Sunday, January 21, 2018

Bubbleology 102: What could derail this momentum rally?

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: Bullish*
  • 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.

Looking for the bearish trigger
Last week, I wrote about how the price momentum factor is dominating equity returns (see Bubbleology 101: How to spot the top in a market melt-up). Most intermediate term tops, even with a parabolic market, saw double tops that are marked by negative technical divergences at the second top. As stock prices continue to rise, we have not even seen the first retreat yet.

What is likely to spark the first pullback? Recently, a number of extreme overbought readings have appeared, indicating risk levels last seen before the major market crashes in 1929 and 1987. Callum Thomas highlighted analysis by Sven Henrich, otherwise known as Northman Trader. Henrich found that you would have to go back to pre-crash 1929, before the RSI indicator was invented, to see weekly RSI as high as they are today.

Callum Thomas also highlighted this chart from Ed Yardeni which indicated that the II bull/bear ratio has not seen these heights since pre-crash 1987.

Are the appearance of these ominous signs warnings of an imminent market crash?

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

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