Sunday, August 20, 2017

Imagining the next bear market

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 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 the 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 mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

What will the next bear market look like?
Recently, Lawrence Hamtil of Fortune Financial wrote an article entitled "Imagining the next bear market (with examples from the last two)". He analyzed the effects of sector performance, large and small cap returns, asset correlations, and other characteristics of the last two two equity bears.

While that kind of analysis represents a good starting point, we know that history doesn't repeat, but rhymes. With that in mind, here is an examination of the stress points of the next bear market, based on the assumption that it is sparked by a recession.

My main focus estimating equity downside risk. What will the next bear market look like (chart bars =annual returns, dots=annual drawdowns)? Will the recession be mild (1990), or long and protracted (1980-82, 2000-02)? Will the market crash? If so, will it be accompanied by a recession (2008) or not (1987)?

Recessions are periods when the excesses of the past expansions are unwound. Arguably, there have been few excesses in the current expansion except for the proliferation of Silicon Valley unicorns. That argues for a shallow bear market with a drawdown in the order of 20%, such as 1990. On the other hand, the excesses have occurred outside the US (see Looking for froth in the wrong places), which makes the case for higher losses if the economic downturn is global.

The answer can be found by analyzing the fault lines of the economy today for clues of how the next recession might develop.

The full post can be found at our new site here.

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