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A question of leadership

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.
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 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.
 

Nagging questions of leadership

It is said that the most bullish thing a market could do is to make fresh highs. An even more bullish development is to see the market break out to fresh highs across all spectrums. Indeed, the large-cap S&P 500, mid-cap S&P 400, small-cap S&P 600, and the NASDAQ Composite has achieved all-time highs.
However, discussions with several readers revealed nagging questions about the quality of the leadership in this advance.

A broad advance?

Conventional breadth analysis leads to a bullish conclusion of a broad advance. The Advance-Decline Lines of the S&P 500, NYSE, and S&P 400 have all made all-time highs. Only the NASDAQ and S&P 600 A-D Lines are lagging. The standard interpretation is that most of the troops are advancing with the generals, which is bullish.
However, a review of the relative performance of the top five sectors reveals a less exciting story. As a reminder, the top five sectors make up about three-quarters of S&P 500 weight and it would be virtually impossible for the index to meaningfully rise or fall without their broad participation. The analysis of the top five sectors shows that technology stocks are in a minor relative uptrend and the cap-weight consumer discretionary sector is surging. However, the relative performance of the equal-weighted consumer discretionary sector, which reflects the breadth of the sector, is much weaker. More disturbing is the relative weakness of communication services, healthcare, and financials. The lack of relative strength in financial stocks is disconcerting in light of the Fed’s dovish taper announcement, which should be bullish for the sector.
A more detailed analysis of large-cap strength shows that the recent advance was attributable to only a handful of stocks. A comparison of the relative strength of consumer discretionary to consumer staple stocks, which is often used as an equity risk appetite indicator, shows that most of the strength can be explained by the gargantuan gains of a single stock, Tesla (TSLA). The equal-weight relative performance of the two sectors (bottom panel), while positive, is less clear-cut bullish.
The recent upside breakout of the Dow Transports to all-time highs can be interpreted as a Dow Theory buy signal. However, the strength in that index is attributable to a surge in the price of Avis (CAR). This is another sign of a single stock pulling up an indicator or index.
Similarly, while the strength in the NASDAQ 100 appears bullish, the relative performance of the equal-weighted to cap-weighted NASDAQ 100 has been tanking, which is another sign of narrowing leadership.

Resolving the doubts

How can investors square the question? Is the leadership broad or narrow and what does it mean for the durability of the current market rally? Both statements can be true. 
  • The stock market is rising with broad participation; and
  • Within large caps, the indices are being pulled up by a handful of speculative names.
I interpret these conditions to mean that the stock market can continue to advance, but investors need to be cautious about excess enthusiasm for soaring single stock stories. This environment has distorted factor returns. In particular, the Fed’s recent dovish taper should be bullish for value and cyclical stocks at the expense of growth. Instead, growth has dominated, but that’s because of a handful of stocks.
Under these circumstances, I am inclined to adopt a balanced approach to leadership of both value and growth with a possible small value tilt.

Trading the melt-up

Putting the concerns about leadership quality aside, confirmations are emerging that the stock market is undergoing a melt-up. The S&P 500 has reached the upper Bollinger Band defined by its 200 dma, which is a telltale sign of a market melt-up. In the past five years, there have been six other instances when this has happened. In five of the six, the market topped out when the 14-day RSI flashed a negative divergence. This is a FOMO stampede. Stay long and buy the dip.
The measured objective from a point and figure chart is 5220, which represents an upside potential of 11% from Friday’s closing price.
In the short-term, however, the market is very overbought and the advance could pause at any time. The 5-day RSI is at an extreme, and the 14-day RSI has risen above 70 where advances have temporarily stalled in the last year. One possible trigger of volatility could be the CPI print on Wednesday.
You can tell a lot about the psychology of a market by how it reacts to news. The House of Representatives passed the Infrastructure Bill late Friday, sending it to Biden’s desk for signature. Keep an eye on infrastructure stocks (PAVE) on Monday. Will they be rising in relief that the legislative impasse is over, or will investors sell the news?
In conclusion, the stock market is following the script for a melt-up into year-end. However, market leadership may be changing as selected speculative issues are leading in a massive way. Investors should be positioned bullishly, but adopt a more balanced approach between value and growth.

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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