Sunday, July 10, 2016

How to get in on the ground floor of a market bubble

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 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 Model is an asset allocation model which 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. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Neutral*
  • Trading model: Bullish*
The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

A nascent bubble
Cullen Roche wrote an article last week in Marketwatch making the case that the US equity and real estate market is ripe for the formation of a market bubble.
What’s even more interesting is that this environment appears (at least in my view) to be ripe for a financial-asset bubble. That is, as weakness abroad drives yields lower in the U.S., stocks and real estate look increasingly attractive. Stocks have clearly benefited from this “reach for yield,” as have certain types of higher-risk bonds.
Indeed, as government bond yields turn negative around the world, US Treasury assets seem to be the only yield game in town. Investors are rewarded with the additional bonus of steady US growth. Stocks should benefit as falling UST yields translate into P/E expansion.

Roche continued:
But we haven’t seen the big boom in real estate yet (with the exception of, maybe, San Francisco). But could we be there? I am not certain, but here in Southern California the chatter is starting to get a little crazy again. As rents rise rapidly and future returns on stocks and bonds just don’t look that great, many people are turning to real estate.

The other day I was talking to one of the most rational and intelligent guys I have ever known. I was talking about all of this and how absurdly low mortgage rates are. He said: “Yes, that’s why you buy a house in today’s market and then go out and buy another one.” Now, this is an Ivy League econ PhD talking here, not your average stripper circa 2006 from “The Big Short.”

When rational people start saying irrational things, my ears perk up. And it makes me wonder (still) if we’re not on the precipice of something that looks a lot more like 1999 than 2008. Add it all together and it makes you wonder: Are we ripe for a big financial-market bubble, thanks in large part to foreign economic weakness? It might seem paradoxical, but don’t discount that risk.

While a market bubble is not my base case scenario and I don't like to bet on market bubbles because the thesis depends on the Greater Fool Theory of investing, what Roche says deserves some consideration. I would like to expand on the points made and explore how a bubble could form based on the following factors:
  • Better than expected growth
  • Skeptical sentiment turning into greedy sentiment
  • A market friendly Federal Reserve
The full post can be found at our new site here.

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