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A blow-off top ahead?

Summary:
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

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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.

 
A blow-off top ahead?
The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • 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 those email alerts is shown here.
 

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

Setting up for a blow-off top

The S&P 500 has been rising steadily since late February. As the stock market advanced, readings became increasingly overbought. The S&P 500 has spent two consecutive weeks above its weekly Bollinger Band (BB). Past upper BB episodes have tended to be signals of positive momentum. that led to further gains. The market spent several months on an upper BB ride in late 2017 and early 2018 before it finally topped out.
A blow-off top ahead?
It appears the S&P 500 is undergoing another melt-up, with a blow-off top ahead. In the last four years, overruns of a rising trend line have been signals of an imminent blow-off top that lasts no more than two weeks.
A closeup look at the S&P 500 daily chart shows more details. The index has overrun rising trend line resistance, which happened twice since the March low. The market topped out after prices went parabolic within a week of the overruns.
A blow-off top ahead?

Sentiment not stretched

While the recent historical evidence points to a market top in the middle of next week, the rally could run a little further because a number of key sentiment models are not overly stretched. In particular, the Goldman Sentiment Indicator, which measures positioning instead of just opinion, took a step back from “stretched” territory indicating further room for equities to advance.
A blow-off top ahead?
A blow-off top ahead?

Time for a pause?

The big picture points to a temporary pause in the advance. I have highlighted this analysis in the past. The percentage of S&P 500 stocks above their 200 dma is well over 90%, and such readings have been “good overbought” signals that resolved in steady multi-week advances. The rallies usually did not pause or terminate until the 14-week RSI cross the 70 overbought level, which it did last week.
A blow-off top ahead?
As for the timing of a top, my working hypothesis is the next one or two weeks. Technical analyst Dean Christians recently pointed out that “the percentage of S&P 500 members trading above their respective 50-day moving average registered an overbought momentum buy signal on the close of trading on 4/8/21. The table below contains all signals that occurred at a 252-day.” As this signal was triggered on April 8, 2021, the historical study (n=22) shows that returns peak out between two weeks and a month after the signal. If history is any guide, this puts the timing of a peak sometime in late April or early May.
A blow-off top ahead?

A rotation update

  • An opportunity to lighten up on growth stocks;
  • An opportunity to buy into value stocks; 
  • A bond market rally; and
  • A possible bullish setup for gold and gold stocks.
Those setups have generally worked well. First, I had pointed out that value stocks had become severely oversold against growth stocks and due for a rebound. The value/growth ratio has recycled off an oversold reading and value appears to be headed for renewed leadership after several weeks of relative weakness.
A blow-off top ahead?
I also observed that the bond market was poised for a rally, and bond price duly rebounded. You can tell the character of a market by the way it responds to news. Last Thursday, initial jobless claims dropped by an astounding -193,000, blowout prints in retail sales, NY Empire Manufacturing, and Philly Fed Manufacturing. The market reaction was a decline in the 10-year Treasury yield. Bond yields appear to be ready to fall and prices appear to be ready to rise. The risk is this is just a countertrend move and yields are tracing out bull flags they way they did in the last few months.
A blow-off top ahead?
Lastly, I had highlighted a bull flag in gold mining stocks (GDX). GDX staged an upside breakout from the bull flag – a buy signal.
A blow-off top ahead?

Waiting for the top

My base case scenario calls for a possible buying frenzy that traders should sell into. There is no need to panic just yet. The relative strength of defensive sectors have mostly bottomed out and they are trading sideways. However, none have begun relative uptrends that would be cautionary signals.
A blow-off top ahead?
Despite my caution, I expect any weakness to be no more than 5-10%. This is still a bull market. Both the Dow Jones Industrials and Transports have achieved fresh all-time highs, which are classic Dow Theory buy signals indicating the long-term trend is up.
A blow-off top ahead?
Investors should view any weakness as buying opportunities. Traders should be positioned for a possible blow-off top, followed by a sharp pullback of no more than 5-10%.
Disclosure: Long IJS
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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