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A classic washout bottom

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 classic washout bottom
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 classic washout bottom
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.
 

Panic and recovery

Last week, I wrote, “A tactical low looks near.,,[but] traders should be open to the possibility that the market may need one final panic for a tradable bottom to appear.” What I didn’t expect was the China Evergrande panic that gripped the market, though the subsequent relief rally was not unexpected. 
The S&P 500 fell -4% from its all-time high and rebounded by the end of the week to regain its 50-day moving average. The VIX Index flashed a buy signal when it rose above its upper Bollinger Band last week. However, traders should be aware of the caveat that rallies can stall once the VIX recycles from above the upper BB to the 20 dma. This scenario is a very real possibility as market jitters over a debt ceiling impasse, Treasury default, and a widespread government shutdown looms ahead.
A classic washout bottom

Capitulation sentiment

There were signs of capitulation level sentiment everywhere. Starting in Hong Kong, where China Evergrande is listed, Jason Goepfert of SentimenTrader documented how the net advance-decline breadth fell to levels seen at short-term lows.
A classic washout bottom
Rob Hanna at Quantifiable Edges wrote that his “Quantifiable Edges Capitulative Breadth Index (CBI), which measures short-term capitulative selling among S&P 100 stocks, closed at 11 on Tuesday and 12 Wednesday”.  Readings of 10 or more have historically been short-term buy signals, especially if the S&P 500 is above its 200 dma.
A classic washout bottom
The NYSE McClellan Oscillator (NYMO) fell to an oversold level last week. With the exception of the COVID Crash, such readings have provided good short-term long entry points for traders in the past.
A classic washout bottom
Credit market risk appetite, as measured by the relative price performance of junk bonds to their duration-equivalent Treasuries, made an all-time high.
A classic washout bottom

Interpreting the yield breakout

As for market leadership, it is noteworthy that the 10-year Treasury yield staged a decisive upside breakout in the wake of the September FOMC meeting, though the 5-year yield had already shown signs of strength.
A classic washout bottom
In the wake of the yield breakout, bear in mind the historical record of sector and industry sensitivity to rising yields has been cyclical and value stocks.
A classic washout bottom
Should yields continue to strengthen, the value stock revival may finally be realized.
A classic washout bottom
In the very short-term, however, breadth is highly extended. Don’t be surprised if the market rally pauses early next week.
A classic washout bottom
In conclusion, the stock market made a classic washout bottom last week. While I wouldn’t necessarily discount the possibility of a pause in the advance, the intermediate-term path of least resistance for stock prices is up.

Disclosure: Long SPXL
 

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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