Sunday, October 1, 2017

Buy the breakout?

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: Bearish*
* 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.

A typical late cycle advance
In a recent post (see Equity lessons from the bond market), I urged equity investors to monitor the signals from the bond market as they contained important and often overlooked information about the future direction of stock prices. In particular, the yield curve was an important indicator, as past instances of an inverted yield curve, where short rates trade above long rates, was an uncanny signal of recession, and equity bear markets.

While the shape of the yield curve is an important indicator, I may have discovered an indicator that leads the yield curve signal. As the chart below shows, the copper/CRB ratio has risen strongly ahead of yield curve inversions in the last two cycles. The copper/CRB ratio is valuable because copper is a cyclically sensitive commodity, and the ratio filters out the noise from changes in overall commodity prices.

This ratio has worked well in both disinflationary and inflationary eras. The top in the late 1990's was a disinflationary period characterized by falling commodity prices (see bottom panel). But the copper/CRB ratio rallied out of a relative downtrend (green line, middle panel) just before the yield curve inverted (top panel). During the inflationary era that ended in 2007-08, the copper/CRB ratio flashed a parabolic climb ahead of the last yield curve inversion.

Fast forward to 2017. The copper/CRB ratio has staged a relative breakout in late 2016 and early 2017 and roared ahead, which is an indication of a late cycle blow-off. The yield curve has not inverted yet, and it may not necessarily invert this cycle because of the Fed's extraordinary measures of the past few years. By the Fed's own estimates, its QE program has depressed the term premium on the 10-year Treasury note by 100 basis points. Unwinding QE will put upward pressure on long dated yields, which has the effect of delaying an inversion signal - until it's too late.

The analysis of sector and industry rotation confirms the thesis of a late cycle rotation. The Relative Rotation Graph (RRG) is a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again. The latest RRG chart of the US market shows leadership by late cycle inflation hedge groups such as energy, mining, and gold stocks.

The same pattern of inflation hedge leadership can also be found in Europe. While US technology has revived and revised into the top right leadership quadrant, European technology stocks have weakened, which makes the tech rally suspect.

In short, the current market action has the feel of a bull market blow-off top. For investors and traders, the question is whether they should jump on the rally, with an emphasis on inflation hedge groups. This week, I examine the bull and bear cases, first for the equity market, then address the question of sector exposure.

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

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