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Election jitters are rising

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.
 

Election jitters are rising

The latest signals of each model are as follows:

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

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.

Subscribers can access the latest signal in real-time here.
 

More election volatility

While I am not a volatility trader, my recent calls on the evolution of volatility have been on the mark. Three weeks ago, I raised the possibility of a volatility storm (see Volmageddon, or market melt-up?) owing to rising election jitters. I concluded “I would estimate a two-thirds probability of a correction, and one-third probability of a melt-up, but I am keeping an open mind as to the ultimate outcome”. Two weeks ago, I turned more definitive about rising volatility and called for a volatility storm (see Brace for the volatility storm).
The rising election induced volatility theme has become increasingly mainstream in the financial press. Bloomberg highlighted that the one and three month spread in the MOVE Index, which measures bond market volatility, is spiking.
Election jitters are rising
Marketwatch also reported that analysis from BNP Paribas shows that the implied equity market volatility over the election window is sky high compared to past realized returns of election results. 
Election jitters are rising
In addition, all these option readings were taken before the news about the death of Supreme Court Justice Ruth Bader Ginsburg. Should the election results be contested and wind up in the Supreme Court, the odds of a 4-4 deadlocked decision just rose with Ginburg’s death, in which case the lower court’s decision would stand. This raises the odds of judicial and constitutional chaos. Imagine different states with wildly inconsistent decisions on balloting. The Supreme Court nomination fight also raises the political resolve of both sides in Congress. Don’t expect any stimulus bill before the election, and even a Continuing Resolution to fund the federal government beyond September 30 is in jeopardy. Watch for implied volatility to rise in the coming week.
It seems that the bears have taken control of the tape, based on a combination of election uncertainty and a reversal of excessive bullish retail positioning on Big Tech stocks.

Technical breaks

The S&P 500 and NASDAQ 100 are experiencing major technical breaks from both short and intermediate term perspectives, which is leading to the conclusion that the correction isn’t over.
In the short run, the daily chart of the market leadership NASDAQ 100 violated both a rising trend line and its 50 day moving average (dma), which are important levels of psychological and technical support. As Big Tech sectors (technology, communication services, and Amazon) comprise 44% of S&P 500 index weight, weakness in the tech heavy NASDAQ 100 is an important indicator of the direction of the broader market.
Election jitters are rising
The S&P 500 also violated an important rising trend line and exhibited a minor break below its 50 dma.
Election jitters are rising
The weekly chart of the S&P 500 is just as ominous. The index has broken down through a breakout turned support level for two weeks. In addition, the stochastic has recycled from an overbought reading, which is an intermediate term sell signal. 
Election jitters are rising
The weekly chart of the NASDAQ 100 also flashed a similar stochastic sell signal.
Election jitters are rising
These conditions lead me to believe that an intermediate term correction has begun, and will not be complete until the election in early November.

Sentiment still frothy

The second major reason for the bearish break is the unwind of excessive bullish sentiment among retail traders. There has been an explosion of stories about the speculative activity among Robinhood traders due to the attraction of its zero commission policy, and the frenzy has spread to other major online brokerage firms. The froth was quite evident when even TMZ began publishing sponsored articles about day trading.
Election jitters are rising
Moreover, retail call option activity has exploded. An astute reader pointed out analysis from SentimenTrader showing that while retail call volumes have receded, they are still very high and small traders are still very bullish. Despite the pullback in the popular Big Tech stocks, SentimenTrader wrote that bullish sentiment remains elevated and it has not fully capitulated.

Clearly, there was a big pullback in speculative volume last week, dropping off by more than 50% from the upside panic to start September. But when zooming out, we can see that last week was still higher than any previous record high, by far.

Election jitters are rising

An orderly retreat

The market has been devoid of the panic that marks intermediate term bottoms. The Fear and Greed Index is falling, but the reading is only neutral.
Election jitters are rising
The weakness in the NASDAQ 100, which had been the market leadership, is especially disconcerting. BoA pointed out that FANG short interest is extraordinarily low, indicating that short covering demand will not put a floor on these stocks as they weaken.
Election jitters are rising
Moreover, the market’s retreat has been orderly. The percentage of stocks above their 10 dma are in a downward sloping channel of lower lows and lower highs.
Election jitters are rising
Election jitters are rising
In conclusion, the bears have taken control of the tape. Traders should brace for a period of weak and choppy markets until the November election and beyond. Much will depend on the course of electoral fortunes. The Presidential debates lie ahead, and there is always the possibility of an October surprise. Moreover, there is a high level of uncertainty over whether the election results would be contested in the courts, or even worse, in the streets, after November 3. It is therefore difficult to formulate downside target levels, except to say that the combination of sentiment and technical indicators are not pointing to a bottom today.
Disclosure: Long SPXU
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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