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Buy the dip, or sell the rip?

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.
 

Buy the dip, or sell the rip?

The latest signals of each model are as follows:

  • Ultimate market timing model: Sell equities
  • Trend Model signal: Bearish
  • Trading model: Neutral

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.
 

Buy or sell?

Looking to the week ahead, the recent market action presents a mixed picture. The SPX, DJIA, and NYSE Composite all broke above their 50 day moving averages (dma), which are positives. But they remain under the broken rising trend lines, which are signs that the bulls have lost control of the tape.
 

Buy the dip, or sell the rip?

Should traders be buying the dips, or selling the rips? Here are the bull and bear cases.
 

Bull case

Let’s start with the bull case. In the last 20 years, the NYSE McClellan Summation Index (NYSI) has never recovered from an oversold condition without bouncing back to an overbought reading (warning, n=2).
 

Buy the dip, or sell the rip?

I wrote about the risks of narrow leadership last week (see Factor review: Narrow leadership and its implications). The leadership of the FANG+ stocks have begun to pause, and other groups, such as small cap stocks are starting to turn up on a relative basis. This could be interpreted as a healthy rotation in an uptrend.
 

Buy the dip, or sell the rip?

The bear case

Here is the bear case. The market is exhibiting signs of bullish exhaustion, as evidenced by a possible stochastic recycle from overbought to neutral territory, which is a sell signal. As well, the NYSE Advance-Decline Line has been lagging the market, which is a negative divergence.
 

Buy the dip, or sell the rip?

Inter-market, or cross-asset, analysis shows that gold, which has acted as a bear market hedge, is holding its upside breakout. Moreover, it is tracing out a bull flag, which is a bullish continuation pattern.
 

Buy the dip, or sell the rip?

Bond prices, which are also hedges against equity declines, staged an upside breakout about a week ago. They pulled back and they are holding below their breakout level.
 

Buy the dip, or sell the rip?

Keep an on on gold and bonds. Bullish breakouts by these assets will represent bearish tripwires for stock prices.
 

Waiting for clarity

My inner trader covered his short positions last week for risk control reasons. He must have displeased the market gods, because stock prices fell sooner afterwards. Despite the late week market weakness, he is still waiting for signs of clarity on short-term market direction.

Short-term breadth, as measured by % of stocks above their 5 dma, is oversold. Looking over a 1-3 day time horizon, the market is due for a bounce.
 

Buy the dip, or sell the rip?

Looking out slightly longer term to the % of stocks above their 10 dma, however, the market is not oversold, and readings are in neutral territory. If the market were to stage a relief rally early in the week, recent episodes of turnarounds with this indicator at similar levels have resolved themselves with further market advances. The weakness late last week could be just a pause within an uptrend.
 

Buy the dip, or sell the rip?

As well, new highs – new lows readings are dead neutral, indicating little momentum.
 

Buy the dip, or sell the rip?

Sentiment readings, such as NAAIM, are normalizing after falling below its lower Bollinger Band, which has been a reasonable buy signal in the past.
 

Buy the dip, or sell the rip?

My inner investor remains cautiously positioned. As I pointed out yesterday (see The recovery scenario), turning bullish at these levels requires too many courageous assumptions about how the global economy is likely to develop.

My inner trader remains on the sidelines in cash, waiting for greater clarity from the tape behavior next week. The risk/reward ratio is unfavorable for taking a directional bet at this stage, especially in light of the high level of uncertainty in today’s volatile environment.

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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