian Crisis? Robin Brooks pointed out that a Trump win could create instability and a crisis in currency markets. The widespread imposition of tariffs puts enormous depreciation pressure on emerging market currencies and makes any Dollar peg unsustainable.
Brooks further argued that large U.S. tariffs on Chinese imports would force Beijing to devalue its currency in a major fashion in order to pre-emptively stem capital flight. This would drag down all of the EM and tank commodity prices because China represents a significant portion of global demand. As a reminder, the 2015 Chinese unexpected devaluation episode represented a significant negative shock to the global financial system.
The risk of an EM debt crisis spiraling out of control is high. It will be up to the IMF, which relies heavily on U.S. support, but the prospect of any rescue will depend on the politics of the IMF, which heavily relies on U.S. support. It is unclear what level of systemic risk a synchronized devaluation of EM currencies would have on the global financial system.
On a collision course with bond vigilantes
Expectations of higher inflation under Trump may already be showing up in the bond market. The term premium, or the excess investors demand to hold long-dated debt, has been steadily rising. Either the market is becoming rattled at the re-ignition of inflation or it’s sniffing out the odds of a Trump victory. Of the two explanations, the former represents the more unfavourable backdrop of market psychology, as it would indicate that bond vigilantes are becoming hyper-sensitive to changes in inflationary expectations.
This puts Trump, who is a self-professed “debt guy”, on a collision course with the bond and currency markets.
Trump said in August that he would like to have “a say” in interest rate policy if he were to become President, which is a signal that he wants to reduce Federal Reserve independence. While Trump has brushed off the notion of firing Fed Chair Jerome Powell, “especially if I thought he was doing the right thing”, Trump offered that he had a strong sense of what it takes to set interest rate policy in a recent interview with Bloomberg’s editor-in-chief John Micklethwait: “As a very good business man and somebody that’s used a lot of sense, I think I have the right to say that, you know, I think I’m better than he [Powell] would be. I think I’m better than most people would be in that position.”
He went on to denigrate Powell and the Fed’s interest rate setting process during the Bloomberg interview: “I think it’s the greatest job in government. You show up to the office once a month, and you say, ‘Let’s see — flip a coin.’ And everybody talks about you like you’re a god.”
Trump economic adviser Scott Bessent recently floated a trial balloon in Barron’s as a way of sidelining Powell. Trump could nominate a Fed Chair well ahead of the end of Powell’s term as a way to function as a “shadow Fed Chair”, which makes Powell a lame duck.
Imagine how the markets might have reacted in a bygone era if a Fed Chair, such as Volcker or Greenspan, announced he was resigning because of undue pressure from the White House? Bond yields would skyrocket and the USD would tank. The term premium on 10-year Treasuries is already rising on the hint of a Trump victory, what would an explicit policy to erode Fed independence do?
On a collision course with demographics
Finally, Trump’s plan to reduce and reverse legal and illegal immigration risks a collision course with population demographics.
The U.S. population is aging. Analysis from BoA shows that foreign-born workers account for all of the labour force growth since February 2020. An initiative to depress foreign-born workers would have an immediate effect of reducing the labour supply, raise wage rates and spark a wage-price inflation spiral.
The Fed’s textbook response would be to raise interest rates, if it were allowed to be independent. Otherwise, the effects would be felt in rising bond yields and a falling USD.
The worst-case scenario
To be brutally honest, the market doesn’t care very much about many of the social and cultural issues raised in this election, such as abortion or the “wokeness” of DEI policies. It does care about earnings, inflation and interest rates, and the policies that affect those factors.
Fischer King recently outlined a short-term pain for long-term gain scenario under a Trump Presidency, and surprisingly gained agreement from Trump supporter Elon Musk, who is in contention for a cabinet position as an “economic czar” under a Trump Administration. Trump could cause a severe recession, which would crater asset prices before building the base for sustainable economic growth. Wall Street would definitely react badly to such an outcome.
In conclusion, even though the odds have narrowed, the market continues to discount the chances of a Trump victory. My base case under a Trump win calls for higher inflation, higher rates and an equity bull. However, investors should be aware of high levels of tail-risk from Trump’s policies which could create uncertainty and volatility.
The week ahead
The October seasonal pattern of election years tend to see a pre-election dip just before the election and a rally shortly afterwards. This year, the market weakness occurred in late October instead of the usual early October period. Regardless, pre-election jitters can be seen in the option market. The term structure of the VIX Index is inverted at the one-to-month and 9-day to one-month levels.
Three of the five components of my Bottom Spotting Model flashed buy signals last Thursday when the S&P 500 skidded to test its 50 dma. Historically, the market tends to see a tactical bottom whenever two or more components are triggered.
My inner trader was early in his decision to take a long position in stocks. He was fooled by the exhibition of strong positive price momentum, which reversed. He believes that this is a time to be doubling down on his long position in light of evidence of rising fear, which is contrarian bullish, and the absence of defensive sector relative strength.
The usual disclaimers are applicable 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
“Say it ain’t so Cam” …. The 1974 Trade Act allowed the President to unilaterally impose a 15% tariff for 150 days. After that it needs to be extended by Congress. House and Senate outcomes critical … along with politicians having backbone. Obviously I’m a free trader … and rubbing my eyes in disbelief – along with Milton Friedman and Ronald Reagan. We are not going back to the “Smoot-Hawley Tariff Act” days … it just ain’t happenin’ Cam. Also … in those high deficit projections … am wondering what assumptions are made regarding increased tax collections relating to productivity increases and employment growth.