What Comes After the Software Apocalypse?

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.

 

 

The latest signals of each model are as follows:

 

 

A Software Apocalypse

The upward progress of the NASDAQ 100 has been hampered by the crash in software stocks, though semiconductors have held up well. Even though the index remains range bound, it violated a key relative support level (second panel) and relative breadth (bottom two panels) has been weak.
 

 

In light of the turmoil in software and technology stocks, it would be useful to conduct a market leadership review to see where we are in the market cycle.
 

 

Still Bullish

My primary tool for market leadership analysis is the RRG chart. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotate to lagging groups (bottom left), which change to improving groups (top left), and finally complete the cycle by improving to leading groups (top right) again.

A conventional RRG chart of asset classes against a 60/40 benchmark measured in a common USD currency shows that the equity bull is still intact. The risk-on asset classes, such as equities and commodities, are in the top right leading quadrant. The only equity indices in the lower left lagging quadrant are U.S. and Chinese stocks. Bonds are either in the improving quadrant (Non-U.S. sovereigns) or just below the line in the lagging quadrant but poised to rise into the improving quadrant (Treasuries).
 

The only anomaly in this chart is the behaviour of gold, which interrupted its normal clockwise rotation, which would have pushed it down to the weakening quadrant, but gained a second wind to exhibit strong price momentum. I interpret the continued strength as a signal that gold is undergoing a secular bull and it should be bought on pullbacks.
 

 

 

 Cyclicals Come Alive

A review of S&P 500 sector leadership shows strong leadership by cyclical sectors, namely energy, materials and industrials. The heavyweight technology sector has deteriorated into the lagging quadrant. While the other growth sectors, communication services and the Amazon and Tesla-dominated consumer discretionary stocks are technically in the improving quadrant, a normal clockwise rotation depicted by the arrows would weaken them into the lagging quadrant.
 

 

I would sound a word of warning about the extended nature of cyclical stocks despite their obviously exhibition of market leadership. Each of the cyclical sectors is showing similar extreme overbought patterns. The accompanying chart shows the industrial stocks, which staged upside absolute and relative breakouts while exhibiting a series of “good” overbought RSI conditions. Moreover, relative breadth indicators (bottom two panels) are strong.
 

 

The technical conditions of energy stocks are similarly extended, though the strength in energy is partly supported by a geopolitical risk premium because of Middle East tensions. Energy staged upside absolute and relative breakouts even as RSI underwent a series of “good” overbought conditions.
 

 

Material stocks represent the third and final cyclical leadership sector. While the technical pattern is similar to the others, this sector is the least extended relative to the S&P 500 (second panel).
 

 

Even though the RRG sector analysis doesn’t show the risks, I believe the extended nature of the cyclical advance makes the stock market vulnerable to a short-term correction. The relative performance of defensive sectors is making multi-month saucer-shaped relative bottoms, indicating that the bears are preparing to take control of the tape.
 

 

 

Quantitative Factor Review

For completeness, the accompanying chart shows an RRG analysis of quantitative equity factors benchmarked against an equal-weighted S&P 500. The high-octane growth factors are all in the lower left lagging quadrant, while value factors are clustered in the leading quadrant or just below in the weakening quadrant.

High-quality defensive factors, such as shareholder yield and dividend aristocrats, are in the leading quadrant. By contrast, low volatility, which is even more defensive, is in the lagging quadrant but poised to rise into the improving quadrant. Combined with the saucer-shaped relative bottoms exhibited by defensive sectors, I interpret these conditions as the market is preparing for a significant correction in the coming weeks and months.
 

 

Indeed, I have highlighted heightened correction risk by pointing out the recent cluster of Hindenburg Omen signals. The ominously sounding Hindenburg Omen is triggered when a highly bifurcated market in an uptrend starts to lose momentum. Another way of measuring market bifurcation is the NYSE High Low Logic Index, which measures the dispersion of 52-week highs and lows. As the accompanying chart shows, an elevated reading in the NYSE High Low Logic Index has tended to resolve in corrective market action (pink lines). Will the latest episode be any different?
 

 

In conclusion, a market leadership analysis of asset classes and the U.S. equity market shows that we are in an equity bull with minimal risk of a major bear market. Cyclical stocks are leading the way, but their advance is highly extended. Market internals shows U.S. equities are vulnerable to a significant correction in the context of a bull trend in the coming weeks and months.