This Will Not End Well, But When?

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.

 

 

This Will Not End Well

I have documented in the past how the U.S. equity market is undergoing a frothy advance. There are many ways of measuring froth. Goldman’s Speculative Trading Indicator has risen to its third-highest level in its own history, which will lead to a “this will not end well” condition. I don’t like “this well not end well” warnings because they only highlight the risks without the obvious signs of a bearish trigger. I would highlight Bob Farrell’s Rule 4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways”.

 

There is no doubt that “this will not end well”, but when? I explore the set of current risks and opportunities open to traders.
 

 

A Bullish Trend

Let’s begin with the intermediate trend. My Trend Asset Allocation Model, which applies trend-following techniques to a variety of global stock markets and commodities, is bullish.

It is said that there is nothing more bullish than a fresh high. In the U.S., the S&P 500 is at or near its all-time high.
 

 

Looking globally, Jurrien Timmer at Fidelity observed that 72% of stock markets are in uptrends. That’s another bullish sign.
 

 

Commodity indices are all above their 50 and 200 dma, indicating uptrends. The cyclically sensitive copper/gold ratio underwent some volatility owing to changes in Trump’s tariff regime, and the volatility can be dismissed as regulatory noise. The broadly based base metals/gold ratio is moving sideways. Call the commodity score neutral to bullish.
 

In addition, both the U.S. and European economies are about to experience bouts of fiscal stimulus. The OBBB Act’s fiscal deficits are front-loaded, while savings are back-loaded. Germany has made a pivot from fiscal austerity to stimulus. These measures should be equity bullish.

What do you have to worry about?
 

 

Warning Signs

However, some concerning warning signals of a market stall are appearing. Last week, I highlighted constructive signs of a broadening market breadth from U.S. large-cap growth to other sectors. The rotation is unwinding.

The relative performance of selected cyclical industries is failing. Even semiconductor stocks, which have been part of the technology leadership, are starting to roll over. While these are not outright sell signals, they are nevertheless warning flags that the market rally could be faltering.
 

 

Equally disturbing is the weakness shown by the small caps. At an absolute level, the Russell 2000 failed at a resistance zone and violated a rising trend line (top panel). At a relative level, the index broke down through relative support (bottom panel).
 

 

Another cross-asset bearish warning can be seen in the behaviour of gold mining stocks (GDX). Gold miners, which tend to trade as risk-off assets, have been consolidating sideways for about two months. At the same time, the junior miner GDXJ to GDX ratio has collapsed, indicating that bullish sentiment has gone out of the group. While there is no obvious bullish trigger for GDX, it appears ripe and poised for another bull leg, which would be bearish for the stock market in general.
 

 

Putting it all together, these cross-asset, or inter-market, indicators are creating a mosaic picture of a leadership transition failure, which is concerning.
 

 

The Bearish Trigger

Despite these warnings, I see no major bearish breaks in my technical indicators. Friday’s sudden downdraft left the S&P 500 testing its uptrend line and oversold on the 5-day RSI.
 

 

Fundamental momentum is supportive of price gains. Aggregate forward 12-month EPS estimates continue to rise during Q2 earnings reporting season.
 

 

One possible lurking tail-risk may be arising in tariff policy. In the wake of recent trade deal “wins”, and a reduction in trade war tensions as measured by my trade war factor, and both bond and stock market implied volatility nearing recent lows, Trump may feel emboldened to re-assert himself as Tariff Man. The market already responded with a risk-off tone when he announced tariffs imposed on over 60 countries ranging from 15% to 41% which will go into effect on August 7.
 

 

There may be more to the tariff drama. Trump has a history of using tariffs not only as an instrument of trade policy, but foreign policy (see Brazil). He recently voiced his impatience with Putin over the Russo-Ukraine war, and reduced the deadline for a resolution from 50 days to 10 days, which expires on August 8. The risk to the markets is the imposition of secondary sanctions and punishing tariffs on countries that trade with Russia. China, India, and Turkey are major buyers of Russia oil, and secondary tariffs will hit those countries hard, as well as spark a price shock to energy prices.

On Friday, Trump doubled down on his belligerence against Russia when Medvedev mocked Trump’s shortened deadline. Trump publicly announced that the U.S. is re-positioning two nuclear submarines to “appropriate regions”. The American submarine fleet consists of two main types of subs, nuclear-powered attack subs armed with conventional weapons, and ballistic missile subs armed with nuclear-tipped Trident missiles that form part of the nuclear tried of land-based missiles, bombers, and submarines. It’s highly unusual for the U.S. to announce the re-positioning of its submarines, and it’s unclear which type of submarine Trump is referring to. Ballistic missile subs that are on station are already in position to strike Russia at any time, but the announcement could be interpreted as a provocative and belligerent signal to indicate the seriousness of the Russo-Ukraine war issue.

Stay tuned for escalation risk. Compared to rising nuclear tensions, secondary tariffs could be just a walk in the park.
 

 

In conclusion, the U.S. stock market is undergoing a frothy advance. The intermediate trend is bullish, but some technical warnings are appearing. While I can’t predict the exact nature or timing of a possible market disruption, investors may find it prudent to opportunistically take advantage of the relatively low implied volatility environment to buy cheap downside protection.

My inner trader dodged a bullet last week. Subscribers received an alert Thursday that he was exiting his long S&P 500 position. I would like to say that my trading model is that precise, but it was just lucky.