Saturday , December 5 2020

Time to de-risk

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.
 

Time to de-risk
The latest signals of each model are as follows:
  • Ultimate market timing model: Sell equities
  • Trend Model signal: Bearish (downgrade)
  • 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.
 

Time to be cautious

This is an out-of-sample application of my Asset Allocation Trend Model signals to a model portfolio. If the Trend Model is bullish, the model portfolio will take a 80% position in SPY (stocks) and 20% position in IEF (bonds), neutral at 60% SPY and 40% IEF, and bearish at 40% SPY and 60% IEF. As the chart shows, the model portfolio has been able to achieve equity-like returns over the test period with balance fund-like risk.
Time to de-risk
The Trend Model’s signal was upgraded to neutral from bearish on May 15, 2020 and it has remained in neutral ever since. Recent developments have caused it to turn more cautious. Here is why.

A tour around the world

The Trend Model applies trend following principles to a variety of equity and commodity prices around the world. There have been numerous technical breakdowns that have sparked general risk-off conditions on a global basis. Let’s take a tour around the world and assess conditions.
Starting in the US, we can see that the S&P 500 and NASDAQ 100 have decisively breached their 50 day moving averages (dma). While the NASDAQ 100 is trying to consolidate sideways, the small cap S&P 600 is even weaker, as it is trading below both its 50 and 200 dma.
Time to de-risk
Across the Atlantic, the Euro STOXX 50 has also breached both its 50 and 200 dma. The other major core and peripheral stock markets are also showing signs of weakness.
Time to de-risk
Across the English Channel, both the large cap FTSE 100 and small cap FTSE 250 are showing signs of weakness. The relative performance of the FTSE 250 to FTSE 100 has pulled back to test a relative support level, largely over increasing anxiety about the collapse in Brexit talks.
Time to de-risk
Over in Asia, the performance of China and the markets of her major Asian trading partners are also weak. The Chinese stock market is dominated mainly by retail investors, who treat it like a casino. That’s why I focus mainly on the signals from the other Asian markets. All of them are showing differing signs of weakness. In particular, the downside support violations in Hong Kong and Taiwan are especially ominous.
Time to de-risk
Cracks are showing up again in the mountain of debt in China. The plight of China’s largest property developer, China Evergrande, may be the canary in the Chinese coalmine. Reuters reported that Evergrande, which is highly indebted, pleaded with local authorities for debt support:

The time has come for China to confront a too-big-to-fail quandary. In a letter to local government officials, highly indebted property developer China Evergrande contends that if it doesn’t secure approval soon for its reverse merger plan, it will wreak widespread havoc. Although the company says the missive is fake, the questions in it regarding systemic risk are real for investors and Beijing.

Evergrande beseeched officials in its home province of Guangdong for assistance with a so-called back-door listing, according to a copy of the Aug. 24 letter, whose authenticity was confirmed by Reuters sources. The idea, first proposed as part of an October 2016 restructuring, was for subsidiary Hengda to combine with a publicly traded state developer. If the deal doesn’t happen by January 2021, a group of investors can demand repayment of some 144 billion yuan, or about $21 billion, all of Evergrande’s cash as of June 30.

Time to de-risk
The one bright spot in Asia is Japan. The Nikkei Index price pattern remains constructive. However, there are three major trading blocs in the world, anchored by the US, Europe, and China. Japan is becoming a peripheral player from a global perspective.
Time to de-risk
Commodity prices can also be an important signal of global reflation or deflation. The message from commodities is one of caution. The Invesco-DB Commodity Index, as represented by the ETF DBC, has breached both its 50 and 200 dma. Gold prices have weakened in response to falling inflation expectations as hope fades for a fiscal response from Congress. The cyclically sensitive copper price has retreated to test its 50 dma.
Time to de-risk

A change in tone

The tone of the market seems to be changing, and such changes are often characterized by a shift in leadership. The old leadership is faltering, but no new market leaders have emerged. 
From a global perspective, the old US leadership has plateaued and begun to trade sideways (top panel), but none of the other major regions have emerged to be the new market leaders.
Time to de-risk
From a trend following viewpoint, these are all signs of a change in global trends. Coupled with a general weak tone in global equity and commodity prices, it is time for asset allocators to adopt a more cautious tone and de-risk portfolios. This cautious signal is also consistent with my past observation of a bearish 14-month RSI negative divergence in the Wilshire 5000, just after it flashed a bullish MACD buy signal. As a reminder, the last RSI divergence sell signal occurred in August 2018 (see Market top ahead? My inner investor turns cautious), which resolved with a mini-bear market that ended with the Christmas Eve panic of 2018.
Time to de-risk
The key risk to the bearish call is that the Trend Model is already too late in its cautiousness. SentimenTrader pointed out that large speculators and trend following CTAs are already in a crowded short in equity futures, which is contrarian bullish. 
Time to de-risk

However, analysis from Callum Thomas showed that when futures positions are normalized for open interest, the net short speculative position isn’t as severe. In fact, large speculators were correct in their positioning at market extremes during and before the GFC.

Time to de-risk

_(ツ)_/¯

Trend following models, by their nature, are slow to react to trends. They tend to be late, and they will never get you in and out at the exact top and bottom. This is a feature and not a bug. Investors therefore need to be prepared for relief rallies in the short run. Nothing goes up or down in a straight line.

The week ahead

The market faces a critical technical test early in the week. The market leadership NASDAQ 100 is testing overhead resistance at the 50 dma. The bulls need to demonstrate some momentum to show that they are regaining control of the tape. The bears need to hold the line at the 50 dma, and preferably to push relative returns below the rising trend line.
Time to de-risk
The bulls will have a tough task ahead of them. The market is already overbought on the percentage of NDX stocks above their 5 dma. 
Time to de-risk
The percentage of NDX above their 10 dma remains in a falling channel of lower lows and lower highs. A decisive upside breakout will be a positive development.
Time to de-risk
In terms of event risk, we have the first scheduled debate between Biden and Trump on Tuesday, September 29. As there are very few undecided voters in this polarized electorate, the debate is unlikely to move the needle, but there is always the possibility of a stumble by one or both candidates. In addition, there is a flood of Fed speakers, and the September Jobs Report is due on Friday.
In conclusion, a review of global equity and commodity markets reveals a growing risk-off trend, which is a signal for investors to be more cautious in their asset allocation. This bearish signal is confirmed by a monthly RSI negative divergence sell signal that was triggered in August 2018, just before the market fell by -20% into the Christmas Eve panic bottom of that year. In the short run, the market may be too stretched to the downside, and a relief rally is always possible. Nothing goes up or down in a straight line but the risk/reward is tilted to the downside.
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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