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The market endures a summer squall

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.
The market endures a summer squall
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.
The market endures a summer squall
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.
 

A risk-off episode

A week ago, I highlighted the risk of stock market weakness because the correlation between the S&P 500 and VVIX, or the volatility of the VIX, had spiked. The pullback duly arrived and the S&P 500 briefly tested its 50 dma.
The market endures a summer squall
In the past, S&P 500 and VVIX correlation spike sell signal sell-offs have bottomed when the VIX Index spiked above its upper Bollinger Band. Barring a new and unexpected shock, market internals have sufficiently deteriorated that a short-term bottom is near.
If I am right in my tactical assessment, the minor panic last week was just a brief summer squall.

An oversold market

The Zweig Breadth Thrust buy signal is a rare momentum-based buy signal that occurs only once every few years and almost never fails. It requires the market to move from an oversold condition to an overbought reading within 10 trading days. The ZBT Indicator went oversold last Thursday, indicating an oversold condition. While I am not holding my breath for a ZBT buy signal, technical conditions are stretched enough to be consistent with a technically driven market bottom. The only recent exception was the COVID panic of March 2020.
The market endures a summer squall
As well, three of my four trading bottom indicators are flashing buy signals. The 5-day RSI became oversold; the VIX Index rose above its upper Bollinger Band; and the NYSE McClellan Oscillator (NYMO) reached an oversold reading.
The market endures a summer squall
The only exception is the term structure of the VIX, which did not invert to indicate panic. To be sure, while my main indicator of the 1-month to 3-month VIX futures did not invert, the 9-day to 1-month VIX briefly did.
The market endures a summer squall

A sentiment extreme

I also believe the cyclical and reflation trade is due for a rebound. Defensive sentiment is becoming overly stretched. Ben Breitholtz at Arbor Capital recently observed, “The gap between cyclical vs defensive ETF flows rebounding from an extreme. Cyclical IG credits tend to outperform after these extremes.”
The market endures a summer squall

Sector internals favors cyclicals over growth

A brief survey of the market internals of cyclical and growth sectors tells the story. Consider, for example, the performance of material stocks, which is an important cyclical sector. The sector is making saucer-shaped bottoms on both an absolute and market relative basis. In addition, the relative breadth internals has been improving in the past month.
The market endures a summer squall
Industrials stocks is another cyclical sector exhibiting a similar pattern of saucer-shaped absolute and relative bottoms and strong relative breadth internals.
The market endures a summer squall
By contrast, the technology sector, which is the largest growth stock sector in the S&P 500, is testing both absolute and market relative resistance levels while relative breadth internals deteriorate.
The market endures a summer squall
These relative breadth conditions are consistent with the analysis of fund flow data indicating an easing of small cap and value fund redemptions and a rollover of inflows into tech.
The market endures a summer squall

Finally, I offer the cover of Barron’s as a contrarian magazine cover indicator.
 

The market endures a summer squall
In conclusion, short-term market conditions have become sufficiently oversold that, barring an unexpected negative shock, the stock market should rebound. Based on my analysis of market internals, cyclical and reflation sectors are poised to be the next leadership, and growth stocks have become increasingly vulnerable.
Disclosure: Long SPXL
Publication note: I am taking a week off next week. Barring any episodes of market volatility, there will be no mid-week market comment on Wednesday. Regular service will resume next weekend.
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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