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A stock market roller coaster

Summary:
Preface: Explaining our market timing modelsWe 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 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 a trading model, which is a blend of price momentum (is

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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 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 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 those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

A stock market roller coaster

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bearish
  • Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

Here we go again?

For two consecutive Fridays, the market has rallied into the close to exhibit hammer-like reversal candles. The first candle reversal was confirmed by a massive 4.3% surge on the following Monday, will the same happen this coming Monday?

A stock market roller coaster

While I am cautiously bullish at a tactical level, it could also be argued that the market has not sufficiently tested the February lows. Should stock prices retreat to test those lows early next week, the bulls can take some comfort that any test would likely be accompanied by positive 5 and 14 day RSI divergences. On the other hand, the bears are likely to defend the highs set in the rally last week, which could make trading the market an interesting challenge.

Investors and traders should brace for more thrills from the market roller coast.

Sentiment buy signals everywhere

Sentiment buy signals are popping up everywhere. One useful sentiment indicator is the capitulation shown by the NAAIM Exposure Index, which measures the views of RIAs managing individual client funds. This index skidded below its 26-week Bollinger Band, which historically has signaled good bullish entry points to the stock market.

A stock market roller coaster

Similarly, Market Vane bulls has fallen to the levels last seen in 2010 and 2011. Readings were only exceeded by the market crash of 2008-09.

A stock market roller coaster

The normalized equity-only put/call ratio has spiked to levels that has marked tradable bottoms in the past.

A stock market roller coaster

The VIX Index spiked over 50 last week, which is extremely high by historical standards. It did not even reach these levels during the Russia Crisis, or the NASDAQ top of 2000. Similarly, the degree of VIX term structure inversion has only been exceeded during the market crash during the Great Financial Crisis.

A stock market roller coaster

Sentiment models are very washed out.

Momentum sell sginals

Arguably, this time is different inasmuch as the market pullback is occurring in conjunction with a Fed inter-meeting rate cut. The Fed doesn’t usually just cut rates out of the blue, this was an emergency action. The word “emergency” should be a flashing warning that there is something seriously wrong with the economy.

From a long-term technical perspective, the monthly MACD model has negated a recent buy signal and flashed an interim sell signal for the market, which can only be confirmed if the index closes at these levels at the end of March. Past buy signals have usually led to prolonged bull phases, and this potential bearish development is highly unusual.

A stock market roller coaster

MACD sell signals are the result of negative price momentum. As an example of negative price momentum, Jeff Hirsch found that the combination of a down January and down February has led to subpar equity returns for the remainder of the year.

A stock market roller coaster

There are also worrisome signs from fundamental and macro perspectives as well. FactSet reported that Street analysts are starting to downgrade their earnings estimates, indicating bearish fundamental momentum.

A stock market roller coaster

In addition, some cracks are appearing in the labor market. Despite the blow-out Jobs Report, leading indicators such as temporary employment, and the quits to layoffs rate (which will be updated next week in the JOLTS report), are exhibiting signs of weakness. These troublesome signs are showing up during a period that pre-dates any effects of the COVID-19 outbreak in the US. What happens in March, when the full effects of the coronavirus slowdown hit the economy?

A stock market roller coaster

Bull or bear?

Here is how I resolve the bull and bear cases. Arthur Hill at StockCharts questioned the usefulness of traditional technical analysis techniques because he believes that the market environment has switched from bull to bear:

Support levels and bullish retracement zones are questionable, at best, in bear market environments. Why? Because the path of least resistance is down in a bear market. As such, the odds that a support level holds or a bullish retracement zone leads to a reversal are greatly reduced. The odds favor bearish outcomes and bearish resolutions during bear markets.

Even though the S&P 500 is battling its 200-day SMA this week, I am in bear market mode because the breadth models at TrendInvestorPro.com turned bearish for the first time since early September. This means support levels and bullish retracement zones are much less reliable.

If a bear market has indeed begun, one sign of a bottom is insider buying. There were clusters of insider buying during 2008, 2011, and in late 2018. There is no such signs today.

A stock market roller coaster

While I am not ready to officially declare a bear market, or a recession just yet, traders should prepare for bear market style volatility, at least for risk control purposes.

Here is how that scenario would play out in the context of my Ultimate Intermediate Bottom Spotting Model. This model flashes a buy signal whenever both the Zweig Breadth Thrust Indicator becomes oversold (check), and the McClellan NYSE Summation Index (NYSI) is negative (check). This model flashed four buy signals during the bear market of 2007-09. In each case, the market staged a relief rally, but the rally failed as stock prices retraced the gains to new lows in each of the cases.

A stock market roller coaster

Looking to the week ahead, the market reached an oversold condition consistent with a relief rally. While short-term breadth could weakens slightly further, downside risk is relatively limited.

A stock market roller coaster

The hourly S&P 500 chart provides some guides to rally targets. At a minimum, the gap at 3000 should be filled. The 50% retracement level of 3124 had acted at resistance in the past, and the bulls will find it to be a formidable obstacle. Above 3124 is the gap at 3260-3330 that needs to be filled, followed by a test of the old highs. I am not holding my breath for an advance beyond the 50% retracement level.

A stock market roller coaster

My inner investor is adopting a risk-off profile in his portfolio, with an underweight position in equities. My inner trader took and initial long position on Friday. Should the market weaken further early in the week and the market continues to exhibit positive RSI divergences, he will add to his long positions.

Disclosure: Long SPXL

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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