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 04-Oct-2024)
- Trading model: Neutral (Last changed from “bearish” on 19-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.
The drumbeats of war
Oil prices have risen in response to rising tensions in the Middle East, but the year-over-year change is still negative. While war isn’t in our base-case scenario, investing is about pricing risk. I argue that the market is underpricing the risk of a conflict.
Setting the scene
Perhaps emboldened by its successes against Hezbollah and the subsequent weak Iranian response, Israel has threatened to bomb Iranian oil facilities.
When President Biden was asked by the press whether he supports an attack, his response was informative, “We’re discussing that. I think that would be a little… anyway.” In a separate session in the White House briefing room, Biden elaborated, “The Israelis have not concluded how they, what they’re going to do in terms of a strike. That’s under discussion. If I were in their shoes, I would be thinking about other alternatives than striking oil fields.”
We can infer that if discussions are at the level all the way up to the U.S. President, an Israeli strike is one of the options on the table, and the risks are very real. Not surprisingly, the U.S. is against the idea of bombing Iranian oil facilities. Biden’s “if I were in their shoes” framing of the issue is a signal that the U.S. has limited ways of restraining on Israeli initiatives, as was demonstrated during the Gaza incursions.
Much of the published analysis focuses on the first-order effects of an attack. What are the effects on oil prices? Will Iran be able to successfully close the Strait of Hormuz?
Here are some second-order effects to contemplate, with many unanswered questions:
- So far, the Ukrainians have targeted Russian refining capacity to pressure its domestic economy but refrained from attacking oil exports. If Israel bombs Iranian oil facilities, will it embolden Ukraine to hit Russian oil exports, which the U.S. had restrained Ukraine from?
- Iran has threatened to retaliate by hitting oil facilities in the Gulf, which are static targets and far easier to implement than to try and actively close shipping in the the Strait of Hormuz.
- China is a buyer of Iranian oil, which it obtains at a discount because of ongoing sanctions. How is China positioning itself behind the scenes? What are its intentions and how will it react if the missiles start flying, especially when it’s undertaking a program to stabilize its economy?
While no one knows what the actual odds of an attack, but the odds are probably higher than what the market is pricing in, and the fallout may be worse than expected.
The market reaction
Here is the market reaction so far.
The accompanying chart shows how different groups within the energy sector are trading. The energy sector ETF (XLE), which consists mainly of heavyweight integrated energy companies like Exxon and Chevron, has rallied above a key resistance level. The Oil & Gas Exploration & Production stocks (XOP), which are upstream producers, are just testing resistance, while Oil Services (OIH) is weaker on a relative basis.
I interpret these readings in a number of ways. The strength in XLE represents an initial stampede into the sector based mainly on liquidity considerations. The lagging price movement of XOP indicates that the fears of energy price disruption haven’t been fully priced in yet. The relative weakness of OIH is a logical response, as oil services is more representative of long-term investment in extraction infrastructure and any oil spike is likely to be temporary.
Now take a look at the VIX Index, which recently rose above 20. Its term structure isn’t inverted yet, indicating a lack of fear.
Mispriced risk
I reiterate our bullish base case that I recently outlined (see A Powerful Buy Signal, with Caveats), but part of investing are proper risk management and the pricing of risk. While war in the Middle East is not my base-case scenario, I believe the odds of an Israeli attack on Iran are higher than the market expects. The market is underpricing the risk of war and investors should be aware of this tail risk and position themselves accordingly.
This year, the Wall Street adage of “sell Rosh Hashanah (October 2), buy Yom Kippur (October 12)” may line up with the war jitters time frame.
What does Israel have to gain by bombing Iranian oil facilities? It won’t make the Iranians feel different except more animosity. It is unlikely to provide long term safety.
I doubt that those who wish Israel gone will change their minds.
If China has it’s oil supply from Iran disrupted, they will buy their oil from someone else.
More suffering on both sides.
So hopefully they show restraint.
I am afraid this situation will increase the east west tension and encourage the east countries to put more energy and thinking into bypassing the western financial system. The BRICS+ group is gaining steam and flirting with OPEC countries. Dilma Rouseff and her team are working hard to put the MBridge system to work. MBridge system is backed by the Bank of International Settlements (BIS). Gold and silver are going up like crazy, as has been pointed out by Cam and others in this forum. Summing up, it still seems reasonable to me to buy precious metals even though they are very expensive. Silver has military uses, by the way
it is interesting to note that China bought the London Metals Exchange