Mid-week market update: Today’s market action should be a lesson to me to change model rankings based on overnight futures prices, which trades in a thin and volatile market (see What now?). To set the record straight, the Trend Model did not move to a neutral, or risk-off reading based on today’s market action. The change last night was based on ES futures falling 3-4% at the time of writing.

One common refrain made by politicians who concede elections is, “The people have spoken!” In this case, the market has spoken and it has decided to adopt the bullish view that Trump is a reflationary president, rather than the bearish view of Trump the protectionist. This interpretation was made evident by the rally in the cyclically sensitive industrial metals, even as gold prices fell.
 

From a technical viewpoint, the stock market’s behavior is showing a path to an uber-bullish outcome. As the chart below shows, the market is showing the combination of a fear unwind, indicated by the normalization of the VIX term structure from an inverted state, and two days where TRIN has dipped below 0.50, which is a signal of a buying stampede.
 

Such momentum have either resolved themselves into periods of extended bullish momentum, or fizzled out within a few days.

The historical record

I went back to 2008 and looked at past episodes where such circumstances have repeated themselves. In 2015, TRIN fell below 0.50 while the VIX term structure was normalizing. The market rose for two days and stalled.
 

In 2014, the continued to advance for ten days after the signal.
 

In 2013 and late 2012, stock prices continued to rise for quite some time after the two signals.
 

There were several instances of these signals in 2011. Most stalled within a few days, but the last one in October marked the start of a sustained advance in stock prices.
 

In 2010, the market stalled after the signal.
 

The market bottom in 2008 and 2009 saw several instances of this signal. Some were decent trading signals with advances that lasted for about a week. More importantly, the market saw such a signal when it made its possible generational bottom in March 2009.
 

So where does that leave us? The historical evidence indicates that the combination signal of buying stampedes as fear fades yields sustainable advances about one-third of the time. One way is to trade these episodes is to get long, but with tight trailing stop losses.

A ZBT buy signal setup

As price momentum is the main component of these advances, there is another possible buy signal that the market could be setting us up for, namely the Zweig Breadth Thrust (see Bingo! We have a buy signal!). Steven Achelis at Metastock explained the indicator this way:

A “Breadth Thrust” occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A “Thrust” indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.

According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.

As the chart below shows, the ZBT Indicator (second bottom panel, bottom panel a real-time estimate) moved off its oversold level last Friday, which was day 1. The market therefore has 10 trading days to get the indicator up to 61.5%, which is not an easy task. Readers who want to follow along at home can use this link to get a real-time update.
 

Should we see an actual ZBT buy signal, there will undoubtedly be lots of skeptics as the market will be challenging or breaking out to new highs. Many traders will think that it will be too late to be buying. However, momentum thrusts are funny that way, as their strength can extend a lot further than you think.

My inner investor remains constructive on equities. My inner trader was fortunate not to get stopped out of his long positions at the open this morning. He remains long equities.

Disclosure: Long SPXL, TNA

As I write these words, there is pandemonium in the markets. ES futures are down about 4%. My 16 year-old (Canadian) daughter received an offer of marriage over the internet from an American.

I recognize that a lot of people view a Trump presidency with horror, but it’s time to assess the investment implications of these electoral results. Arguably, fear levels have already spiked and any panic selling could be viewed as a buying opportunity for stocks. As the chart below shows, the CBOE put/call ratio (middle panel) spiked to 1.48 yesterday and the VIX term structure inverted. These are readings consistent with short-term bottoms rather than the start of a sustained bear leg.
 

So let’s take a deep breath and review the bull and bear case for equities under a Trump administration.

The first 100 days

There are two major causes of sustained equity bear markets:

• War or rebellion that results in the permanent loss of capital
• Recession

As equity futures are deeply in the red, let’s first consider these possibilities, starting with Trump’s first 100 days. There are several accounts of Donald Trump’s priorities in his first 100 days. As examples, see NBC, the WSJ, and The Telegraph. The common threads that are likely to spook the markets are:

• Trade: Trump has vowed to cancel American participation in TPP. In addition, he announced that he intends to re-negotiate NAFTA. Undoubtedly, China will be labeled a “currency manipulator” and Washington will slap tariffs on all sorts of Chinese imports.
• Foreign policy: The chill in trade will extend to foreign policy as America will become more isolationist. No longer can NATO and other allies count on America’s military help if countries don’t “pay their way”. 

Trade slowdown = Recession?

On the first issue of trade, the key question for investor is whether a slowdown in global trade under a Trump administration be enough to spark a recession.

Notwithstanding the chilling effects of Trump’s protectionist policies, global trade has already been slowing down. FT Alphaville highlighted research from UBS showing that global trade volumes have been flat for much of this decade (left chart). Not only that, the “beta of trade growth to industrial output” has been falling (right chart).
 

A recent study by the European Central Bank revealed the reasons for the slowdown:

The change in the global income elasticity of trade between the pre-crisis period and more recent years is found to be mainly driven by two developments. One source of change arises from compositional effects, such as the shift of growth in trade and economic activity towards economies with lower trade intensity, and changes in the composition of aggregate demand factors towards less trade-intensive components. These shifts are not necessarily structural and could reverse in part over the medium term. The other source of change relates to structural factors that are altering the fundamental relationship between trade and economic activity, such as the degree of trade liberalisation and the reliance on global value chains (GVCs). These tend to be slow-moving changes reflecting fundamental shifts in the economy. The main difference between these two sources is that the latter fundamentally changes the relationship between trade and economic activity at the level of individual countries or demand components, while the former changes the global income elasticity of trade by shifting the weight of activity among countries or demand.

In other words, the world had already picked the low hanging fruit of globalization. Greater globalization policies were in effect mining lower and lower grade ore.

The markets will undoubtedly react in a knee-jerk fashion to the prospect of greater American protectionism, but if the benefits of globalization are already mostly played out, will it matter that much?

Rising risk premium

Trump’s isolationist foreign policy instincts could be a greater cause for concern. If US allies cannot unconditionally rely on American military help, then the markets will start to price in a higher possibility of conflict in global flash points such as the Baltic states (Estonia, Lithuania, and Latvia) and the South China Sea.

As this Credit Suisse historical study of asset returns shows, war can be devastating to asset prices if they lead to the permanent loss of capital. In those instances, you would be lucky to escape with your life and the value of your savings might be the least of your worries.
 

The bull case

There are silver linings to this dark cloud overhanging the markets. First of all, you can forget a December rate hike. The Fed is unlikely to raise interest rates in the face of market volatility and uncertainty. The Yellen Put still lives.

In addition, the effects of Donald Trump’s fiscal policy of tax cuts and spending, such as the Wall, will be enormously expansionary. As the Republicans have control of both the House and Senate, a Trump administration should not relatively little trouble getting his proposals passed.

Expect a big shot of fiscal stimulus to the American economy.

Should Trump carry through with his desire to replace Janet Yellen as Fed chair when her term expires on February 3, 2018, the replacement would likely be even more dovish than Yellen and head an even more accommodative Federal Reserve. If that were to occur, then the circumstances are ripe for the next grand experiment in economics, namely “helicopter money” as described by Ben Bernanke in a Brookings Institute essay:

Money-financed fiscal programs (MFFPs), known colloquially as helicopter drops, are very unlikely to be needed in the United States in the foreseeable future. They also present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. However, under certain extreme circumstances—sharply deficient aggregate demand, exhausted monetary policy, and unwillingness of the legislature to use debt-financed fiscal policies—such programs may be the best available alternative. It would be premature to rule them out.

The idea is not totally without merit. Bloomberg reported that Bernanke was an advocate for the idea in a meeting with the Japanese in July 2016.

Don’t panic

What should investors do? It’s hard to give advice without knowing the specific circumstances of any investor. If you were to ask my inner investor, he would likely say that if you haven’t raised cash, you should probably either raise cash or de-risk your asset allocation back to the investment policy weight as the Trend Model has moved from a risk-on reading to neutral. The market action in the past week indicates that many investors or their advisers have already done some hedging so further selling may not be necessary. Undoubtedly the market will experience substantial volatility in the days ahead, but don’t panic and evaluate the risk and reward in the market in light of the bull and bear cases that I have outlined.

My inner trader will probably see his long equity positions get stopped out when the market opens. He will be watching for whether the bears can take control of the tape, or if technical and sentiment readings are at an extreme before making further commitments.

I got a few questions about an apparent contradiction in my last post (see Don’t be fooled, Election 2016 isn’t the Brexit referendum). I had highlighted a Mark Hulbert article indicating that former Value Line researcher director Sam Eisenstadt had a SPX target of 2270 to 2310 by April 2017.

At about the same time, Hulbert had also written a Barron’s article on November 3, 2016 where he postulated little or no upside in stock prices, based on the analysis of the Value Line Median Appreciation Potential (VLMAP). In fact, VLMAP readings are similar to levels seen at the 2007 market top:

Market timers use the VLMAP to project where the stock market will be in four years, the midpoint of the analysts’ three-to-five-year horizon.

The VLMAP is currently at one of its lowest levels in years—as low, in fact, as it stood at the top of the bull market in October 2007, right before the worst bear market in the U.S. since the Great Depression.

Value Line itself does not recommend using the VLMAP as a market-timing tool, even though the firm is not against anyone using it or any of the other data it produces. As far as I can tell, the VLMAP-based market-timing model originates in work done in the 1970s and 1980s by Daniel Seiver, a member of the economics faculty at California Polytechnic State University and editor of an investment advisory service called the PAD System Report.

It’s worth noting that a casual reader of the Value Line Investment Survey wouldn’t immediately become alarmed upon viewing the latest VLMAP reading. It stands at 40%, which over four years is the equivalent to an annualized return of 8.8%.

As Eisenstadt had been the long serving research director of Value Line until 2009, how can investors reconcile these apparent contradictory bullish and bearish views based on similar data. Which interpretation of Value Line data should we believe?

VLMAP vs. Eisenstadt

There are some crucial differences to the two approaches. As Hulbert correctly points out, Value Line does not endorse the use of VLMAP for market timing purposes. Market timing analysis of VLMAP is based on the academic research by Daniel Seiver. Siever’s work on the use of VLMAP assumes long time horizons, whereas Eisenstadt’s only makes six-month market forecasts.

Having said that, let’s examine the recent track record of the two timing systems. Hulbert wrote that VLMAP flashed a warning signal for stock prices in a WSJ article in April, 2013:

The stock market in four years’ time is unlikely to be much higher than it is now.
That sobering forecast comes from a simple stock-market timing model that has an impressive track record over the past five decades. Among the more than 100 market timing strategies tracked by the Hulbert Financial Digest, in fact, this model has turned in the best performance of any in forecasting the market’s four-year return.

This market timing system is based on a single number that appears each week in the Value Line Investment Survey, the flagship publication of Value Line, a New York-based research firm. The number represents the median of the percentage gains that Value Line’s analysts estimate the 1,700 widely followed stocks they monitor will produce over the next three to five years.

Over the past five years, for example, this number—known as the VLMAP, for Value Line’s Median Appreciation Potential—has been as low as 45% and as high as 185%. It currently stands at 50%.

Value Line itself doesn’t endorse using the VLMAP for market-timing purposes. Though the firm doesn’t actively discourage investors from relying on this number or any of the other data that it produces, Value Line instead showcases a market-timing model that has a shorter-term focus.

Those who do follow the VLMAP for market-timing purposes use it to project where the market will be in four years, the midpoint of the analysts’ three- to five-year horizon. Because Value Line’s analysts—like most of Wall Street—are on average too optimistic, followers of the VLMAP often adjust it downward when translating it into a specific four-year forecast.

For example, Dan Seiver, an emeritus economics professor at Miami University of Ohio and chief economist at Reilly Financial Advisors in La Mesa, Calif., told me that he advises clients to use any VLMAP reading below 55% as the occasion to build up cash.

Hulbert reiterated that warning several months later in a Marketwatch article in August 2014:

The VLMAP recently dropped to just 35%. The last time it was this low was in July 2007. At the top bull market in October of that year, it stood at 40%.

As Seiver recently pointed out to his clients, the VLMAP’s current level “puts it in the worst 5% of all readings since 1966. In the past, a level as low as this has preceded months or years of poor stock returns. We doubt this time will be different.”

To be sure, Seiver’s model is not a short-term market-timing tool. As he pointed out the last time I wrote a column about it, “the stock market can continue to rise for months, if not years, after a sell reading.” Indeed, as documented in his Journal of Wealth Management study, it’s over a four-year horizon that the model has impressive forecasting powers.

Hulbert hit the nail on the head when he wrote that “Seiver’s model is not a short-term market-timing tool”. By contrast, Sam Eisenstadt makes short-term forecasts with six month horizons. The chart below shows the record of Seiver’s VLMAP sell signals (in blue) against Eisenstadt’s calls (in red), both of which were documented by Mark Hulbert.

In the past, Eisenstadt has tended set index targets that were overly bullish. Here are his forecasts that I could find:

• June 10, 2016
• April 3, 2015
• November 5, 2014
• June 4, 2014
• December 27, 2013
• July 13, 2013

The latest was dated November 4, 2016, which called for a six-month target of 2170 to 2310.

Horses for courses

Which one should you believe? Both have their uses. I have used VLMAP successfully in the past for long-term asset allocation purposes, but it is less effective as a short-term timing tool. On the other hand, Eisenstadt has been consistently bullish since 2013, though his targets have tended to be overly ambitious. His forecasts have been better at the direction of the market, rather than the specific target level. Their utility may be better as a forecast of the macro and fundamental drivers of stock prices, such as earnings growth and interest rates.

Each of these quant models have their own uses. Make sure you are using the right tool for the right purpose.

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 Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Risk-on
• Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

It’s all about the election

I have some terrible news to report. As a result of the change from Daylight Savings to Standard Time this weekend, the entire world will have to endure the US election for an extra hour.

All kidding aside, I could see the market anxiety rising all of last week. It wasn’t just the market action, which had taken on an increasingly risk-off tone as the week went on. It wasn’t the rising bearishness on social media. The biggest indicator of concerns over electoral uncertainty occurred when I saw that the traffic on my last post (see Trading the Trump Tantrum) was roughly triple the usual rate.

Despite some half-hearted rally attempts, the SPX ended the week testing its 200 day moving average (dma), and oversold on a number of key metrics. Traders are treating next week’s US election as the same kind of market moving event as the Brexit referendum. There is one key difference. The market was relatively sanguine going into the UK vote and expected a favorable outcome. By contrast, the market is positioning for a bearish outcome, even though the polls show that the bullish scenario, namely a Clinton win, as the more likelyt scenario.

Market analysis in the face of event risk involves answering the following questions:

• How would the market likely behave in the absence of tail-risk?
• How are market participants positioned ahead of the event?
• What are the likely bullish and bearish scenarios after the event?

Good news everywhere

If there had been no tail-risk, the markets would likely be responding with a risk-on tone as there has been good macro and fundamental news everywhere. Evidence of a growth surge is piling up.

Even better, the growth revival is global in scope. Callum Thomas observed that we are seeing a synchronized upturn in global manufacturing in both the developed and emerging market economies.

Another sign of the reflationary factors that I cited is the behavior of the cyclically sensitive industrial metals, which staged a breakout to new recovery highs. The broader CRB Index of commodities, however, was dragged down by weak energy prices due to uncertainties over OPEC actions.

Drilling down to the global reflation thesis by going around the world, Markit Economics pointed out that China PMI has surged to its best level since March 2013.

In addition, Bloomberg featured 9 charts showing why the Chinese economy is on fire:

• Chinese growth is firming as monetary conditions ease.
• Manufacturing PMIs are improving.
• Chinese industrial corporate profits are growing again.
• Macau gaming revenues, which is an indirect measure of the Chinese economy, is rebounding.
• Asian container throughput is rising.
• A firmer tone for the Australian Dollar, which is another market based indicator of the China’s “old economy” demand.
• Factory gate inflation is rising, indicating that China won’t be exporting deflation abroad
• The prices of iron ore and copper, which are also metrics of Chinese “old economy” demand, have steadied.
• The Li Keqiang Index, which measures electricity consumption, rail freight, and bank loans, has turned up again.

Does this represent an attempt by Beijing to artificially boost demand? Yes. Will it all end badly? Probably, but it won’t come crashing down on us today. Anyone who thinks that China is about to experience a hard landing will have to wait a bit longer.

In Europe, Markit Economics showed that the eurozone also also enjoying a manufacturing revival.

In the UK, the political news turned a bit more market friendly. Theresa May’s Tory government suffered a constitutional setback when the High Court ruled that the prime minister could not rely on the “royal prerogative” to invoke Article 50 of the Lisbon Treaty to exit the EU. Any decision to leave must be done by an act of Parliament. While the court ruling will not end the Brexit process, it does create delay and uncertainty, especially when in light of past MPs intentions in the Brexit referendum, which amounted to about 70% in favor of Remain.

The May government has stated that it will appeal the High Court ruling. It does appear that the scenario I outlined before where Theresa May sabotages and discredits the Brexit process in order to call an election in the spring is coming to pass (see Silver linings in Europe’s political dark clouds).

Across the Atlantic, the US economy continues to motor along. Productivity, which had been lagging, surged in Q3 and beat expectations.

The headline Non-Farm Payroll figure in the October Jobs Report missed expectations, but August and September employment were revised upwards. Unemployment edged down to 4.9% from 5.0%. It was a solid report by most measures. More importantly, temporary employment rose to a cycle high in October. As temp jobs tend to lead full employment by a few months, this is a sign of a healthy job market and there is no sign of any slowdown in sight.

From a bottom-up perspective, optimism about earnings growth continues unabated. According to Factset, 85% of the index has reported earnings. The EPS beat rate is well above average and the sales beat rate is in line with the historical experience. Forward 12-month EPS continues to rise, which is reflective of improving expectations.

Q3 earnings season is nearly over as 85% of the index have reported. Blended actual and forecast Q3 EPS is up 2.7% YoY. We can finally declare an end to the earnings recession.

In conclusion, there has been no shortage of good news on the macro and fundamental front, which creates a bullish equity backdrop in the absence of event risk. In fact, Mark Hulbert reported that former Value Line research director Sam Eisenstadt, who is one of the few market timers with a consistent historical record, is forecasting an April SPX target of 2270-2310, which represents a solid 10% gain from current levels. His October 31 SPX target of 2220 last April was very close to its target.

Rising electoral fears

Despite these bullish tailwinds, risk appetite has taken on a decidedly bearish tone in the last couple of weeks as market participants have turned defensive ahead of the US election. Anecdotal evidence indicates that a pervasive atmosphere of fear. A discussion with a friend and market letter writer for advisers revealed that, while some advisers recognize the bullish factors that are building up, no one was willing to buy equities ahead of the election.

The negative sentiment among advisers can be seen from the weekly NAAIM survey, whose sentiment has fallen to the bottom of its Bollinger Band. In the past, such abrupt declines in NAAIM sentiment have shown themselves to have limited downside risk.

We can see the evidence of rising fear in other indicators. For example, indicators of fear can be found in the CBOE put/call ratio. The chart below shows the 5 dma of the put/call ratio, which is at levels roughly on par with the market crash of 2008.

If you knew where to look, the urgent need to hedge electoral risk is evident. The ratio of 9-day VIX to 1-month VIX has reached its fourth highest in its history. By comparison, the ratio of the 1-month to 3-month VIX (bottom panel) is high, but not as high by historical standards. The cost disparity between the 9-day VIX and other volatility indicators is reflective of the desire to hedge a short-term event, namely next week’s US election.

What happens next?

There is no question that fear is the dominant emotion and the market is oversold. But oversold markets can get more oversold. I have no crystal ball that can tell me the electoral outcome, but we can prepare for different eventualities.

Should Hillary Clinton win the White House, we will undoubtedly see a relief rally. Clinton is the status quo candidate and, in the absence of tail-risk, the growth outlook is bright. Stocks should rally from here.

One of the real-time market-based clues of the election odds can be found in the Mexican peso. As Trump’s popularity rose last week, the peso weakened. As the effects of the FBI inquiry started to wear off, the peso began to rally later in the week.

This is a seasonally positive period for stocks, but the positive seasonal effects the week before the election was nowhere to be seen (chart via Sean Emory, annotations are mine). The market pattern of the current electoral cycle may be reminiscent of the Reagan-Carter contest of 1980. Going into the election, Reagan and Carter were running neck and neck in the opinion polls, but Reagan was well ahead in the betting markets. Stock prices declined into the election and rallied after the results were known. Today, Clinton holds a narrow lead over Trump, and she is well ahead in the betting markets. Stock prices are weakening as the election approaches. Will history repeat itself?

It will be an entirely different story should Donald Trump become president. The markets are already oversold and sentiment is showing a crowded short reading. But there could be even more selling as the uncertainty over the policies of a Trump administration. Even though NAAIM sentiment is already depressed, the dispersion of NAAIM votes is the third highest it has been in its own history. Not everyone has hedged for a bearish outcome. Traders should brace for more volatility regardless of who wins on Tuesday.

We can also see a similar unfinished business effect in the gold market. A recent (unscientific) poll showed that the asset class most likely to benefit from a Trump win is gold (also see my post The Trump Arbitrage trade).

As the top panel of the chart below shows, gold prices haven’t been that strong despite Trump’s revival in the polls. It has yet to rally above its downtrend line. In addition, an examination of the relative strength of gold to the CRB Index and the cyclical sensitive industrial metals suggests that much of the strength in the yellow metal could be attributable to the global reflation effect on commodity prices. In the event of a Trump win, gold has much more upside potential.

Even though gold may soar and stock prices tank, don’t count on a new bear market starting for stocks should Trump prevail next week. On an longer term basis, overly bearish individual investor sentiment is likely to put a floor on any equity decline. This 20-year chart of the 52-week moving average of AAII Bulls – Bears shows that sentiment readings consistent with market bottoms, not stock markets that are within 5% of their all-time highs.

The most likely scenario under should Trump win on Tuesday is a short and sharp sell-off, followed by a bounce back. Ryan Detrick of LPL Research went back to 1952 and showed the historical pattern of market performance in the November and December after a presidential election. There were two instances where the market suffered significant losses. They occurred in 2000 after the bursting of the NASDAQ bubble and the hanging chad electoral uncertainty, and in 2008 because of the Lehman Crisis. Both of those periods marked the start of recessions.

Could a Trump win spark a recession? Notwithstanding his anti-trade and isolationist stance, Trump’s fiscal policy is likely to be highly expansionary and could actually be short-term bullish for the economy and the stock market (see Super Tuesday special: How President Trump could spark a market blow-off). Therefore a panic sell-off, followed by a V-shaped stock market recovery is the more likely scenario. Then be prepared for a period of choppiness and uncertainty as the new administration sorts out its priorities and reveals its policy initiatives.

For my readers who have misgivings over the prospect of a Trump presidency, let me say this. Italy survived the brash, outspoken and larger than life Silvio Berlusconi*. America can cope with Donald Trump as president.

* Berlusconi was once attacked on TV over the frequent stories of his womanizing, he quipped: “They did a poll of Italian women and asked, ‘Would you like to sleep with Silvio Berlusconi?’ 50% said yes. The other 50% said, ‘What, again?'” Donald Trump isn’t even in the same league.

Playing the odds

Looking ahead to next week, what should investors and traders do ahead of the election? In light of the anticipated volatility, it would be inappropriate for me to advise anyone as different people have different risk-reward preferences and pain thresholds.

However, as market participants have largely hedged themselves against and adverse event, namely a Trump win, and the political odds favor the equity market friendly event of a Clinton win, the high percentage play would be to take a measured long position in risky assets.

My inner investor remains constructive on stocks. My inner trader is still nervously long equities.

Some sensible advice

Whatever happens in the election, let me close with a piece of advice. Learn to view the results through a market-driven lens rather than an ideological one. Cullen Roche recently wrote:

A University of Chicago research paper recently found that 50% of Americans believe in conspiracy theories. I see it every day in financial circles. But how is this possible? How do the conspiracy theories about hyperinflation, crashing dollar, the unemployment rate, etc. persist when we have almost a decade of real-time data showing us that these theories and myths were totally and completely wrong?

This is crazy stuff. Especially when it comes to the economic data. Americans are distrustful of government data, but the USA has the most transparent and expansive government data sources of any government anywhere. I know because I’ve tried to compile economic data all over the world and no government comes close to the degree of transparency and sheer quantity of data. Is it perfect? Of course not. But it’s abundant and much of it is confirmed by private sources.

It would be too easy to get into an impotent rage should your favored candidate lose, or if policy doesn’t go in your desired direction. That kind of thinking clouds judgement and leads to subpar investment results.

Disclosure: Long SPXL, TNA

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 Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Risk-on
• Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

In the absence of political tail-risk…

Up until Friday, the big story of last week was the bond market’s shellacking in the face of rising inflationary expectations. I had been planning to discuss whether the rout in bonds is likely to take down stock prices.

Then the news hit the tape that the FBI was investigation new Clinton emails that were discovered in the course of the Anthony Weiner sexting investigation. Stock prices, which were up modestly, tanked on the news. At the height of the sell-off, the SPX fell and tested the key support level at 2120, and the market flashed oversold warnings on selected indicators. By the close, the bears were unable to gain the upper hand and 2120 support held.

As the market has been trading sideways since the upside breakout in July, the question is whether this news is enough to signal the start of a bear phase (see my last post The bulls and bears wait for Godot). The bulls had been unable to push stock prices to new highs despite the emergence of renewed growth (see Q3 earnings season: Stud or dud?), can the bears take advantage of the news of a new FBI probe of Hillary Clinton`s email to weaken stock prices?

I begin this week’s market analysis with an examination of the stock market’s macro and fundamental backdrop. and then consider the ramifications of Friday’s political bombshell.

The bond market rout

Until Friday, the biggest market headlines related to the rout in the bond market. As the chart below shows, the increase in interest rates was global in scope, It wasn’t just about anticipation of Fed rates in the US, nor was it just about Brexit jitters and falling Sterling in the UK, German Bund yields rose as well.

As an illustration of the universal carnage in bond prices, Callum Thomas at Topdown Charts showed the negative breadth of global sovereign bond prices in the chart below. From a technical perspective, bond prices may be oversold enough to see a bounce.

The main cause of the backup in interest rates was rising inflationary expectations. As the chart below shows, global inflationary expectations have bottomed and started to rise, which eventually fed through to higher bond yields.

Will the sell-off in bond prices also spook the stock market too? Dana Lyon highlighted a historical study of rising rates and weakish stock prices. The prognosis doesn’t look too good for equities.

What about growth?

All is not lost. I have made the point repeatedly that stock prices tend to rise during the initial phase of an interest rate hike cycle. That’s because the market focuses more on the bullish effects of improving growth, rather than the bearish effects of higher interest rates.

We are also starting to see the signs of a cyclical recovery in growth. It began early last week with the upbeat Manufacturing and Services PMIs, and ended with the 2.7% Q3 GDP growth, which beat expectations.

Other signs of cyclical recovery were also in evidence. Industrial commodities rose to test a key resistance area. The strength in industrial metals is particularly remarkable in light of the strong Dollar. Historically, the USD has been inversely correlated with commodity prices.

An analysis of the Commitment of Traders data from Hedgopia reveals that large speculators (hedge funds) are in a crowded long position in the USD. When you combine that with a technical test of overhead channel resistance and an overbought reading in the USD Index, the Dollar is likely to weaken in the short-term. A weaker greenback could therefore provide tailwinds for higher commodity prices.

Even though inflationary expectations from the bond market were rising, the yield curve was also steepening, which is a signal that it expected higher growth. This confirms my belief that the fixed income market expects the positive effects of better economic growth to overcome the negative effects of monetary tightening.

Rising inflationary expectations is equity bullish. In the past higher inflationary expectations have provided a cyclical lift to equity prices.

Along with inflationary expectations, growth expectations are also on the rise. The latest update from John Butters of Factset shows that forward 12-month EPS continues to march upward. Last week’s earnings reports were not as strong as the previous week’s and therefore some of the sloppy market action last week could be attributable to earnings disappointment. However, the overall Q3 interim report card still points to a strong quarter.

Ned Davis Research believes that earnings growth is likely and consistent with the reflation theme.

Sentiment analysis also favors equities. As the chart below from JPM shows, individual investors have been selling equity funds in favor of bond funds for most of 2016, and relative flow levels are consistent with panic bottoms during the Lehman Crisis in 2009 and the eurozone debt crisis in 2012.

As I pointed out before, institutions had been underweight bonds, roughly neutral weight stocks, and overweight cash (see A sentimental embrace of risk). They have been slowly buying into equities because of the reflation thesis. The fund flow laggards, in this case, are retail investors. The potential for a FOMO rally into stocks is high as the retail money joins the institutional rush into equities.

Stay bullish on stocks

To summarize, the macro and fundamental equity market outlook continues to be bullish on an intermediate term basis. The economy is in the late stages of an expansion where it is starting to overheat. Market participants are starting to shift their focus from safety to growth.

In light of the cyclical recovery and steepening yield curve, a couple of leadership groups that maybe be of interest would be financials and technology. Brian Gilmartin observed:

This requires a separate blog post later this weekend, but for Q4 ’16, Technology and Financial’s are the two sectors seeing higher upward revisions, versus the current Q3 ’16 results. Again, it bears repeating many times for readers, but the trend in revisions at this time for forward quarters is usually downward, so to see upward revisions for a sector is an important tell.

Last week’s equity weakness from a less than robust earnings reports was likely just a hiccup. Gilmartin concluded: “The takeaway today is that Q3 ’16 earnings look very healthy.”

The top panel of the chart below shows that the relative performance of financial stocks is highly correlated with the shape of the yield curve, which is currently steepening. In addition, semiconductors and technology have also displayed leadership within the cyclical group and has potential for further gains.

The fundamental outlook for equities looks bright (in the absence of political tail-risk).

The FBI investigation effect

How do we assess the political tail-risk? For traders and investors, the FBI probe of more Clinton emails could be a game-changer.

As an analytical framework, I am making a key assumption that a Clinton presidency represents the status quo, which is equity bullish, and a Trump presidency represents the unknown, which is bearish. So rather than indulge in instant knee-jerk reaction, let’s take a deep breath and consider what has happened so far.

FBI director Comey sent a letter to Congress on Friday indicating the FBI had “learned of the existence of emails that appear to be pertinent to the investigation” of Hillary Clinton’s personal email server during her time as Secretary of State. The results of any FBI investigation is unlikely to be concluded before the election.

Right now, we know little. Business Insider pointed out that there are wildly conflicting accounts of what is in the emails. Moreover, the DoJ has astonishingly filed a complaint against FBI director Comey.

Benjamin Wittes at Lawfare blog has a more reasoned analysis of the Comey letter to Congress. He believes that it amounts to a CYA exercise by the FBI:

When the FBI wants to say it is reopening an investigation, it knows perfectly well how to say that. In this case, the investigation was actually never formally closed, so it doesn’t need to be reopened. The relevance of this letter is thus likely not that some explosive new evidence of Clinton criminality has suddenly emerged.

It is, rather, that Comey made a set of representations to Congress that have been complicated by new information, apparently from the Anthony Weiner sexting case. So he’s informing Congress of that fact before the election.

Comey represented to Congress that the Clinton email investigation was “complete.” But as the letter relates, new emails have now come to the bureau’s attention that appears relevant to the email investigation. (Weiner’s estranged wife is one Clinton’s top aides.) Comey has okayed a review of that new information to determine whether the emails contain classified material and also whether they are, in fact, relevant. And this fact renders his prior statement to Congress no longer true.

The key point here, in other words, is not that Comey is “reopening” a closed matter because of some bombshell. It is that he is amending his public testimony to Congress that the FBI is done while the bureau examines new material that may or may not have implications for investigative conclusions previously reached.

What about the political fallout from this latest revelation? Polls are useless in cases like these as the data is stale. We do have some clues to the reaction from the analysis of social media (via CNBC):

The headlines about the FBI investigation of Clinton’s emails and Trump’s comments about women spread like wildfire on social media as political commentators from both sides of the aisle weighed in.

Social media analytics company Spredfast said that while both scandals proliferated on Twitter, there were marked differences in the trends.

“In the case of Clinton, we saw a huge spike when the news first broke this afternoon, but buzz has since been declining,” said Chris Kerns, vice president of research and insights at Spredfast. “Conversely, with the Trump tapes, the news built throughout the day and didn’t peak until almost nine hours later with 5.7K tweets per minute.”

Should no further news come out over the weekend, the FBI investigation story is likely to just blow over. Analysis from FiveThirtyEight shows that prior to the news, Clinton held such a commanding lead that Trump has to win virtually every swing state in order to win the election. If there was to be political fallout, the more likely damage would be weakness for the Democrats in down ballot races. The latest update from PredictWise shows that the Clinton odds in the presidential race have edged down slightly, and a diminished probability that the Democrats would take control of the Senate. Since the Senate race margin in many states is only 1-2% points, a minor swing at the last week could dramatically alter the outcome. The Republicans are likely to retain control of the House. Arguably, such an outcome where the race tightens would be slightly equity bullish, as the market tends to prefer gridlock over the takeover of both the Presidency and Congress by any single party.

The stock market reaction on Friday was relatively muted. This chart from IndexIndicators shows that the index has been tested the bottom of a wedge and support held at 2120. In addition, breadth indicators show a mild oversold condition where the market has bounced in the past.

Similarly, the Fear and Greed Index has fallen to a level where the market has bottomed in the past, but could fall further.

In summary, the stock market weakened last week, first in response to higher interest rates, weaker than expected earnings results, and heightened political tail-risk from an FBI investigation of Clinton emails. I have shown that higher rates translate to higher growth, which is equity bullish, earnings results are still better than historical expectations, and political tail-risk is likely to diminish. The market fell but the decline was arrested at a key support level.

My inner investor remains constructive on the equity market outlook. My inner trader is bullish, but nervously watching support levels and sentiment readings.

Disclosure: Long SPXL, TNA