7 reasons to embrace the melt-up into year-end

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: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
  • Trading model: Bullish (Last changed from “neutral” on 20-Nov-2023)

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 cup and handle breakout

Much has been made about a nascent cup and handle pattern in the S&P 500 and the NASDAQ 100, which would have strong bullish implications if either index were to stage upside breakouts. While investors wait for those breakouts, here is a cup and handle that has staged a definitive upside breakout on both an absolute basis and relative to the S&P 500. It was made by the NYSE FANG+ Index, which represents megacap growth stocks.

 

 

In light of the strong price momentum exhibited by the stock market in the wake of the Zweig Breadth Thrust buy signal, I believe these are strong indications that investors and traders should embrace a market melt-up scenario into year-end and possibly beyond.

 

 

Learn to love Magnificent Seven

There have been warnings about excessive herding into the Magnificent Seven, or the seven largest megacap growth stocks in the S&P 500. FT Alphaville highlighted a report by Goldman Sachs that hedge fund concentration in the Magnificent Seven is in the 99th percentile. Instead of fading these stocks, I argue that investors and traders should stay with price momentum and buy the Magnificent Seven as a beta chase into year-end is likely to cause a melt-up in these names for the following reasons.

 

First, contrary to popular belief, hedge funds are underweight the Magnificent Seven, not overweight. The FT Alphaville article reported that these stocks account for “13 per cent of the aggregate hedge fund long portfolio, twice their weight at the start of 2023”, but went on to acknowledge that this exposure only represents half of the index weight in the Russell 3000. In other words, a fund that bought the S&P 500 index would be overweight the Magnificent Seven when compared to the aggregated bottom-up hedge fund holdings in these stocks.

 

What overcrowding?

 

Are you worried about valuation? An analysis of the Magnificent Seven’s forward P/E ratio shows that it’s only roughly at the average for the time frame starting in 2015.

 

 

Worried about excessive concentration in the S&P 500? FT Alphaville editor Robin Wigglesworth looked up the 1976 prospectus for the First Index Investment Trust (now Vanguard 500). He found that the top five companies in 1976 “accounted for over 21% of S&P 500, and top 10 were 28.3%. Not far off today’s 23.5% and 32%, respectively.”

 

Using the NASDAQ 100 as a proxy for megacap growth, the NASDAQ 100 to S&P 500 ratio (black line) is not overly extended by historical standards. Growth stocks have more room to run.

 

 

 

More breadth thrusts

In addition to the Zweig Breadth Thrust that I have documented in past publications, the S&P 500 gained over 9.5% since the October bottom. Call it what you want, a breadth thrust or just strong price momentum. A rose by any other name. Since 1990, there were 15 similar episodes and 11 of them signaled the start of new bull phases.

 

 

Jay Kaeppel of SentimenTrader also pointed out that the percentage of major S&P 500 sectors above their 200 dma rose above 30% from below, which is a sector-level breadth thrust. If history is any guide, the market should see strong returns over the next six months.
 

 

 

Supportive macro backdrop

Worried about macro conditions? Don’t be.

 

Citations of “inflation” during earnings calls have been falling for nearly two years, indicating that inflation is coming under control and confirms market expectations of a rate hike pause.

 

 

In addition, citations of “recession” on earnings calls topped out six quarters ago and they have been falling sharply.

 

 

 

Supportive sentiment

As well, sentiment readings aren’t overly stretched. The accompanying chart shows the 10 dma of the CBOE put/call ratio and the equity put/call ratio (blue lines) around their 1 standard deviation 200 dma Bollinger Bands. Both indicators are in neutral and neither are showing any signs of excess froth.

 

 

 

The 2019 ZBT template

The V-shaped rebound off the October bottom generated a Zweig Breadth Thrust buy signal in early November. That buy signal is highly reminiscent of the ZBT signal in early 2019, which saw the market also form a V-shaped price surge off the Christmas Eve bottom of 2018.

 

While history doesn’t repeat itself but rhymes, the 2019 experience could be a useful template for expectations of market performance in the current circumstances. If we use the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) as a tactical trading signal, we can see that the S&P 500 ran up for seven weeks and returned 8.5% from the date of the ZBT buy signal until ITBM flashed a trading sell signal when its 14-day RSI recycled from overbought to neutral. The S&P 500 went on to show a total return of 28.8% a year after the ZBT buy signal.

 

If we were to use the 2019 experience as a guide, the equivalent ITBM sell signal would occur seven weeks after the ZBT buy signal on December 24 and the S&P 500 would reach a level of 4730. As December 24 is in the middle of the seasonally strong period for stock prices, my base-case scenario calls for a tactical rally into early January, followed by a period of consolidation or pullback.

 

 

 

Too early to buy small caps

One concern raised by some technicians is the lack of breadth participation. The equal-weighted S&P 500 and the Russell 2000 are lagging the S&P 500 in the current rally. I don’t believe that should be a significant worry in the short run as the fast money engages in a FOMO beta chase into year-end.

 

 

As smaller stocks have lagged in a strong year for the S&P 500, I would expect there would be more losers among these stocks that would be subject to tax-loss selling pressure into year-end. Tactically, nimble traders could rotate from megacap growth to small caps during the second or third week of December in order to take profits in the Magnificent Seven names and position for an anticipated year-end and January small-cap rebound once tax-loss selling season is over.

 

 

 

Buy the dip!

Tactically, the market may be due for a brief pause in the advance. Both the 14-day RSI and the percentage of S&P 500 stocks above their 20 dma are extended, which is likely to resolve in a brief pullback or consolidation. Don’t worry, the S&P 500 continues to rise on a series of “good overbought” 5-day RSI conditions. Any weakness would be a welcome opportunity to buy the dip.

 

 

In summary, I would not go as far as to call the current circumstance a generational buying opportunity, but a rare and obvious “fat pitch” that comes along only once or twice per decade. Most of my models have been designed to minimize risk and not maximize return. As an example, my very successful Trend Asset Allocation Model was designed to eliminate significant drawdowns by sidestepping prolonged equity bear markets. The accompanying chart shows the performance of a model portfolio based on a rule varying by 20% in equity weight against a 60/40 benchmark using out-of-sample Trend Model signals.

 

The current episode of strong breadth thrust off the market bottom in late October is a rare and clear and extraordinary trading signal of a major market bottom. I believe investors should, at a minimum, embrace the likely melt-uTp into year-end and re-evaluate market conditions in January.

 

My inner investor is bullishly positioned and so is my inner trader. The usual disclaimers apply 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

 

How a global leadership review reveals opportunities

Posted by Cam Hui -

Much has happened since my last global market review. Investors saw a bond market tantrum, followed by a down yield reversal and a risk-on rally in asset prices. Willie Delwiche at Hi Mount Research put the equity price surge into perspective when he observed that 94% of global markets in the MSCI All-Country World Index (ACWI) had exceeded their 50 dma. This is a sign of strong global breadth that shouldn’t be ignored.
 

 

Drilling down, let’s take a quick trip around the world to spot investing opportunities.
 

 

U.S. growth has been dominant

Starting with the U.S., as it represents about 60% of capitalization within ACWI, growth has become the dominant leadership. Two of the three growth sectors in the S&P 500 have exhibited strong relative strength. I am inclined to stay with the current U.S. growth leadership until the December to early January time frame as hedge funds and other investors will likely be engaged in a beta chase for returns into year-end.
 

 

The growth investing style isn’t just dominant in the U.S., but in the non-U.S. developed markets as well. Growth began its outperformance against value stocks both within and outside the U.S. in early October.
 

 

By contrast, here is the relative performance of U.S. value and cyclical sectors, which can be best described as pedestrian.
 

 

For completeness, here is the relative performance of defensive sectors in the S&P 500. It is not surprising that these sectors are showing no signs of leadership in the face of a strong equity rally.
 

 

 

Emerging Non-U.S. leadership

Turning our focus outside the U.S., the accompanying chart of the relative performance of different regions is revealing. While U.S. equities are leading, their outperformance is starting to flatten out. The two regions that show promise as emerging leadership are Europe (middle panel, black line) and emerging markets ex-China (bottom panel, black line). Both are exhibiting saucer-shaped bases which are set-ups for possible new leadership.
 

 

European relative performance is more advanced. An analysis of relative returns of selected eurozone markets shows relative strength by France, Italy and Greece (yes, that Greece).
 

 

Across the English Channel, U.K. markets are showing signs of relative weakness. Large-cap U.K. stocks have been highly correlated to energy due to the heavy energy weight in the large-cap British market. Small caps, which are more reflective of the U.K. economy, are still weak.
 

 

 

Asia and Emerging Markets

Pivoting to Asia, the relative performance of the equity markets of China and her major Asian trading partners can be best described as unexciting.
 

 

However, the chart of the major emerging markets ex-China is starting to reveal some opportunities. While China’s relative performance (top panel, dotted red line) has been in a relative downtrend, EM ex-China (top panel, black line) is starting to flatten out and possibly turn up. The analysis of the top four countries in the index, which make up 68.6% of index weight, shows that the sources of relative strength are appearing in all countries except South Korea.
 


 

In conclusion, here are my main takeaways from my review of global leadership:

  • Global equities are surging, led by growth stocks. I am inclined to stay with the current leadership until year-end as hedge funds are likely to engage in a beta chase for performance.
  • U.S. stocks are still the leaders, especially the megacap growth stocks.
  • Set-ups for a new leadership are emerging in Europe and EM ex-China. I am inclined to wait until early 2024 to re-evaluate the evolution of leadership before making any decisions on rotation. Historically, Q1 in an election year tends to be choppy and move sideways.

 

 

Three white soldiers lead the way

Posted by Cam Hui -

Mid-week market update: The “three white soldiers” candlestick pattern is made up of three long white candles, and typically occurs after a falling price trend. It is indicative of strong price momentum after a price reversal. This pattern is evident in the weekly S&P 500 chart shown below.  Usually, the market consolidates sideways after the “three white soldiers”, but the market has continued to advance on the back of the strength of the recent breadth thrust signals. As well, the index faces initial resistance at about 4600, which should be overwhelmed in light of a combination of strong price momentum and the lack of volume resistance (see side bars).
 

 

This is a timely gift to all investors and traders who observe U.S. Thanksgiving.
 

 

Risk on!

The NASDAQ 100 ETF QQQ is exhibiting a similar “three white soldiers” bullish pattern, which I interpret to indicate megacap growth leadership in the latest advance.
 

 

Risk appetite indicators are all flashing green and confirming the market advance. Risk on!
 

 

 

Small cap laggards

Do you know what’s not exhibiting strong price momentum? It’s small cap stocks. Take a look at the Russell 2000, where the “three white soldiers” are not evident.
 

 

Market breadth is not broadening out in this rally, as evidenced by the relative downtrend of the equal-weighted S&P 500, which gives higher weight to the smaller companies in the index, and the Russell 2000. In the short run, this should not be a concern (see my previous analysis in Will narrow leadership unravel the ZBT buy signal?).
 

 

My inner investor has an overweight position in equities. My inner trader has jumped on the bull train in anticipation of a strong rally into year-end. The usual disclaimers apply 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

 

How far can this rally run?

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: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
  • Trading model: Neutral (Last changed from “bullish” on 14-Nov-2023)

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.

 

 

An extraordinary price surge

The S&P 500 rally off the bottom in late October has been extraordinary. It resolved itself in a Zweig Breadth Thrust buy signal and four price gaps that likely won’t be filled. Classical chartists would characterize them as breakaway gaps indicating strong price momentum.
 

 

How far can this rally run?
 

 

Breakaway gaps

For some context on the price momentum that generated four consecutive price gaps in a short period, Jason Goepfert of SentimenTrader made a study of such events. While the sample size is relatively small (n=9), past returns of four unfilled price gaps showed very bullish results.
 

 

Price momentum can be thought of as “the stock market will continue to rally once it’s started rising”, while the price momentum factor is “stocks that outperform will continue to outperform”, regardless of market direction. Not only is the market’s price momentum strong, but the renewed performance of the price momentum factor also underscores the strength of this rally. The accompanying chart shows the relative performance of different price momentum factor ETFs, which have begun to beat the market in the last month.
 

 

 

Estimating upside potential

Under these circumstances, how should investors estimate upside potential? At what point should they take profits?

 

The point and figure chart offers some perspective from a longer-term point of view. Using different box sizes, the point and figure chart of the S&P 500 shows measured objectives in the 5300 range, which represents an upside potential of roughly 18%.

 

 

The point and figure chart of the NASDAQ Composite shows an even more impressive measured objective representing upside potential of over 20%.

 

 

Using the same technique, the upside potential for the Russell 2000, which is lagging the S&P 500, is similar to the S&P 500 at about 17%.

 

 

Unfortunately, the one drawback of point and figure charting is it’s silent on time horizon. While measured objectives are useful, it’s difficult to form realistic expectations of how long it will take to achieve those price objectives.

 

 

Sell signal triggers

For traders with shorter time horizons, I can offer a few indicators that can trigger a “take profit” warning.

 

The accompanying weekly chart shows the NYSE McClellan Summation Index (NYSI, middle panel). NYSI rebounded from a near oversold condition. If history is any guide, the rally will start to peter out when the stochastic (bottom panel) becomes overbought.

 

 

Here is the NASDAQ McClellan Summation Index (NASI). NASI reached an extreme oversold condition of under -1000 and bounced. Such severely oversold episodes have marked major market bottoms in the past, and the rally hasn’t ended until the stochastic becomes overbought. The NASI rebound from such an oversold extreme consequently results in my belief that megacap growth stocks will lead to the upside in this rally.