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As good as it gets?

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.

 
As good as it gets?
The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities
  • Trend Model signal: Bullish
  • 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 those email alerts is shown here.
 

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

What’s wrong with this picture?

The six biggest stocks in the S&P 500 reported earnings last week. Every one of them beat consensus expectations. In addition, the FOMC reiterated its dovish stance after its meeting. These developments should all be bullish. Instead, the S&P 500 only made marginal gains while exhibiting negative divergences.
As good as it gets?
From a longer term perspective, the weekly S&P 500 chart shows the index recycling after overrunning  a rising trend line indicating a possible blow-off top. The S&P 500 then printed two consecutive weekly doji candles, each of which are signs of indecision.
As good as it gets?
What’s wrong with this picture?

A failure of leadership?

Where’s the leadership? The top five sectors of the S&P 500 comprise 74% of index weight and it would be difficult for the market to move significantly without the participation of a majority of these sectors. Of the five, the top three sectors are showing flat to declining relative strength, while the bottom two are showing some strength, but in a choppy fashion.
As good as it gets?
The leadership of high-beta growth stocks is narrowing. Even as the NASDAQ 100 is barely holding above a key support level, the high-octane ARK Innovations ETF (ARKK) is struggling to hold a relative support zone when measured against the S&P 500.
As good as it gets?
Sustained bullish advances simply don’t behave this way.

A tiring bull

Instead, this market looks like a tiring bull. Ryan Detrick of LPL Financial highlighted the pattern of major market recoveries, in 1982 and 2009. If history is any guide, the market is due to take a breather.
As good as it gets?
While history doesn’t repeat but rhymes, the key difference between today and the past may be higher volatility. Tracy Alloway recently wrote a Bloomberg column about the higher propensity of investors to herd today compared to the past [emphasis added].
 
It’s the 10th anniversary of “Margin Call” and yesterday I hosted a live chat with its director, J.C. Chandor, as well as Citigroup strategist Matt King. The film traces a blow-up at a big bank that’s reminiscent of what happened in the 2008 subprime crisis. King famously penned a research note just before the collapse of Lehman Brothers, arguing that the big problem for U.S. banks was short-term funding secured by subprime and other collateral.  
In “Margin Call,” the bank’s senior executives don’t realize they’re sitting on a powder keg until a junior risk manager stumbles on the numbers by chance. That scenario always seemed a little far-fetched to me, but King brought up some anecdotes from 2008 that showed just how much senior leaders seemed to be unaware of the scale of the problem they faced. As he put it:
“I myself remember having a conversation with desk heads in early 2008 on CDOs of asset-backed securities, and they were being relatively incredulous at the idea that if the junior tranches went, the whole structure was likely to go (I actually wrote another research piece that hardly anyone remembers!)” 
So how much has changed on Wall Street in the past decade? We recently saw banks handle another — albeit much smaller — blow-up in the form of Archegos. There were huge losses from that but no broader contagion, a testament to post-crisis regulation on capital and leverage. Is the system safer? King argues that there are some things that give him pause in the current environment, notably the March 2020 drama in the world’s biggest funding market:
“More subtly but just as importantly, what the periodic bouts of illiquidity in Treasuries are suggestive of is investor herding. The real recipe for a liquid and stable market is a heterogeneous market: Buyers and sellers, bottom-up investors and top-down investors, mark-to-market investors and buy-and-hold investors.
Somehow what we seem to have done post-2008 is to take a whole load of steps, which are individually designed to make the system safer, but collectively have killed off that heterogeneity and made for one-sided markets. The bottom-up, value-based, non-mark-to-market investor — they’ve been killed off by a decade of quantitative easing making everything more expensive and by regulators demanding everyone take a risk-based approach to capital. That gives you a market in which investors get herded into a broad-based reach for yield that they don’t really believe in. And that gives you those pockets of illiquidity: We don’t get one and two-standard-deviation movements any more — we either get zero or we get 16.” 

Weak, but not catastrophic

A review of market internals shows some signs of weakness, but nothing catastrophic. Value stocks are recovering against growth stocks, indicating that Big Tech leadership may be past its best before date.
As good as it gets?
That’s somewhat problematic for the S&P 500 because the weight of growth sectors is 10% greater than the weight of value sectors.
As good as it gets?

On a relative basis, defensive sectors are not acting well, indicating that the bears haven’t seized control of the tape.
 

As good as it gets?
One warning comes from the performance of semiconductors, which are growth cyclicals that should be benefiting from the widespread accounts of chip shortages. These stocks violated a key relative uptrend, which may turn out to be an important risk-off signal. The break is more clearly defined when the SOX is charted relative to the NASDAQ 100.
As good as it gets?
In conclusion, the tone of the recent market action looks like a tiring bull. The stock market has begun to consolidate and take a breather about now in the history of past major rallies off recessionary bottoms. Value continues to dominate growth, and investors should be able to find better returns in value stocks during this period. 
There is no need to panic just yet. The bears haven’t taken control of the tape, but this may be a good time to tactically reduce some equity risk.
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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