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In search of the next bearish catalyst

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.
 

Another leg down?

Here is some good news and bad news. The good news is that the S&P 500 tested its 50-day moving average (dma) while exhibiting a positive 5-day RSI divergence. That’s bullish, right?
The bad news is the same pattern occurred during the COVID Crash of 2020. Even though RSI showed a series of higher lows and higher highs, the market continued to fall after a brief relief rally.
The moral of this story is that RSI divergences can be more persistent than you expect. Will history repeat itself? Will the market experience another leg down?

Similarities and differences

Here is what is similar and different between 2020 and today.The market is severely oversold today. All of my market bottom models have flashed buy signals in the past week. But oversold markets can become even more oversold, which is exactly what happened during the COVID Crash of 2020.
As the market became oversold in 2020, selling was sparked by further bad news. Global markets were suddenly faced with an exogenous shock. A pandemic had gripped the world. While initial models had penciled in a SARS-like outcome, the reality was actually far worse. There were no treatments. China reacted by shutting down its economy. The global economy was collapsing.
Here is what’s different today. The markets were surprised by the appearance of a new variant and a hawkish pivot from the Federal Reserve. The markets are already oversold. What’s the next shoe to drop that could spark another down leg?
Omicron running out of control? The latest mRNA technology allows pharmaceutical companies to re-program vaccines quickly. In the worst case, a new vaccine could be available within 3-4 months, depending on testing and the regulatory approval process.
Government shutdown? House and Senate leaders came to an agreement to continue to fund the US government until February. Crisis averted.
A hawkish Fed? The yield curve flattened in the wake of the November Jobs report, indicating that the market believes economic growth is decelerating and a probable Fed policy mistake.
I know I am tempting fate by asking this question. What’s the worst thing that could happen? The market is already oversold. Oversold markets become more oversold from existential bearish catalysts such as a Russia Crisis, a Lehman collapse that threatens the global financial system, or an unexpected pandemic that shuts down the global economy. What else could go wrong?
Otherwise, this market weakness is just a temporary panic and a buying opportunity.

Poised for a rally

Last week, I observed that the market was oversold, but upon further investigation, sentiment was still complacent. Most traders expected the market to rally after the Black Friday downdraft.
This week, the market became even more oversold. Ed Clissold of Ned Davis Research observed that 7.0% of S&P 500 stocks were above their 10 dma, which is below the 7.7% oversold threshold level. Forward returns have historically been strong after similar signals.
More importantly, evidence of panic is appearing in the markets. The markets are extremely jittery. The Bollinger Band of the VIX Index has spiked above 90. While similar readings have not marked exact market bottoms in the past, they do indicate a heightened state of anxiety.
The put/call ratio has risen to levels consistent with fear.
As well, insider buying is starting to look constructive, though this indicator is an inexact market timing tool.
Another constructive sign is selling pressure may be abating on NYSE stocks. NYSE new lows peaked on November 30, just before the S&P 500 tested its 50 dma. However, NASDAQ new lows are still expanding, which is still bearish. Viewed through a style lens, this is bullish for value (NYSE) over growth (NASDAQ).
In short, the stock market is sufficiently oversold and washed out that a meaningful relief rally is imminent.

Looking for opportunity

Under a relief rally scenario, where are the greatest opportunities?
The most straightforward way to benefit would be to buy S&P 500 exposure in anticipation of a rebound. A most speculative way to participate would be small-cap stocks. Small-caps are washed out and hated. The small-cap indices staged a failed upside breakout and they are approaching the bottom of their trading range that has been in place for most of this year. Watch for additional selling pressure in the next few weeks as investors harvest tax losses for 2021. Buy them in anticipation of a year-end relief rally into early January.
Mark Hulbert recently cited a study showing that December tax-loss sale candidates usually turn into January winners. This Santa Claus effect begins just after Christmas and lasts into the new year.
Notwithstanding the tax-loss selling scenario, portfolio manager Steve Deppe conducted a historical study of the Russell 2000 when the index reached an all-time high weekly close followed by a three-week losing streak. While the sample size is small (n=8), the index has never closed lower a month later.
In conclusion, the stock market is oversold and there are signs of capitulation. Barring another major negative shock, the market is poised for a relief rally into year-end and possibly January. Small-caps are washed out and could prove to be a worthwhile speculative buy as a way of taking advantage of the Santa Claus rally seasonal pattern.
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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