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Prepare for a growth stock correction

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.
Prepare for a growth stock correction
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.
Prepare for a growth stock correction
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.
 

Growth leadership faltering

Changes in macro conditions are setting up for a growth stock correction. The strength in the 10-year Treasury yield is putting downward pressure on growth stock leadership. The growth style is a duration play because it is more sensitive to changes in interest rates than value. 
Prepare for a growth stock correction
In addition, I made the case yesterday for a value style revival which is negative for the growth stock leadership (see Constructive value and reflation green shoots). The blogger Macro Charts also observed that ETF flows indicate crowded long positionings in growth and defensive sectors and capitulation in cyclicals. This sets up the potential for a violent rotation should the cyclical and reflation outlook improve.
Prepare for a growth stock correction

A short-term warning

The stock market may be vulnerable to a short-term setback. The rising correlation between the S&P 500 and VVIX, or the volatility of the VIX Index, is flashing a tactical sell signal. Such correlation spikes have indicated discomfort in the option market with the market advance. In the past three years, similar conditions have resolved themselves with market weakness of about 4-5% two-thirds of the time.
Prepare for a growth stock correction
However, I expect that any S&P 500 pullback should be relatively shallow. The analysis of the relative performance of the top five sectors tells the story of nascent weakness by growth sectors and strength by value stocks. Technology, communication services, and cap-weighted consumer discretionary (Amazon and Tesla) stocks are all either trading sideways or weakening relative to the market. Financials, which is the only value sector, is gaining relative strength, I interpret these conditions as a setup for an internal rotation from growth to value. Since growth stocks have a higher weight in the S&P 500 than value, the rotation may manifest itself as overall minor market weakness.
Prepare for a growth stock correction

Constructive breadth

In other words, the bad news is that growth stocks are weakening. The good news is the weakness is unlikely to significantly drag down the S&P 500 as leadership rotates into value and reflation names. 
That’s because market breadth is starting to improve after a long period of deterioration. The NYSE Advance-Decline Line is rising and testing overhead resistance. The Equal-weighted S&P 500 is outperforming the S&P 500, indicating small and mid-cap relative strength. Market internals, such as the percentage of stocks above their 50 dma, are also recovering.
Prepare for a growth stock correction
Even credit market risk appetite, which measures the relative price performance of junk bonds relative to their duration-equivalent Treasuries, is trying to make a bottom.
Prepare for a growth stock correction

Supportive sentiment

Notwithstanding any weakness by growth stocks, sentiment model readings are likely to put a floor on overall stock prices. Ned Davis Research’s daily sentiment index is only in neutral despite the S&P 500 reaching record highs. The market is climbing the proverbial Wall of Worry.
Prepare for a growth stock correction
Jurien Timmer at Fidelity also observed that “the 12-month rolling net flow into stocks is only now turning positive” after a gargantuan S&P 500 rally.
Prepare for a growth stock correction

Still a bifurcated market

In conclusion, the 2021 stock market has been characterized by a steady advance by the S&P 500. Beneath the surface, the market remains bifurcated between growth and value and internal rotations between the two styles have served to put a floor on overall market weakness. 
Prepare for a growth stock correction
Value is in the process of regaining the leadership baton from growth. I expect that the trajectory of the market to be flat to up. Investors may have to allow for the possibility that the S&P 500 could start to trade flat to down as large-cap growth has a much larger weight in the index than value.
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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