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A range-bound August?

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. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here. My inner trader uses a trading model, which is a blend of price

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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. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.
A range-bound August?
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 is 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 range-bound August?
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.
 

A holding pattern

Regular readers will know that I have been calling for a sideways holding pattern for the S&P 500. That remains my base case scenario for the rest of August. Continuing concerns about the Delta variant stalling growth are likely to put downward pressure on risk appetite. On the other hand, an improving EPS growth outlook is putting a floor on stock prices.
A range-bound August?
To be sure, the S&P 500 made a marginal new high on Friday, but the market’s less than enthusiastic reception to Friday’s strong jobs report is indicative of the market’s internals and makes my case that the stock market is likely to be range-bound. On the surface, the S&P 500 advance. Looking under the hood, the yield curve steepened and cyclical and value stocks rallied, while growth stocks fell.

The virus: Good news and bad news

I have some good news and bad news about COVID-19. The bad news is well-known. Almost every day, the media is full of stories about rising infections, especially among the unvaccinated. Events are being cancelled and people are forced to change their behavior. The good news that is US vaccination rates are slowly rising, and the virulent Delta variant has shown itself to peak after two months.
The accompanying chart shows the progress of new case counts per million in India, where the Delta variant first appeared and there were few vaccinated people, and in the UK, which is struggling with the Delta variant but has a highly vaccinated population. In both instances, the infection rate peaks about two months after it first appeared. The rise and fall in the UK case count was steeper than India’s, likely owing to the higher British vaccination rate. In the US, the duration of the ascent in case counts has been a month. Using the India and UK as templates, this puts the US peak in about early September.
A range-bound August?
The markets have responded cautiously to these developments. The relative performance of cyclical sectors and industries have stopped falling and they are moving sideways. I interpret these conditions as the market believes the worlds of the growth pause is over, but it is waiting for a new catalyst before launching a new bullish or bearish impulse.
A range-bound August?

Stellar Q2 earnings

Another bullish consideration is the strength of Q2 earnings results. Both the EPS and sales beat rates are astoundingly high by historical standards and the EPS beat rate would be the highest on record since FactSet started maintaining statistics in 2008. As a consequence, forward 12-month EPS estimates are surging.
A range-bound August?
If earnings estimates rise and prices are stable, the forward P/E ratio declines. So far, the S&P 500 forward P/E is nearing the bottom of its post-COVID range, which makes the market more attractive, especially in light of a falling 10-year Treasury yield.
A range-bound August?

Uncertain leadership

My analysis of the relative performance of the top five sectors of the S&P 500 reveals a story of uncertain leadership. The top five sectors comprise about 75% of index weight and it would be difficult for the market to either rally or drop without the participation of a majority. Of the top five sectors, only healthcare could be described as exhibiting positive relative performance in the last month. The rest are mostly trading sideways or slightly weak compared to the S&P 500.
A range-bound August?
These conditions indicate that the market is marking time and waiting for either a bullish or bearish catalyst. I am reserving judgment until the Russell 2000 breaks out of its tight range. One hopeful sign for the bulls is the Russell 2000 to S&P 500 ratio may be trying to turn up against the S&P 500.
A range-bound August?
Similarly, the value and growth cycle has been trading sideways in the last month.
A range-bound August?
The most likely scenario is a continued sideways pattern for another month until it becomes evident that the worst of the Delta variant has run its course, which would be followed by a cyclical and value stock rally. The bearish scenario is a legislative impasse in Washington, either over the debt ceiling or the infrastructure bill. In that case, watch for renewed concerns over economic growth, dovish Fed, falling bond yields, and rising risk aversion.
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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