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How to spot the correction low

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 that 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

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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 that 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 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.
 

How to spot the correction low
The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • 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 those email alerts is shown here.
 

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

Here comes the pullback

I have been increasingly cautious about the tactical market outlook for the past few weeks (see Take some chips off the table). Last week’s sudden air pocket certainly gave the bulls a fright. Is this the start of a correction, and how can investors and traders spot the bottom?
The daily S&P 500 chart shows that the S&P 500 has definitively violated its rising channel and it is now testing support at the 50-day moving average (dma). The VIX Index spiked above its upper Bollinger Band which signals an oversold condition. The VIX appears to be going on an upper BB ride indicating a more prolonged downdraft.
How to spot the correction low
Looking longer-term, the weekly S&P 500 chart shows that the S&P 500 is just testing its rising trend line. There are nevertheless warnings from the negative 5-week RSI divergence and a rollover in relative strength in the popular ARK Innovation ETF (ARKK).
How to spot the correction low
Should the market weaken in line with the historical experience of the last four years, it would translate into a pullback of 6-12% or 3200-3640 on the S&P 500.

Correction ahead

Last week’s downdraft may be a sign that the long-awaited correction may have begun. The VIX Index spiked over 40% last Wednesday, which is a relatively rare occurrence. If history is any guide the risk/reward of such episodes is not favorable. The market tends to recover in the first week but slides looking out 2-4 weeks.
How to spot the correction low
As well, global breadth and momentum are losing some steam. The percentage of world markets above their 50-day moving averages (dma) peaked and fell to 78%. While this reading is not below the 70% tactical sell signal just yet, it is a warning signal of waning momentum.
How to spot the correction low
Another area of concern is the market response to Q4 earnings season. The market is not rewarding earnings beats. The inability of a market to respond to positive news is another red flag.
How to spot the correction low

Signposts of a bottom

With that preface, these are some of the signposts of a corrective bottom. First, watch for positive or negative divergences in risk appetite. Equity risk appetite can be measured by the ratio of high beta to low volatility stocks, and the equal-weighted consumer discretionary to consumer staple stocks. Right now, they are exhibiting minor negative divergences.
How to spot the correction low
Credit market risk appetite, which can be measured by the relative price performance of high yield (junk) bonds to their duration-equivalent Treasuries and leveraged loans to USTs, are also showing minor negative divergences.
How to spot the correction low
Foreign exchange (FX) market risk appetite can be measured by the inverse of the USD Index, which is also slightly underperforming the S&P 500.
How to spot the correction low
Last week’s initial downdraft took the market to a sufficiently oversold condition on the S&P 500 McClellan Oscillator to signal the start of a correction. However, the weekly chart shown at the top of this publication indicates that the magnitude of past pullbacks has mostly been in the 7-12% range. Last week’s peak-to-trough drawdown was about -4%. If history is any guide, there is more downside risk over the next few weeks.
 
The most likely pattern is a period of choppiness as the market tries to find a bottom. While V-shaped bottoms are always possible, W-shaped bottoms tend to be the norm. In such instances, look for positive divergences after a re-test of the initial low, such as a flat reading or higher low on RSI or the McClellan Oscillator.
How to spot the correction low
Should the market be engulfed by a selling panic, my Trifecta Bottom Spotting Model should flash a buy signal. The three components of this model are:
  • The term structure of the VIX Index: An inverted term structure is a signal of option market fear.
  • NYSE TRIN: A spike above 2 is an indication of a price-insensitive forced liquidation, or a “margin clerk” market.
  • Intermediate-term overbought-oversold indicator: A reading below 0.5 is a signal of an oversold market.
If all three models flash buy signals within a 2-3 days of each other, I call that a Trifecta buy signal. Sometimes just an exacta (two model) signal is good enough for a bottom.
The market flashed an exacta buy signal last Thursday when the VIX term structure inverted and TRIN rose above 2. In all likelihood, that signal should be discounted because of the brief nature of the term structure inversion, and a mean reversion of TRIN. TRIN showed the unusual condition of skidding below 0.5 last Wednesday when the S&P 500 fell -2.6%, indicating a buying stampede. The “buying stampede” and subsequent volatility of TRIN are attributable to the WallStreetBets crowd forcing short-covering of highly shorted stocks like GameStop. This interpretation is confirmed by the buying stampede readings of NASDAQ TRIN and the lack of a NASDAQ TRIN spike during the same period.
How to spot the correction low
Lastly, timing the following tools from Index Indicators can be useful in timing exact bottoms. Watch for oversold conditions on the percentage of S&P 500 stocks above their 5 dma.
How to spot the correction low
Also, keep an eye on the percentage of S&P 500 stocks at their 5-day lows.
How to spot the correction low
W-shaped bottoms will be choppy. The percentage of S&P 500 stocks at their 5-day highs can also be helpful for timing short-term entries and exits for traders who want to reload their short positions. From a tactical perspective, the market is setting up for a bounce early in the week, but too much technical damage has been done and the pullback isn’t over. Any strength would be a good opportunity for traders to short the market in accordance with their risk appetite and preferences.
How to spot the correction low
In conclusion, the market is likely just starting a pullback in the 6-12% range. My base case scenario calls for some choppiness over the next few weeks, which is consistent with NDR’s seasonal analysis. 
How to spot the correction low
To summarize, spotting a corrective bottom involves keeping an eye on the following:
  • Positive and negative divergence in risk appetite indicators;
  • Positive and negative divergences in breadth and momentum indicators like the McClellan Oscillator and RSI;
  • The Trifecta Bottom Spotting Model; and
  • Short-term breadth indicators to time the approximate date of the bottom.
My inner investor is bullishly positioned, but he has selectively sold call options against existing long positions in order to mitigate short-term downside risk. My inner trader is short the S&P 500. 
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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