Bond rout = Stock rout?

Posted by Cam Hui -

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: Sell equities (Last changed from “buy” on 26-Mar-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 17-Mar-2023)
  • Trading model: Neutral (Last changed from “bearish” on 15-Jun-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on Twitter at @humblestudent and on Mastodon at @humblestudent@toot.community. 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.

 

 

Trading the island reversal

The S&P 500 hit an air pocket last week as it was rattled by the rout in bond prices. As the index weakened, SPY formed a textbook island reversal with a measured objective of about 435, which represents a fairly shallow pullback. However, the VIX spiked above its upper Bollinger Band, which is an oversold condition that could be indicative of a short-term bottom.

 

 

Notwithstanding the market’s short-term volatility, what’s the intermediate-term prognosis? Can the bulls hold support at that initial support level?

 

 

An ominous rate spike

The recent spike in interest rates looks ominous. The 2-year Treasury yield is a proxy for the market’s expectations of the direction of the Fed Funds rate. In the past, peaks in the 2-year rate have been coincident or led peaks in the Fed Funds rate. Last week’s rate spike may be a signal that the bond market expects more Fed tightening than generally expected.

 

 

 

 

An unexpected rotation

Turning to the stock market, the AI frenzy appears to be petering out. Google searches for “AI” and “ChatGPT” peaked in late April and they’ve begun to tail off ever since.
 

 

From a technical perspective, the relative performance of the NASDAQ 100 normalized against a rolling past 52-week window, reached an overbought extreme and retreated (bottom panel). There were eight similar episodes since 1997. The NASDAQ 100 continued to advance in half of the cases (shown in grey) and corrected in the other half (pink). Looking ahead a year, the index rose in most cases. I conclude that the current stall should be characterized as a pause that refreshes.

 

 

As large-cap technology stalled, new leadership has appeared from an unusual quarter –transportation stocks. The Dow Jones Transports have been on a tear compared to the Dow Jones Industrials Average. Even as the Transports test resistance while tracing out a possible inverse head and shoulders pattern, the Industrials are weaker by contrast.

 

 

A similar pattern can be seen in the travel-related stocks comprising airlines, hotels and cruise lines. This group has staged a decisive upside breakout on an absolute basis (top panel) and on and a relative basis (bottom panel). The strength in these stocks should be comforting to the soft landing narrative as it represents a signal of consumer resilience.

 

 

 

Weak cyclicals = Caution

Before the bulls become overly excited, the analysis of value and cyclical sectors tells a different story. The relative performance of these sectors is weak, except for industrial stocks, whose strength is mainly attributable to the transportation stocks.

 

 

In particular, the financial stocks, which will kick off Q2 earnings season, are still weak and their relative performance has been closely correlated with the shape of the yield curve as the recent downdraft in bond prices hasn’t materially affected that dynamic. Regional banks have fallen back to test a long-term relative support level (bottom panel), which is concerning.

 

 

As well, the usually reliable S&P 500 Intermediate Breadth Momentum Oscillator just flashed a sell signal when its 14-day RSI recycled from overbought to neutral. To be sure, it’s difficult to interpret that signal as the VIX Index is already above its upper Bollinger Band, which is an oversold reading for the stock market.
 

 

 

The AAII bull-bear sentiment spread is elevated by historical standards, which is contrarian bearish.

 

 

In conclusion, these conditions argue for a corrective period or consolidation before equity bulls can regain their mojo. Traders should look for either a panic and sentiment washout or more evidence of oversold conditions before tactically turning bullish.

 

4 thoughts on “Bond rout = Stock rout?”

  1. A couple of on-the-ground observations.

    (a) Re wage inflation. The latest round of wage adjustments for my company (which now includes employees across the US following a merger a few years back) was announced earlier in the week and will average +2.5%. In comparison, the past two years averaged +4.6%. Quite a change.

    (b) Housing expenses. Our youngest will begin grad school at UC Irvine this September, and we toured apartment complexes in the area over the weekend. What I noticed was the disparity between asking prices (rental rates) and occupancy rates. The asks are ridiculously high. High enough that we broadened the search to include rooms with private baths being rented out by Asian families in affluent newly-developed neighborhoods looking to defray the expenses of 6-7% mortgages. No contest. The typical room is located inside a 4-bed 4.5-bath home constructed within the past few years in planned subdivisions surrounded by green hills and walking paths. Quiet and safe. Maybe a 10-15 minute drive to campus. Half the price of much older apartments in relatively congested neighborhoods with traffic or airport noise near campus. I predict a wave of students coming to the same conclusion if interest rates remain high.

    1. Most apt complexes are now owned by corporates (PEs, REITs, etc). The trend accelerated following the COVID rent moratorium which decimated many small independent landlords. Rent decline in the future is very unlikely. Of all UC campuses, four are in population centers. The biggest housing crunch for UC students is in Berkeley, and LA especially. This year SD is also showing signs of stress due to increase in enrollment. Irvine used to OK, but the last several years it has become a boom town with many Asian immigrants flocking in. Now Irvine is just as bad. But at least Orange County has many beaches you can enjoy surfing.

      I met a UCLA graduate who told me he was one of 10 students living in a two-bedroom apt in a corner of Westwood. They spent as much time as possible in campus and using school facilities, just like one Indian student who lived in office and not renting when I was in graduate school . This guy also told me that one of the cohabitants is a genius which made everyone else feeling very inadequate. Talking about mental aggravation when you are in those highly competitive colleges. When I met this guy he was quitting his finance job and was training to be a chiropractor. Another Cal graduate I know, a very smart cookie majored in chemical engineering, became a pharmacy tech.

      So, big name and hyper competitive colleges guaranteed nothing. Many HS students have not figured this out. Sure if you are really talented you should go to these schools. Do not waste time in average colleges.

  2. Maybe we are barking up the wrong tree.
    There is recency bias about rates because they were so low for so long, that now people are freaking out because they are at 5% which was normal or even lower than normal for many years.
    Maybe rates are bogus. This would explain why there is such a lag effect. Maybe the economy just rights itself regardless of rates unless they are truly wild.
    It makes sense that the cost of money matters, so I get why rate hikes lead people to think that the market will face a headwind. Same story applies to debt, but maybe this is all incidental.
    Who knows? Maybe the market will keep going up until the inevitable crash (there will be one eventually) and the pundits will say what caused it.
    That’s the good thing about TA, it is agnostic about what people say.

    1. Pundits make money by talking and then add a disclaimer at the end. It’s funny that people even pay attention to them. If data say odds are in my favor then it is time I care.

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